The Asian Financial Crisis in 1997 encouraged China’s leadership to embark on true financial reform, write Carl Walter and Fraser Howie in Red Capitalism. The crisis of 2008 has had the opposite effect: Rather than awaken the leadership to the dangers of half-finished reforms, it has instilled them with a sense of security regarding China’s financial strength.
This strength, the authors argue, does not go far beneath the surface. Since 2005, both China and foreign investors have bought into and fed the Chinese growth story, putting money into equities that are not backed by assets. They have been rewarded with healthy returns but not necessarily equivalent value. In other words, they have not yet learned the lesson any seasoned gambler eventually learns: sooner or later luck turns.
Walter and Howie are veterans of China’s financial circles. Walter lives in Beijing and has been at the front line of many of the country’s reforms, including the first overseas initial public offering and the first listing of a state-owned enterprise in New York. Howie moved to China in 1998 and is now the managing director of regional brokerage CLSA in Singapore.
This is their second collaboration. Their first book in 2005, Privatizing China, was an incisive history of the birth of China’s stock markets.
Concise and erudite, Red Capitalism is a fantastic deep dive into China’s structurally flawed financial system. China’s leaders, the authors note, are past masters of navigating surface waters and of burying their mistakes in the sands of time. And on the surface, the country has come out of the global financial crisis stronger than ever. These appearances are deceiving.
Equities markets are nowhere near as open as they seem at first glance. The country’s seemingly unassailable economic strength hides significant actual debt levels. Economic growth is based on bank financing, which depends on savings, which depends on economic growth. It’s a vicious circle of dependency that works well as long as the growth doesn’t stop and the banks are kept afloat. Banks are the linchpins – they are China’s financial system. Walter and Howie underline their importance early on.
China’s big four banks are now among the largest in the world and have attracted heavyweight investors, never mind that recapitalizing them is a once-in-a-decade ritual, that they remain tools of the state and that their public floats are a carefully constructed fiction.
Between 2004 and 2008, bank IPOs in Hong Kong and Shanghai raised about US$42 billion. In the same period, they paid out exactly that amount in dividends. The money raised in IPOs paid for only a fraction of the banks’ total shares, since the government held on to a majority. At the same time, dividends were paid mostly to the government – meaning that money raised from foreign investors through IPOs has gone straight to government coffers, rather than create any value in the institutions themselves.
Father of reform
It didn’t have to be this way. Zhu Rongji, whom the authors call China’s greatest reformer, got things rolling with a comprehensive cleanup of the banking sector in the 1990s. But despite his impressive drive, the reforms he came to embody were stalled by infighting and the new generation of leaders, technocrats with limited financial understanding. Zhu’s reforms were a good and necessary start but the lack of follow-through has put progress in jeopardy.
In no small part, this is because China’s financial reforms are principally directed inward. For the ruling Communist Party, the main aim of all reforms is to strengthen the Chinese economy and its stature. Integration into the global economy is a by-product.
Not all is bad news. China has been good at making mistakes and learning from them. Through trial and error, the government has managed to incorporate enough sound policies to prop up the system – maybe just enough.
Red Capitalism is not a call for panic, but it does raise serious doubts about the truth behind the financial strength that China portrays. Its clear explanations make it easy to imagine, at any given moment, a couple of unhappy coincidences toppling the whole house of cards.