“Instead of promoting sound markets, the government twisted them to drive economic growth”

A report from the Economist writes about the contradiction between state control and problems of the financial system, “IF YOU SCOUR the annual reports of China’s biggest banks, you will find hardly a mention of the Communist Party. There are passing references to the “Party Discipline Office” in descriptions of the banks’ internal structures, and the biographies of a few executives note that they graduated from the “Party School”. But that is about it. Only when you get to Citic Bank, the ninth-largest by assets, is there any suggestion that the party might play an important role. The first four of Citic’s objectives for 2015 read like those of banks anywhere in the world: improve management, increase profits, control risks and boost efficiency. Its fifth and final objective, though, is quite distinctive: “Comprehensively strengthen construction of the party”. In all countries there is a gap between what banks and regulators reveal to the outside world and what happens behind the scenes”.

Crucially it adds, “In China that gap is wider than usual. The party’s unchallenged, spectral position at China’s apex gives it a tight grip on the financial system but also causes many of its ills. The key to understanding the party’s influence is that it does not simply sit atop China’s financial institutions. At the highest levels, it is them. The same people often hold senior roles in both their firms and the party. As far back as 1995 the Chinese government declared that banks were to be commercial entities, focused on making money and responsible for their losses. When the government invited foreign firms to take stakes in the country’s biggest banks in the early 2000s and encouraged them to list on stock exchanges, its ambition was to instil a businesslike mindset. Hard-nosed investors would scrutinise their books and put pressure on them to perform well. Up to a point, this has worked. China’s banks, brokers and insurers have acquired the patina of profit-focused banks. They file regular statements to stock exchanges and publish glossy annual reports. Their results are reviewed by international auditors such as KPMG and PwC. Their risk-control departments stress-test their balance-sheets. Over the years they have become leaner: Agricultural Bank of China, for one, has cut back from 50,000 branches in 2000 to less than half that today. But if considerations of social stability and market efficiency clash, the former almost always wins. When the global financial crisis erupted in late 2008, banks had to toe the party’s line and finance the government’s mammoth stimulus. When the stockmarket crashed last June, state-owned brokers were ordered to buy shares and banks were made to lend to them”.

Interestingly he notes “the party’s hand is visible in bankers’ daily lives. If you step out of the lift on a Chinese bank’s executive floor, you will often see signs pointing to the president’s office in one direction and to the office of the discipline inspection committee (the body in charge of enforcing party rules and rooting out corruption) in the other. In much the same way that Xi Jinping is presented to foreigners as China’s president but described domestically as general secretary of the Communist Party, so bankers wear two hats. The person whom investors know as chairman is also known internally as the bank’s party secretary. Like the heads of other state-owned corporations, China’s titans of finance are moved among institutions whenever the party’s organisation department sees fit. In the first decade of the 2000s at least 43 senior cadres shifted from one top financial firm to another”.

Worryingly he writes “in China the whole point is to fuse the elite together. Regulators and financial firms are meant to work towards the common goal of building a prosperous nation. However, just because the party is in control does not mean that it has things under control. Last summer’s stockmarket crash and the capital flight of recent months are only the latest examples of its frailties. Crudely put, shadow banking has evolved in recent years through firms devising investment products that get around regulations; the government slowly catching on; and the firms responding by finding new loopholes. If the party is so powerful, how can its edicts be so blatantly disregarded? Many in the government now believe the failure lies in the structure of regulation. In the early 2000s China divided its supervisory framework, appointing a banking regulator for banks, an insurance regulator for insurers and a securities regulator for brokers. That worked well enough for a decade, but as the financial system has grown bigger, so have the holes in it. Last year’s stockmarket crash exposed some of them. The securities regulator, looking at margin financing on brokers’ books, saw little danger from investors buying stocks with borrowed cash. The bank regulator, focused on lending, did not watch off-balance-sheet products that brought yet more leverage into the market”.

The piece mentions that “the concentration of power has, if anything, been associated with greater instability in markets and unpredictability in policy. Officials at all levels are more hesitant, afraid of making decisions that go against what Mr Xi might want. Regulatory bodies tried their best to recruit people with experience working for top-flight international firms, but after a few years of low pay and limited influence many have left. Some believe the problem lies in the very nature of party control. Governments have three basic functions in finance: as promoters of healthy market development; as regulators of institutions; and as owners or guarantors of firms, especially at times of trouble. In a stinging report last June, the World Bank said China had mangled all three. Instead of promoting sound markets, the government twisted them to drive economic growth; the state’s ownership of financial firms was too pervasive; and regulations were consistently loosened to suit economic priorities”.

The piece advocates for banks and other businesses to go bust, despite the political consequences, “Even with the best intentions, this transition is bound to be volatile. Government guarantees—sometimes explicit, often implicit—blanket much of the economy. Many in China, from investors to bankers, assume that local governments and state-owned enterprises (SOEs) cannot fail. By fostering cohesion, the party encourages the belief that, if the worst happens, it will keep credit rolling over. Private companies understand the power of this belief. Whereas state-owned banks often hide their party background, their shadow peers play up their government connections, however tenuous. Ezubao, the large peer-to-peer lender that collapsed recently, held its annual meeting last year in the Great Hall of the People in Beijing, the venue for big party gatherings (which is available for hire when not in official use), and advertised in state media. Investors who lost their money have protested, demanding that the government compensate them”.

The piece ends “Yet that can have extreme repercussions. In China’s struggling industrial heartland, the Hebei Financing Investment Guarantee Group, a government-owned company, underwrote vast amounts of loans to small manufacturers over the past decade. Thanks to its support, lenders treated the manufacturers as virtually risk-free. But when they began defaulting, Hebei Financing could not come up with the money. Last year it revealed that 32 billion yuan of loans it had guaranteed were in danger. Soon afterwards, a distraught investor stabbed the CEO of Global Wealth Investment, a fund manager that had lent to companies backed by Hebei Financing. Alarmed at the prospect of unrest, the Hebei provincial government has since scurried to make good on the loan guarantees, at least in part. It set up a re-guarantee company, in effect underwriting the underwriter. That has helped mitigate panic, but the trade-off has been moral hazard: investors will continue to expect the government to bail out state-run companies. Elsewhere the party is taking a harder line. A handful of small state firms have missed bond payments this year. A credit-risk officer with a mid-tier bank says his team no longer assumes that provincial-level SOEs will receive bail-outs. He expects a few bankruptcies of government-backed steel mills and coal miners. But neither he nor almost anyone else thinks China will allow the biggest state firms to default. With so many economic and political levers in its hands, the party still retains plenty of control for now. The rest of the world can only watch and wait”.

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