Benjamin A Shobert: Readers may be surprised at your comments about how China's Communist Party views the markets. On page 10 you write that the market is "there to be used tactically by the party and is not allowed to play a dominant role”. Is this relationship between politics and the market controllable?
Fraser J T Howie: I would look at it this way: China's whole market experience, at least what outside observers would look at and the hopes these outsiders have for China as a developing economy, is that the Chinese government wants the good without the bad. They want the fundraising capability of having access to international markets, but they don't want the international standards, accountability and discipline that come with receiving money from independent investors, either local or foreign.
From the Communist Party's perspective, if you have ultimate control, why give it up? Unfortunately, within China's political system, any alternative to the party or any voice of dissent is viewed as potential chaos. This bipolar version of political outcomes is often widely accepted outside of China.
The party believes it is very black and white: the stability of China through their rule, or chaos. It is presented as "if we lose power, then the country will descend into chaos". As a consequence of this, the willingness to accept a plurality of views is not tolerated, and much of their system remains largely closed to outsiders. Westerners don't appreciate that this is not so much a communist system of governing as it is a Chinese tradition.
This sort of authoritarianism is deeply engrained in China's history; it hasn't just evolved over the past few decades. Yes, China's leadership still calls itself Marxist-Leninist, and people in China pay tribute to communism, but China's current view of the market and the role of politics in dictating market policies goes back to the very hierarchal Chinese culture.
BAS: The justification for engagement with China, other than being able to access China's huge markets, historically has been that if we engage them, they will open to trade, and in opening to trade they will democratize. In Washington, this narrative is being challenged. How would you comment on the world's policy of engaging with China?
FH: Up until five years ago, I would say this was very much the case. Back in the 90s you would see someone like Nancy Pelosi pushing against China being granted Most Favored Nation (MFN) status, and the retort was always that if we engage China, they will liberalize.
Now, Americans are awakening to the idea that this isn't going to be the case. Yes, China's economy is growing - they are a swing factor as a global consumer in commodity markets, yet they don't really want to play along by the same rules. If anything, since the Olympics the Chinese government has clamped down even more, which doesn't fit well with the American hope that China would gradually open up and liberalize.
More outside observers are slowly realizing this is not going to happen. Multi-national companies (MNC) keep saying there are opportunities in China for their businesses, but this is a double-edged sword, because what these same companies are seeing is that China doesn't play by global standards and those same MNCs which profit in the short term could well suffer in the long term. Google is one of the few companies who have tried to push back against the Chinese way of doing things.
Even if the cynics are right about Google and they simply aren't making enough money in China and wanted out, then what is wrong with that? Why be in China if you aren't making money? Be realistic about what you can do in China and act accordingly.
Right now, the Chinese are not playing by the rules and we have to engage them on that. At a distance China looks impressive, but up close there are many weaknesses. Their economy has a large number of underperforming sectors, and their businesses just are not beating ours at our own game - that is a fundamental misperception by too many in the States.
Neither the Chinese government nor the Chinese entrepreneur has beaten or cheated the laws of economics. Chinese businesses are often successful because they compete in highly protected markets that foreign firms cannot compete in. This is particularly acute in the banking system we talk about in our book. We need to be a bit tougher and demand more of China, and we need to be willing to withhold some rewards from them if they don't continue to open up.
What some Americans may not appreciate is that the more you deal with China, the less worrying it seems. There was a PEW poll recently that attempted to capture Americans' feelings about China which showed that a large number of people in the US believe China is the world's dominant economy. Well, when that same poll was carried out in 1989 it was Japan that Americans were so worried about. We all know how well that worked out for Japan.
BAS: In your book you make a comment about the huge income disparity China is struggling with. Is this one of the more poorly understood issues about China in America? If so, what do China's concerns over this suggest about the type of challenges it will face?
FH: If you look at the sheer numbers of China, one-sixth of the world's population -you will have a lot of anything, big numbers are everywhere and that appears to be impressive. But what impresses me is an economy like Japan's or the US, where you have 300 million people and an economy three times that of China. That's impressive. China has a lot of poor people, and poor people save because they know that when bad stuff happens they can only rely on themselves, and that's the reality for the majority of Chinese in China.
So, not only do you have this huge income disparity in China, but all of these poor people save because of a rainy day, and that money gets channeled into the state-controlled banking system, which then turns around and lends it, on preferential terms, to State Owned Enterprises, who use it for whatever is the "biggest" or the "longest" or "... est" project they've got. People new to China see Beijing or Shanghai and marvel over how quickly it was all built, and yes, they couldn't be built that fast in the US. But there are good reasons for that. Things like safety, workers’ rights and landowners’ rights slow down the process in America, and they should.
BAS: Does this sort of investing, absent the market forces pushing for new infrastructure versus the party deciding to pursue them, lead to overcapacity?
FH: Yes. In China, the Holy Grail for so many in local government is to go from nothing to something, so if you are a poor province or city and a factory announces it is going to get built, money all of a sudden becomes abundant. But this desire for growth before all else can and does lead to a massive misallocation of capital. But the real question is what will this overcapacity and misallocation of capital lead to? A lot of critics of China point to a property bubble collapse and say that's likely.
Sure, the property market in China may be a bubble in certain cities. But the Internet was a bubble as well and yes, it popped, but look at the Internet now - it is more powerful and central to the global economy than it ever was. Bubbles happen, the key is how you respond to them A more likely result of this overcapacity and it effects will be the upcoming test of what happens when the Chinese SOEs [state-owned enterprises] who were recipients of China's stimulus money need to start paying their loans back. It will be interesting to see how the markets respond if, in two or three years, these companies can't service their debt.
The assumption is the Chinese government will step back in if there are problems, but if investors don't get full disclosure we won't know how bad things really are. Look, we already know securitization in China is booming. Why is that? It's probably because Chinese banks are trying boost lending at any price without fully disclosing the risks, and who knows how much other off-balance-sheet activity is going on?
BAS: Closing out the first chapter, I think readers will be a little unsettled at how China's political and banking system would be able to respond to a financial crisis. How would you respond to those who have some fears about this?
FH: The fears are well founded. Myself and Carl think the banks would not respond well to a crisis but we struggle with the likely scenarios of how this could play out: it just isn't obvious. The reason banks in China appear to be doing well is that their liabilities are not fully exposed, and when a whole host of entanglements reveal themselves (which happens in the midst of a crisis), the system may not be able to handle this.
After all, the financial system in China is still very closed off; the banking system is still dominated by state-owned banks. You have 1.3 billion Chinese saving and putting money into these banks, with very few alternatives. The banks redirect this money and waste it on a lot of underperforming SOEs, which allows government, industry, and the banks to operate inefficiently.
But traders can't short China like you can other countries. By design, it is very difficult to take the opposite view on China, not just to cash out a position in China, but to really short the market. (Sure you can short some stocks here and there but the overall impact is minimal). By controlling the currency and the capital account, China isn't vulnerable to some of the same stresses that other Asian economies are.
Now, what could hurt the Chinese financial system? Well, property values could buckle or outright collapse - it's difficult to say - but inflation could be another and more serious problem that gets out of hand. For banks, non-performing loans could become too much for the state to carry.
Or, a more draconian trade war with punitive tariffs from goods made in China could start. Because China is still in many ways so closed off Carl and I try to downplay the idea of China's collapse. China is part of everyone's global future - it isn't going away. But unless there is a real opening or reform of the capital markets, then a crisis taking hold in the way you see in Europe or the States is difficult to imagine. Information and disclosure in China is still pretty poor and quite simply you don't know what is going on in many parts of the economic system.
BAS: How did the Asian currency crisis impact China's banking regulations, currency policy, and overall financial transparency?
FH: Leaders in China realized they needed to clean up their banking system, and in that sense, their leaders at that time were determined to get the right things done, so what they saw happening around them wouldn't happen inside China. Reforms and changes were made, many in the right direction, but the political infighting and the lack of follow through from the next generation of leaders meant the reforms were only partially implemented. I would say that within China, the stability of their currency has taken on too great a role in their policy making.
What I don't believe they understand, and you hear much of this same thinking from leaders in Hong Kong as well, is that a stable currency may serve you well at one time, but not at another. The danger for China is that they look back at the Asian financial crisis and draw the conclusion that their stable currency is what drew them through, or that their stable government prevented China from slipping into the same problems.
I think China missed an opportunity to move more aggressively after the crisis when they entered the WTO [World Trade Organization] and now at a time of uncertainty they are reluctant or don't have the political will to make the difficult choices. Yes, at that time it may have been necessary to keep the currency fixed, but that isn't necessarily the right thing to do now.
BAS: After the American financial crisis of 2008, Chinese have begun to feel more strongly that their way of doing things in the banking sector is superior to ours. Do you agree with their conclusion?
FH: No, I do not. America clearly has some problems right now, but no country has provided as much wealth to the world as the US. The much talked about Beijing consensus doesn't provide a solution you want. A reality check on China is needed: the model they have requires that 70% of your country be mired in poverty, with no health care, limited education and political rights, an inability to have more than one child - I could go on.
Ultimately, the Beijing model is about taking the savings of 1 billion people and spending it by SOES for the benefit of 300 million people in the coastal provinces. That is a little extreme and simplistic, but I think you get my point. The difficulty in talking about the Beijing model is that if you are another poor country - say Mozambique or Ecuador - you can't follow China's path.
You don't have millions of poor peasants you can throw into the labor market, you don't have the savings of a billion people to tap into to fund state-owned businesses, you can't build the "biggest” and the "longest" like you can in China. You don't have the great public relations and global goodwill which China has, nor the rich ethnic diaspora.
And really, for those who talk about how great the China model is, I always make the point that the only people trying to get into China are North Koreans. Give someone in China the chance to come to the US, legally or not, and they will happily do so; they'll work long hours, sleep anywhere they can, because they know they have better opportunities in America than they do in China.
BAS: Should peering into China's model provide readers of your book with more confidence as to America’s long-term ability to attract capital for investment and to compete against the Beijing model?
FH: Completely. Whenever someone really engages China, the scales fall from their eyes. The reason they can make things for a penny is because environmental regulations are not enforced, poor manufacturing standards, poor quality control, etc. So yes, they can make things at a very cheap rate. A lot of people have had, as I did recently in Malaysia, a bad experience with a poorly made Chinese toy.
Yep, it was cheap, but I'll never buy it again. In the US and elsewhere politicians since the Lehman collapse have envied the way Chinese leaders can dictate and implement policy, but they're wrong. Chinese economic growth comes with restrictions and costs that ordinary Americans wouldn't accept. Americans at the moment feel like they can't do anything right, and they feel threatened by China's success when they shouldn't be. America has some serious problems but they are much, much easier to solve than China's. If nothing else, America stands for something, and wherever you go, the American model and way of life appeals to people, including everyone in China.
Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise by Carl E Walter and Fraser J T Howie. Wiley (February 15, 2011). ISBN-10: 0470825863. Price US$29.95, 256 pages.
Benjamin A Shobert is the managing director of Teleos Inc (www.teleos-inc.com), a consulting firm dedicated to helping Asian businesses bring innovative technologies into the North American market.
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