Book Summary: Red Capitalism

Book: Red Capitalism – the fragile financial foundation of China’s extraordinary rise

Author: Carl E. Walter and Fraser J.T. Howie

Key takeaways:

This is a pretty tough book to get through if you’re not familiar with how a “normal” banking system is supposed to work, but the effort is well worth it. My notes here are so copious because every little context is important to understand why something was done, as on the face of it, the reasons are inexplicable.


How the System is Designed: China’s financial system is dominated by the Big 4 banks, which account for 70% of the $11T controlled by state-owned commercial banks, and 43% of China’s total financial assets. Of the remaining 57%, PBOC is a concentrated major player (21% of total financial assets, at $3.3T of the $16T financial assets, as of ’09); this means that about 2/3rd of China’s financial assets are in 5 banks–PBOC and the Big 4. Framework of the current financial system was set in early 1990s by Jiang Zemin and Zhu Rongji, with the Shanghai and Shenzhen stock exchanges being one of the biggest symbols (both set up in last days of 1990). Reform was strengthened in 1997 after the Asian financial crisis when the banks were recapitalized  ($400 bn bad loans were transferred to bad banks in 2000 and 2003).

The Chinese financial system is designed so that no one can take a position  opposite to that of the government, and is designed to be secluded from the world market (minimal foreign participation, few foreign assets except U.S. Treasuries and commodity investments that will never be marked to market or sold). The fact that it is designed so that no one can take a position opposite to that of the government is not surprising given that Chinese political construct is essentially a family business, who agreed to a big restructuring initiative after the biggest corporate bankruptcy in China (GITIC) and the Asian financial crisis in ’98.

It is worth remembering that China’s world-beating export machine is run from Guangdong and Yangzi River Delta (both together account for 70%+ of China’s FDI and exports), and the state is mostly absent here, with foreign-invested and private sector dominating these two areas. Money from FDI has mostly gone in this area, while the money raised on the domestic (and foreign) capital markets have been gone to SOEs . These two regions constitute one of the two distinct economies that exist in China–the other being domestic-oriented state-owned economy (“inside the system”); this is the foundation of post-’79 political structure and wall behind which the party protects itself and sustains its rule.

History of Reforms:

Stage 1 : 1978/79 – 1990

At the end of the Cultural Revolution in 1976, there were no functioning banks or financial system; there was MOF, a few small banks controlled by the local governments and no independent central bank (PBOC was a  staffed with 80 people, inside MOF). From this small group of 80, a wave of institution building began, and by 1988, there were 20 banking institutions, 745 trust and investment cos and unkown number of small finance cos. The banks’ mandate was economic growth coupled with stable currency, but the former always won out; in fact, PBOC’s key officers were at the province level (who always need more money). This led to spectacular lending booms and busts including the Great Hainan Real Estate Bust of 1993.

Stage 2: 1990 – 2002/03

In 1990, it was decided that capitalist financial system be favored over the Soviet-style financial system before; in ’94, American model was adopted (independent central bank, transformation of the 4 state banks into commercial banks, among other regulations). The leadership was sidetracked because of a raging inflation, but the Asian financial crisis and collapse of GITIC in ’98 and ’99 catalyzed a strong effort to transform the banks. Rongji tried to expose more and more of the banking system to international rules and regulations despite the Party’s preference for outright control (because they know how important the banks remain to the economy).

GITIC Collapse: GITIC, which collapsed in ’98 due to its inability to pay $120m in loans to foreign lenders and remains the country’s largest bankruptcy, could not be contained within China because it and Guangdong were exposed to the global economy. What was interesting that post-bankruptcy, the recovery rate for GITIC alone was a shocking 12.5% and 12-28% for its 3 subs; the money went to finance real-estate and infrastructure projects owned by other governments that do not have any immediate cash-flow to support these investments (this is no different from what it is today).

Hainan Real Estate Bust: Before the GITIC collapse, China did have a come-to-Jesus moment in Hainan Real Estate Bust. In Apr ’88, the island province of Hainan had been made into a SEZ, and trust companies sprouted to become the sole financial system there; speculation on land soared, and 20,000 real estate companies–1 for every 80 people on the island came into existence and when it all came to end in 1993, the publicized bad debt was 10% of the national budget (this kind of party-driven bank lending continues to exist). Because this was “inside the system” this was swallowed up, though it led to the first effort to build a good bank/bad bank system in ’94.

Birth of AMCs (partial restructuring): In the aftermath of the Asian financial crisis, the first step was MOF injecting cash into the banks in ’98, after which the good bank/bad bank system was started in ’99, with Asset Management Companies (AMCs) taking over the bad loans. To get an idea of how bad things had gotten, in 1999, the NPL ratio of the Big 4 banks was 39% (!). From 1999-2008, $480 bn of bad loans were restructured (not written off); it is assumed that bulk of these loans were written up in late 80s and early 90s, or about 20% of the GDP between 1988-1993, the year Rongji started applying brakes, and the recovery rate again was 20% (compared to 60% in the U.S. S&L crisis). It is very important to remember that as the bad loans were transferred off to these Asset Management Companies, they were not written off. They continue to be held on to the balance sheet of the banks at par as investment receivables that are due from these AMCs. To repeat, this arrangement continued to this day. As of 12/31/12, per ICBC’s annual report, Restructuring-related Receivables were 364,715m RMB, and Net Core Capital is 1,010,463m RMB, which means that the bad-bank assets constitute 36% of the total ICBC’s capital, not to say any other NPLs that the bank may have borne out of its good-bank B/S.

There’s an even bigger scandal in the way the money was found to recapitalize the banks. In 1998, when the banks had not subjected to meaningful professional auditing standard, no even knew what an adequate capital ratio would look like and so they simply picked the Basel standard of 8%, which meant that $35bn was needed (25% of foreign reserves and 4% of GDP in ’98–a large number). To achieve this, MOF nationalized savings deposits belonging to the Chinese people. This was done in two steps–in step 1, PBOC lowered the deposit to reserve ratio from 13% to 8%, just enough to free up the $35bn needed and these deposit reserves were used to buy Special Purpose MOF bonds. The MOF, in turn, used the same money that they got from banks as proceeds of these special purpose bonds and lent them back to the banks as capital (at the same interest rate). This made the bank’s customers effective shareholders of the bank without their knowledge or any attribution. Second, as part of CCB and BOC restructuring in 2003, these nominal MOF funds (93 bn RMB) were used to write-off the bad loans at the banks, and obligated MOF for repayment of these loans. MOF did all this (v.s PBOC’s plan, which is more conservative and requires proper recaps and real valuation of the NPLs) because without the approval of State Council and the National People’s Congress, it didn’t have access to nearly these amounts of money.

NPL Portfolio Acquisition by the AMCs, 2000: In Scandinavian and U.S. the NPLs were eventually paid for the national treasury (in effect, taxes), but in China, as long as the NPLs remained “inside the system” it wouldn’t matter (a regulator would be happy to say that the AMC bonds are credit-worthy). But, with the plan of listing the banks on international markets (going “outside the system”) it was hard to explain the value of $105 bn AMC bonds supported by $5 bn of capital given the likelihood of recovery. In 2000, $170 bn of NPLs was transferred at face value from the banks to AMCs (this was funded by bond issues paid by the MOF and $75 bn of credit extended by the PBOC to the AMCs). This is an odd situation–if they’re worth their face, why transfer them at all? The reason is that accepting that they’re worth less than face is accepting that loans made to SOEs is bad and thus the state itself is unable to meet its obligations, which is against the Party ideologues. So, instead of bankrupting its industrial sector, the problem remained concentrated on the banks’ B/Ss. This remains true as of today; in 2009, the Party pushed off AMC obligations by another 10 years.

PBOC Recapitalization of CCB and BOC, 2003: Even after all the effort above, banks had $260 bn of NPLs on their B/Ss. In 2003, PBOC used forex reserves to recapitalize CCB and BOC (by $22.5 bn each) by means of PBOC entity Central SAFE Investment. Then, there was an auction process for more NPLs organized by the PBOC. After all this, the two banks were ready for IPOs in 2005. This was the height of PBOC’s political power–it now owned 100% of CCB and BOC.

Conclusion: There is permanent put option granted by the PBOC to everyone, extending well beyond AMCs (>$300 bn cost as of ’05), and this is why bank management need little care about loan valuation, credit or risk controls. At the end of 2007, PBOC was levered 800x its own capital (which is probably why, in 2005, they created an AMC called Huida to take problems off its own B/S).

Stage 3: 2002/03 – 2005 : End of Reform

2005 signifies the end of reform started in the Jiang/Zhu era. When the Fourth Generation Leadership started in 2003, two major initiatives were underway–(a)second round of bank-restructuring program that began in 1998 and (b) restoring a collapsed stock market to health (even though corporate debt was <3.5% of total issuance in the bond market). Zhou Xiochuan (governor of PBOC, China’s Central Bank), Zhu Rongji’s principal architect, led this effort but the stock market was beyond his mandate. For the bond market, interest rates were made to appear more market-based and the currency was de-linked from a fixed USD rate (two criteria needed to have a functional bond market). But when BofA and Temsek acquired parts of the CCB, an uproar started saying that national jewels were being sold. This, plus changing political climate led of end of PBOC’s reforms and MOF power was restored. In 2003, Xioushan had created Juijin (Central SAFE Investments) whose job was to restructure the Big 4 banks, and other securities companies and sell them to investor, including foreign ones–this never happened. Ironically, the success of previous reforms (and restructuring), which gave the banks their relatively healthy state and allowed them to raise significant cash in IPOs was used as a tool against further reforms by CSRC, NDRC, CBRC and the main institutional rival of PBOC, the MOF. The current system is mid-reform and now addresses problems that it was never supposed to address.

MOF Recapitalization of ABC and ICBC, 2005 and 2007: MOF capitalized these two banks in a different way, by simply taking on the direct responsibility of the NPLs, which appears to be closer to the international model (vs. PBOC AMC model). Having said that, the IOUs that capitalized these banks were not direct liabilities of the MOF (like that of the U.S. Treasury’s Resolution Trust Corp.’s), but instead of a “co-managed account”, which allowed this funding to never show up in the national budget (making it a direct liability would have required approval of the NPC). So, what all this means is that since the funding is not part of the national budget, the banks themselves will be funding it over the coming years (Beijing Financial Asset Exchange, set up in early 2010, suggests how the banks will dispose of the bad loans in these co-managed accounts).



Who Makes the Market? IS it a Market at all?: It is hard to say that a true debt market exists in China–it is captive to a controlled interest-rate framework (market does not measure risk and attach commensurate pricing–it is eventually based on funding cost for bank loans, the one-year deposit rate) and its investors, who’re predominantly banks (70% of the market, with foreign banks at 7% and individuals at 1%, SOEs the rest). It is worth noting that many of these same SOEs are the only issuers in the market. The bond market in China is a disguised loan market.

Who prices the yield curve? Given the need for the Party to control everything, there’s no market-driven yield curve, and the risk-free rate is instead provided by the MOF. The near collapse of the international banking system has only confirmed this belief.

Why primary market is slow to begin with? There’s an obvious reluctance of SOEs to issue debt. After all, if they can raise capital in equity, they’d prefer to do that, as this does not need to be repaid–no Chinese CEO is ever lauded in the press for borrowing money.

What About Secondary Market? If we look at the volume, it is so small that it is hard to say that a meaningful market exists at all. On 12/08/09, the entire Chinese inter-bank market for bonds recorded 1,550 trades (for a $190 bn market), which compared to 600k trades for U.S. Treasury (a $565 bn market at the time). On the same day, 52 MOF bonds traded, which makes drawing a meaningful yield curve almost impossible.

Why Does the Chinese Bond Market Exist?: Chinese bond market evolved over the past 35 years or so, primarily to finance the national budget, which 20 years after its creation, the reformed sought to broaden. In early ’80s, no such market existed, and the last bond at the time was issued in 1959. As ambitious budgets created deficits in the early ’80s, MOF decided to issue bonds to fund the deficit. Since only the SOEs had any money, they funded the government as a political duty. What price though? It was simply set as the one-year bank deposit rate (set by the PBOC) + a small spread. SOE investors were forbidden to sell bonds as that would signal a lack of confidence in state’s credit-worthiness (thus snuffing the idea of a proper secondary market).

Commercial Paper and MTNs: Beginning in 2003, as China’s trade surplus widened and foreign investment poured in, PBOC began to issue ST notes (and some LT notes) to sterilize the creation of RMB (so as to control the domestic money supply). In 2005, PBOC leveraged a regulatory loophole that defined corporate bonds as those with <1 yr maturity to create a new debt product in China, the commercial paper. This quickly became the debt product of choice among SOEs (tripling to ~$50 bn in ’08 from $17 bn in ’05), as this required no regulatory approval, just registration. Further, in ’07, PBOC established NAFMII to manage the issuance (as opposed to opaqueness of China’s equity markets, the universe of debt issuers, financials and prospectuses etc. were all available on the China Bond website). In April ’08, PBOC and NAFMII created a 3-5 yr MTN (which had a maximum limit, as opposed to a fixed principal at the beginning), and this quickly became very popular ($89 bn issuance in ’09) despite NDRC’s displeasure. CPs and MTNs accounted for 22% of all fixed income issuance in ’09.

Evolution of Chinese Muni Bonds: China’s last serious tax reform (at the time of writing) , around 1985, created a clear split between taxes belonging to those of the center and those of the localities. Since then, SOE reform (selling poorly performing SOEs and listing good ones to attract foreign capital), closure of failed local financial institutions etc. had greatly reduced the financial resources available to local governments. To finance budget and service cash flows, local governments rely on cash from projects and land auctions (reportedly contributing 1/3rd of local extra-budgetary revenue). Around the 2009 financial crisis, and further to finance the stimulus package in ’09 ($486 bn in total, 2/3rd to spent by local govts), Beijing recognized the legitimate funding needs of local governments and allowed some provinces to issue bonds in 2008. Local governments had been reincorporating utilities, road, construction brigades etc. as LLCs to raise debt, and thus China’s muni market was born. Still, in 2009, 76% of all money raised went to Greater Shanghai, Beijing and Guangdong–other still depended on the banks via a so-called Local Financing Platform to which the local govt. contributed land and tax subsidies (land used as collateral), borrowed against this platform, and the banks sold interests in this Platform to Trust/Investment companies and to HNW individuals. By September ’09, $880 bn (23% of GDP) had been raised through such Platforms. China International Capital Corporation pegs this number at $1.1T in 2011.



The authors describe this as the lynchpin of the Chinese banking system, and a creature of the MOF in full control and ascendancy. MOF claimed that PBOC management of returns was producing too low a return, and asked to establish CIC. While it was presumably established to invest China’s FX reserves, 2/3rd of the money was eventually used to restructure China’s financing system (recaps of ABC, CDB and other banks and acquisition of Huijin/SAFE, the first SWF created by the PBOC). CIC was capitalized not with any direct capital infusion, but with $200 bn MOF Special Treasury Bond, which were sold to PBOC through ABC (direct dealing with PBOC and MOF is prohibited  but this was apparently okay because this was not for deficit financing). And who paid the interest for these MOF Bonds? CIC! CIC relied on the banks (CCB, BOC and ICBC) for the cash flow to make interest payments on the MOF bonds, and to pay dividends to the MOF. The banks, after their IPOs had a dividend payout ratio of 50%, which is normal for a stable bank, but these banks were driving lending growth of 20% p.a. (in a way this dividend ratio is a reliable indicator of how the government thinks about its banks). It is notable that in the IPOs the international and domestic investors handed over $42 bn in new capital to the banks (indirectly to the MOF), and received <$8 bn in dividends in those years.

Minimum loan to deposit spreads, controlled exchange rates and protectionist measures, among others, will continue to mean that the banks will continue to lend (to generate income and thus pay dividends), and also ensures that the banks must raise new capital every few years to prime the cycle. But how long can this continue, and what is the catalyst? Authors says – “Even if the Emperor is ultimately seen to be naked, he is still the Emperor.”


China’s stock markets are not really about money (which comes from banks): it’s about power. In terms of raising capital, China’s stock markets come nowhere near the loan and bond markets, but have been instrumental in creating its National Champion companies and constructing the impression of a modern capitalist economy. This shouldn’t be a surprise–how can they develop as a genuine market for private ownership of companies when the Party is so hell bent on retaining control. The securities, instead merely have a speculative quality that permits gains and losses from trading and IPOs, and effectively the stock market (along with the real-estate market) is a controlled output for surplus capital (mostly of state agencies) seeking a real return. Everyone is effectively a speculator, and there are no natural stock investors (except, of course, the state itself which already owns the National Champions).

Why Does China Have a Stock Market?: In the 80s, the idea of small (both private and state-owned) companies raising capital from small household investors came into being in many parts of the country, and in a relaxed moment, this was permitted. People didn’t think of the shares as ownership in an entity and rather bought them for their dividends. The massive dividend by the Shenzhen Development Bank in 1989 was the turning point and people realized that these things can appreciate, which led to a “share fever”, which led to restrictions and a market collapse in late 1990. Because authorities learned that this trading can lead to social unrest, formal stock exchanges were established in Shenzhen (December 1990) and Shanghai (July 1991). A question may be asked–why didn’t the Party simply shut it down? They didn’t because the private industry growth rate was far higher, at >16%, vs. 7% for the state sector, and its share of the total industrial output now stood at 43% (vs. 22% in 1980). They did put in several restrictions though–the key being only enterprise investment (not individuals), and no further sale of shares to individuals. So, the outside world saw the country moving toward a capitalist model, whereas this was a retrograde move with restrictions actually being added.

National Champions: In October ’97, China Mobile raised $4.5 bn (25x the average IPO before) and this made everyone sit up and take note. What is often forgotten is that China Mobile, as listed, was a shell company, and the proceeds were used to acquire local telecoms (beginning with acquisition of 6 independent and separate operating subs) and consolidate them to create a giant. In other words, even after the capital raise, China Mobile was just a company on paper. This was the sales-pitch by the American bankers to China–it’s hard to raise capital for small companies in various locales, but if there’s a way to create proxies for growth in the entire country, investors would lap it up, and this indeed happened. So, while capital raising was important, the far bigger impact was the organizational concept that permitted true centralization and control. The Champions were create out of industries that were fragmented, lacked economies of scale, and in some cases (esp. banks) were acknowledged as being bankrupt. In the following years, the “National Team” of champions was rapidly assembled (and used to recapitalize its major banks). Obviously, all these companies are SOEs.


China has become almost an emblematic example of crony capitalism, as the National Team, which were conceived as global world-beaters, now effectively own the government (to a limit). 54 of the 100+ SOEs managed by a central observer entity called SASAC are on the central nomenklatura list; with their Chairmen/CEOs holding ministerial rank, appointed directly by the Organization Department, and ranking equally with provincial governors and all ministers on the China’s State Council (some even members/alternated of the Central Committee of the Party). There is one BIG difference–the 4 banks are classified as vice-ministerial entities, which means that they’re subordinated to the SOEs and are mere mechanical financial facilitators.

SASAC: It was established in 2003 by the State Council as a quasi-governmental entity to oversee the SOEs and has the following impossible responsibilities (a) representing the state as owner of these SOEs, (b) serve as HR function of SOE Sr. Management, and (c) decide on where to invest SOE dividends. First of all, SASAC is not the owner of SOEs in any way. Second, SASAC can oversee management of SOEs, BUT the CEOs are appointed by the Organization Department, so they can’t really fight the CEO. Finally, the SOEs barely pay back any dividends (5-10% post-tax profit range, despite trying hard to raise it) and the investment of these dividends are really reinvesting them back in the SOEs. In certain years, profits of the SOEs have reached up to 20% of the country’s budget, and can be used to finance its deficit, and the fact that the government is unable to access this capital the best illustration of the power of these oligopolies over the nominal government.

Listing and Trading of the SOEs: By 2006-end, the Shanghai index moved to 3,000 from 1,000 just 18 months before. This was attributed to China’s entry into the WTO process, but authors say that real key to the surge was certainty among domestic players that the huge overhang of no-tradeable shares wouldn’t come until after ’08 Olympics, and the appreciation of RMB. Among the domestic players were the “strategic” IPO investors, a category that was created in 1999 when the traditional retail and professional institutional investors failed to step up. Until 1999, all prospective IPO investors had to submit an application but this did not guarantee even a minimum lot of shares. To ensure even a small allocation, investors often produced enough money to subscribe the entire offering, but this did not work in the stagflation of late 1990s, so the “strategic” investors group (essentially SOEs) were created, and this group would buy a block of shares at a predetermined price before the launch; though they’d be subject to a 1-yr lock-up period, they’d get their full allocation. This worked for everyone–larger deals were a thord or so subscribe even before being announced and the friends and family of the “strategic” group enjoyed eye-popping returns upon IPO. Obviously, the incentive now is to set the price low and the underwriting risk is gone, which means that no one needs to understand the company and the risk to arrive at a proper valuation judgement. This is why Chinese investors refer to their stock markets as “policy” markets–they move on expectation of policy changes and not on news of company performance.

The fundamental value-creation proposition is not its enterprises, but the government. For anyone on the nomenklatura list, there are no independent institutions but just the Party and it’s immaterial which box does what.


MOF debt as a % of GDP is <20% (as of ’11), but when we include policy bank debts, Ministry of Railways, near-sovereign entities etc (as any China Statistical Yearbook would indicate) and the NPLs (themselves estimated at >15% of FY11 GDP), the total public debt stood at ~75% of GDP.

BUT, China does not borrow money overseas (except trade finance), and because of non-convertibility of RMB, overseas investors are excluded from the domestic capital markets. Foreign banks are excluded from the domestic bond and loan markets (at <2% of financial assets), so there’s no one who can challenge the Party’s valuation of these obligations. China understands previous debt crises and thus its financial system is a set apart from the world.

But this insulation does not guarantee that its crisis-proof. Household savings (foundation of banks’ ability to lend and saving could decline if consumerism takes hold), pension obligations (as workforce ages) and interest-rate exposure (PBOC has found it difficult to raise interest rates) could all theoretically be the catalysts.

If properly managed, China’s use of debt can continue for a long time. It took over a decade for Greece’s problems to become obvious, and this is when it doesn’t control its currency, is an open economy and has a democracy. Things can be obscured within China’s opaque economic and political system for a very long time. But this also means that there will be no meaningful reform of interest rates, exchange rates or material foreign involvement in domestic financial markets. 2008-09 financial crisis has put an additional seal on this outcome–“don’t show me any failed models”.




PBOC Financial Stability Reports

China Bond and the National Association of Financial Market Institutional Investors (NAFMII), a subset of People’s Bank has detailed information on China’s bond markets.


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