Big Rock Candy Mountain

China Economic Quarterly
Volume 14 Issue 2 June 2010
Financial reform Making capital work

Consuming in the boonies Coal mines: bigger and safer Photovoltaic Barbie dolls The great high-speed railway bonanza
GaveKal Dragonomics
China Economic Quarterly

Contents
The economy
Main economic indicators Economic survey High-speed rail The iron rooster spiffs up Will Freeman Metals Man Death of the annual mating ritual Michael Komesaroff Retail markets How not to B&Q it Paul French Property Relax its different this time Rosealea Yao Capital markets The bear roars but nancial futures soar Chao Gupiao 2 3 6 10 12 15 17
Vol 14 No 2 June 2010

China Economic Quarterly Founded 1997 www.theceq.com Editor Arthur Kroeber Managing editor Tom Miller Researchers Alanis Qin, Rosealea Yao, He Yuxin Janet Zhang, Will Freeman Sales manager Julien Guillaume Production Big Brains Ltd GaveKal Dragonomics Beijing office 15D Oriental Kenzo Office Building 48 Dongzhimenwai Dajie Beijing 100027 China Tel 86 10 8454 9987 Fax 86 10 8454 9984 Editorial advisory board Joe Studwell founding editor Pieter Bottelier Simon Cartledge Thomas Gorman Carsten Holz Robert A. Kapp Albert Keidel Scott Kennedy Elizabeth Knup Davin Mackenzie Daniel H. Rosen Andy Rothman David Wolf Xiao Geng The China Economic Quarterly (CEQ) is published in March, June, September and December by Dragonomics Ltd, a subsidiary of Dragonomics Advisory Services Ltd and affiliate of GaveKal Research. The trademarks China Economic Quarterly, CEQ and Dragonomics are the property of Dragonomics Advisory Services Ltd. Subscriptions to CEQ are normally available only as part of the Dragonomics research service. For information contact julien.guillaume@dragonomics.net.
The big idea Fiscal and nancial reform

Chinas economy will not rebalance until it begins to channel money to those who need it. Why is capital allocation inefcient, and what scal reforms are needed to make the nancial system work better? Fiscal reform Paying for the harmonious society Christine Wong Local government debt Big rock-candy mountain Victor Shih Capital market reform Market? What market? Carl Walter and Fraser Howie 20 26 33 19
Miscellany
Rural consumption Little bang for the farming buck Tom Miller Shanxi coal consolidation Mining a richer seam Gavin Bowring Solar power Black hole sun Matthew Forney Books Inside the Party Arthur Kroeber On the road, with Chinese characteristics Tom Miller
JUNE 2010
41 46 51 56 60
CHINA ECONOMIC QUARTERLY
The economy
Main economic indicators Values GDP, Rmb trn GDP, US$ trn GDP per capita, US$ Fixed asset investment, Rmb trn Industrial value added, Rmb trn Retail sales, Rmb trn Deposits of financial institutions, Rmb trn Loans of financial institutions, Rmb trn Government revenue, Rmb trn Government expenditure, Rmb trn Exports, US$ bn Imports, US$ bn Trade balance, US$ bn Net foreign direct investment, US$ bn Foreign exchange reserves (year-end), US$ bn Growth rates (%) GDP (nominal) GDP (real) Fixed asset investment (real) Industrial value added (real) Retail sales (real) Deposits of financial institutions Loans of financial institutions M2 Government revenue Government expenditure Exports Imports Price indices (%) Implicit GDP deflator Consumer price index, (avg of monthly rates) Producer price index (avg of monthly rates) Urban house prices (year end) 1-yr deposit interest rate (Dec 31) 1-yr loan interest rate (Dec 31) Exchange rate, Rmb/US$, year-end Key ratios (% of GDP) Budget balance Government debt Current account
Growth rates nominal unless otherwise indicated f= forecast Source: NBS, CEIC, IMF, GaveKal Dragonomics estimates
2006 21.6 2.7 2,100 11.0 9.1 7.6 33.5 22.5 3.9 4.0 969 792 178 60 1,066 2006 17.0 12.7 22.2 16.6 12.6 16.8 15.1 16.9 24.3 18.5 27.2 20.0 2006 3.8 1.5 3.0 5.5 2.52 6.12 7.8 2006 (1.0) 17.3 9.3
2007 26.6 3.5 2,600 13.7 11.7 8.9 38.9 26.2 5.1 5.0 1,218 956 262 121 1,528 2007 22.9 14.2 20.1 18.5 12.5 16.1 16.1 16.7 32.4 22.6 25.7 20.8 2007 7.6 4.8 3.1 7.6 4.14 7.47 7.4 2007 0.7 17.0 10.6
2008 31.4 4.5 3,400 17.2 12.9 10.8 46.6 30.3 6.1 6.2 1,429 1,133 296 94 1,946 2008 18.1 9.6 15.2 12.9 14.8 19.7 18.8 17.8 19.5 25.9 17.2 18.5 2008 7.8 5.9 6.9 6.5 2.25 5.31 6.8 2008 (0.4) 16.8 9.6
2009 33.5 4.9 3,700 22.5 13.5 12.5 59.8 40.0 6.8 7.6 1,202 1,006 196 90 2,339 2009 6.8 8.7 33.3 11.0 16.9 28.2 31.7 27.7 11.7 21.2 (16.0) (11.2) 2009 (1.7) (0.7) (5.4) 7.8 2.25 5.31 6.8 2009 (2.2) 18.5 6.1
2010f 38.4 5.6 4,200 27.7 14.9 15.0 71.1 47.5 7.9 8.6 1,364 1,239 125 70 2,634 2010f 14.5 9.0 19.0 10.0 16.0 19.0 18.8 18.0 15.0 13.0 13.5 23.2 2010f 5.0 3.5 6.5 8.0 2.25 5.31 6.8 2010f (1.8) 19.0 3.8
JUNE 2010
The economy
Economic survey
The economy grew by an unexpectedly strong 11.9% year on year in the first quarter of 2010, and most private estimates suggest that sequential quarter-on-quarter growth accelerated too. These figures are well above the potential growth rate, and were driven by the immense monetary and fiscal stimulus delivered in 2009, which we estimate at more than 20% of GDP. Yet investment, which remains the principal engine of growth, is already slowing noticeably, and this slowdown will continue over the next several quarters as monetary stimulus gradually fades. Credit growth, which hit 30% in 2009, will slow to 19% this year and 15% in 2011. Inflationary pressure, however, will likely rise even as investment and industrial production slow. The adoption of draconian property-market policies in mid-April aims to prick a severe house-price bubble in major coastal cities. Consumer price inflation, still relatively subdued at 2.8% year on year in April, is likely to rise above 5% by late summer, but tighter credit controls (rather than interest-rate hikes, which remain an instrument of last resort) could keep it under control. In the medium term, sustained GDP growth much above 8% will generate inflation higher than the government will find tolerable, thanks to the strength of underlying wage pressure. Adjusting to this wage pressure will prove difficult for many companies: a foretaste of things to come was the unprecedented strike that shut down Hondas entire China production in May as assembly-line workers at a components plant in Foshan, a city near Guangzhou, demanded a 50% increase. Watch out for weaker commodity demand Stimulus-driven investment growth reached stratospheric levels in 2009, and even the current rate of just above 20% real growth in fixed-asset investment remains well above the trough of around 14% in early 2008, which is probably closer to a sustainable level. We estimate that the combined monetary and fiscal stimulus (defined as the expansion of bank credit, bond finance and the fiscal deficit above a business-as-usual scenario) reached 21% of GDP in 2009; and for the full 26-month period of the official fiscal stimulus (November 2008-December 2010), stimulus will equal around 15% of aggregate output. This flow of easy money fuelled a construction boom and a land-grab of historic proportions, as local governments sold land at record prices to ravenous developers. House prices in major cities rose to absurd levels: the average house price in Beijing (for a 100-sq-meter flat) crossed US$300,000, the same as the median price in Washington DC. Crucially, home buyer leverage increased dramatically: in 2002-09, mortgage finance accounted for only one-third of the value of housing sold; but in the first quarter of 2010 this ratio rose to two-thirds. Beijing ended the party with a strong set of administrative measures targeting investor purchases of housing. By mid-May housing sales were collapsing in major coastal cities, and house prices should start trending down soon.
Structure of GDP, 2009

% of GDP Production Agriculture Industry Services Expenditure Capital formation Consumption Net exports 11 47 43 47 49 4 Real growth % 4.2 9.5 8.9 18.4 9.5 -51.9
Source: NBS, GaveKal Dragonomics estimates
GDP growth, Q1 2010

Real % yoy growth Production Agriculture Industry Services Expenditure Capital formation Consumption Net exports 11.9 3.8 14.5 10.2 11.9 14.5 12.7 -34.3
Contributions to GDP growth, pp

Capital formation Consumption Net exports 2009 8.2 4.6 -4.1 2010 Q1 6.9 6.2 -1.2
JUNE 2010
The economy
The trick for national policy makers is to prick the housing bubble without causing too severe a slowdown in construction and heavy industrial activity, as occurred in 2008. The solution is to compel state-owned property developers to build desperately needed low-cost housing at a scanty profit. The developers will gain by winning market share from their private rivals, and probably by preferential treatment in future land auctions. But even if this strategy succeeds, construction volume growth in 2010 is unlikely to exceed the 13% recorded in 2009, and more likely will fall a bit to 10%. While this would generally be a healthy outcome, markets have not fully appreciated the consequences for Chinese commodity demand (which is largely a function of housing construction volume) in the remainder of the year. If full-year construction growth matches the 2009 figure of 13%, construction volume for the May-December 2010 period will fall by 19% year on year (because construction volume grew so rapidly in the first four months). Full-year growth of 10% implies a May-December fall of 26%. Thus a healthy slowdown of Chinese investment demand to a more sustainable level will require a much larger correction in commodity demand. Long hot summer ahead The main inflationary story so far has been in property prices: but the story is about to shift to wage-driven rises in consumer prices, which is the real structural story. The relatively modest increase in consumer prices so far this year is deceptive. Seven provinces have already announced they will index social welfare benefits and minimum wages to consumer price inflation; and the National Development and Reform Commission in May announced it would reinstate food subsidies for low-income households a measure last taken in early 2008 when CPI inflation was running above 8%. As we detailed in The end of surplus labor in the March 2010 issue, this increase in wage pressure which is driven by a secular decline in the number of young worker is largely a good thing, because it means that returns to labor will rise at the expense of corporate profits, stimulating household consumption as incomes rise and constraining excessive investment. Over time, this trend will sustain the contraction of the current account surplus, which peaked at 11% of GDP in 2007 and fell to a more reasonable 3.5% in the first quarter of 2010. (This year, for the first time, the State Administration of Foreign Exchange began releasing balance of payments data on a quarterly basis.) Moreover, Chinese wages are so low in absolute terms that sharp upward adjustments can occur without unduly affecting competitiveness. Chinas exports are likely to keep rising at a trend rate of 5-10% for the next few years. But the move to a higher-wage environment also carries risks. As bargaining power inevitably shifts towards labor, workers will become more assertive about their rights. Companies that do not anticipate and accommodate this greater assertiveness will run into trouble, as Honda
JUNE 2010
The economy
did in May when its China production ground to a halt thanks to a series of strikes. Workers initially staged a one-day strike for higher wages; Honda granted a small wage increase and fired the ringleaders. Workers immediately struck again, demanding that their monthly wage be hiked from Rmb1,500 (US$220) to Rmb2,300 (US$340); that Honda reduce the use of minimum-wage interns (recent graduates from technical high schools) who compose one-third of the Foshan plants work force; and that they be allowed freely to elect the plant representative of the toothless All-China Federation of Trade Unions. We suspect that this episode is just the first of many challenges to the corporate and government elites that have ruled uncontested for the past decade.
Balance of payments
US$ bn Current account Merchandise trade Services Income Transfers Capital and nancial account Outbound direct investment Inbound direct investment Portfolio and other investment: assets Portfolio and other investment: liabilities Capital items Errors and omissions Net increase in reserves Current account, % of GDP Estimated short-term capital ows, % of GDP
Source: SAFE, GaveKal Dragonomics estimates
Q1 2010 40.9 29.4 (18.0) 21.3 8.3 55.0 na na na na na na 96.0 3.5 4.2
2009 297.1 249.5 (29.4) 43.3 33.7 144.9 (43.9) 78.2 19.3 87.3 4.0 (43.5) 398.5 6.1 2.3
2008 436.1 360.7 (11.8) 41.4 45.8 19.0 (53.5) 147.8 (73.3) (5.1) 3.3 24.5 479.5 9.6 0.5
JUNE 2010
The economy
High-speed rail
The iron rooster spiffs up

by Will Freeman
Rocketing through Chinas heartland on the 350 km per hour Wuguang Harmony Express is a great way to travel. The train carries passengers 1,000 km from Wuhan to Guangzhou roughly the distance between Washington DC and Chicago in just three hours. Seating is comfortable, travelers are free to walk around, and cell phones and other electronic devices are permitted. Yet critics of Chinas high-speed rail program argue that this latest investment in transportation infrastructure, following the billions of dollars already poured into building a national expressway network, is unnecessary and wasteful. Since few passengers will be able to afford the high-speed ticket prices, the spiffy new trains are doomed to become high-speed white elephants carrying nothing but an enormous pile of debt. That criticism is almost entirely off-target, and betrays a fundamental misunderstanding of the nature of Chinas development. The high-speed rail program is a carefully considered component of a comprehensive and desperately needed upgrade of Chinas entire rail network. The principal long-run economic benefit of building new passenger lines will be a vast increase in capacity on the nations freight lines, slashing logistics costs and speeding the development of an integrated national consumer market. The cost premium of building high-speed rather than conventional rail lines is far lower in China than in other countries, and the advantage of high-speed lines is that they are more likely to draw passengers away from air and car travel, meaning a net improvement in energy efficiency and a reduction in carbon emissions. While the debt load incurred to build the new lines is substantial, the long-run economic benefits will almost certainly outweigh that debt. Speedy connections Economic stimulus funds accelerated investment in high-speed rail in 2009-10, but plans for a high-speed network were on the table for many years. The State Council approved the Ministry of Railways (MOR) mid- to long-range network plan for railway expansion, which included plans for a high-speed passenger rail, in 2003. The plan outlines a 34,000 km expansion of the railway network about the length of Australias entire rail system to a total 120,000 km by 2020. Total investment for this expansion, according to MORs latest estimate, will run to Rmb5 trn. About half the additional length and the majority of the cost will go into building a new 16,000 km high-speed rail network mainly comprising four north-south and four east-west corridors and 19 inter-city lines. The new network will connect most major cities in eastern and central China as well as several western cities including Kunming, Chongqing,
Will Freeman is an analyst at GaveKal Dragonomics.
JUNE 2010
The economy
Chengdu and Xian. High-speed rail will come in two varieties, with top speeds of 250km/hr or 350km/hr. Of the eight main corridors, five will be 350km/hr and three will be 250km/hr. About 4,000 km, or one-quarter, of the high-speed rail network is already complete. Such a massive railway expansion is necessary because China has faced chronic capacity shortages in both passenger and freight rail since the 1980s. A World Bank study in 2008 determined that the capacity shortage (for combined passenger and freight) was 10-20%. Chinas rail network is clogged, and likely to become more so. Freight carriage doubled between 1998 and 2008, and even on conservative growth assumptions will rise another 55% by 2020; passenger-km is forecast to double. On a combined passenger-freight basis, Chinas intensity of rail use is double Indias, triple the USs, and a dozen times higher than the EUs. China carries a quarter of the worlds combined rail freight and passenger traffic with only 6% of the worlds combined rail network. Those who argue that China has even remotely enough track let alone an excess simply do not know what they are talking about. The hare beats the tortoise The need to expand rail capacity is undisputed, and the cost of building high-speed lines in China is not as exorbitant as critics claim. A 350 km/ hr dedicated high-speed passenger line costs only 20%-30% more than a conventional mixed use (passenger and freight) line, according to the World Banks John Scales, who is overseeing US$3 bn of loans for highspeed rail projects. Costs are much lower in China than in developed countries, thanks to the countrys cheap labor and economies of scale. China is also laying as much of the new track as possible on viaducts, to minimize reimbursing farmers for lost agricultural land. High-speed rail offers clear benefits over slower lines. One is the potential to substitute for air and long-distance car travel, which are far more energy intensive. Conventional wisdom suggests that high-speed train lines over 1,000 km long are no match for planes, but the non-stop Wuguang Harmony Express was packed on a Thursday afternoon. One of the main reasons passengers cited for taking the train over a plane was the lower ticket price: a second class train ticket costs Rmb490 versus an average plane ticket price of Rmb700. With average household income in 36 of Chinas largest cities at Rmb72,000 in 2009, there are millions of customers who can afford the price of a high-speed ticket, in addition to business travelers. Besides, present-day incomes are a poor indicator of the usefulness of a transportation infrastructure that will last a century, especially in an economy growing as quickly as Chinas. One could just as well argue that Chinas past investment in highway and airport infrastructure was a waste because most Chinese do not own passenger vehicles and only a small fraction of the population flies. In a forthcoming report, the World Bank reviews around 50 high-speed rail lines across a number of countries. Annual passenger traffic ranges from 5m up to 82m on Japans busiest line. Paul Amos, the former senior
JUNE 2010
China already has enough citizens able to afford high-speed train tickets
The economy
transport advisor to the World Bank, who worked on both the World Bank reports on Chinas railway network, confidently expects that Chinas Beijing-Hong Kong line will exceed 82m passengers annually within just a few years, and that most Chinese high-speed rail lines will be among the worlds busiest. He also points out that Chinas growing urban density will increase the intensity of passenger use. In most countries with highspeed rail, lines run from city A to city B usually the capital to a large regional center. But in China, says Amos, you get a huge city one the size of a European capital every 200-300km. All of a sudden theres not one city pair, but several per line, and therefore the density of passengers increases.
Another debt muddle-through Still, critics point out, managing the debt burden remains a major challenge. Freeing up mixed-use lines for higher freight volumes should bring in enough extra income to cover most capital costs for high-speed passenger lines, according to Amos. Yet MORs cash flow position will unquestionably deteriorate over the next few years, thanks to the lag between its present investments and the time when profits from increased freight traffic begin to accrue. MORs total liabilities rose from Rmb870 bn in 2008 to Rmb1.3 trn in 2009, pushing its debt-to-asset ratio up from 47% to 55%. One rather extreme estimate by CITIC Securities projects MORs total liabilities at Rmb3 trn by 2020 with a debt-to-asset ratio of 70%. Clearly the debt risk is not small, and it is difficult accurately to predict how fast rising freight income will enable MOR to start paying down this debt. But China has a history of successfully managed large-scale debtfinanced infrastructure programs, and there are several mitigating factors that should help MOR execute the classic Chinese debt muddle-through. First, Beijing may step in and directly appropriate budgetary funds for railway expansion. MOR has argued that it cannot be completely commercially viable if Beijing forces it to build railways for the social good, such as lines from Lanzhou to Urumqi. It is likely that Beijing will appropriate central funds to subsidize some of the build-out as part of the 12th Five Year Plan in 2011-15. This is not without precedent as the QinghaiTibet railway was highly subsidized.
If NPLs from Chinas infrastructure roll-out become too big for banks to bear, the government will probably take over the liabilities
Second, the loans that finance the MOR-local government JVs that own these railway lines are for very long terms, generally 10-15 years. This allows time for MOR to increase revenue from freight carriage, and for local governments to increase the tax revenues they will use to service their debt. In any case, it is likely that banks will roll over the principal amounts, which means that the ultimate risk from the infrastructure build-out is being borne by the banks. If non-performing loans from this and other infrastructure programs become too big for the banks to bear, the central government will have to assume the liabilities, effectively bringing some of the cost of rail and other infrastructure on to the central budget. This would not be disastrous: it is perfectly normal for central
JUNE 2010
The economy
governments to bear the capital cost of building high-speed rail lines, and using bank debt to substitute for fiscal expenditure is a perfectly rational method of government cash-flow management that works fine so long as the economy achieves long-run nominal GDP growth of 10% or more which is almost certain in China for the next decade. The great railroad business bonanza The broader economic benefits of a much bigger rail network are hard to calculate, but they will be significant. First, improved delivery times will decrease inventory holding costs for manufacturers, and enable them to move closer to just-in-time delivery systems. Second, transporting goods by rail rather than truck is, ton for ton, at least three times cheaper. Lowering inventory and shipping costs will help manufacturers keep goods prices low and spur the development of consumer markets. Finally, better connectivity will persuade more businesses to invest further afield, expanding commercial opportunities nationwide. According to Moshe Givoni, a senior researcher at the Transport Studies Unit at Oxford University, the economic impact of high-speed rail networks depends on a number of accompanying conditions like local economies ability to take advantage of new opportunities offered by high-speed rail, complementary government policies, and a long-term political vision. China generally scores high on these measures: the central government clearly has a long-term vision of how the rail network will support economic growth; that vision is complemented by other policies on urbanization and the development of consumer markets; and Chinas rapidly developing urban economies are nothing if not dynamic. China appears in a good position to take full advantage of a high-speed transport network that connects almost every major city in the country.
Planes, clean trains and automobiles

Energy efficiency and carbon intensity in passenger transport CO2 Energy use emissions Airplane 67 170 Automobile 42 100 Train (high-speed) 32 30 Train (conventional) 20 20 Bus 16 40
Energy use: watt-hours or ml per passengerkm; CO2 emissions: g/passenger-km Source: World Bank
JUNE 2010
The economy
Metals Man
Death of the annual mating ritual

by Michael Komesaroff
On April 1, Rio Tinto, BHP Billiton and Vale introduced quarterly pricing of iron ore, scrapping the 40-year-old benchmark system of annual contracts. Prices under the new system will rise or fall every quarter according to the weighted average delivered price of iron ore to north Asia. For the past 40 years, most of the worlds iron ore was traded under prices agreed annually between miners and steel makers. Known as benchmark pricing, the system emerged when the post-World War II reindustrialization of Japan created a then unprecedented demand for steel. Hammered out during an acrimonious process known as the annual mating ritual, the price agreed between iron ore miners and Japanese steel mills was a benchmark against which all suppliers sold their ore to Asian mills. For years, Japanese steel makers dominant position in the market allowed them to keep iron ore prices low, and iron ore miners had no incentive to invest in new capacity. But as the huge rise in Chinese imports of iron ore over the past decade rapidly eroded limited surplus mine capacity, pricing power flipped from the steel mills to the miners. That shift in market power ultimately contributed to the collapse of benchmark pricing. Out with the old Chinese steel makers did not formally participate in the benchmark pricing process until 2007 when Baosteel, Chinas biggest steel maker, reached an agreement with the mines ahead of their Japanese peers. In 2008, the Chinese mills were forced to follow the Japanese after ham-fisted lobbying by the China Iron and Steel Association stalled negotiations. In 2009, Chinese steel makers refused to accept the Japanese negotiated benchmark, which they said was too high. With global steel demand collapsing thanks to the global economic slump, the spot price for iron ore fell below the benchmark for the first time. Chinese mills abrogated their benchmark contracts in favor of purchasing what, for a short period, was cheaper spot ore.
The traditional iron ore contract system has been doomed for several years
In retrospect, the traditional contract system had been doomed for several years. Until 2000, all but a small proportion of Chinas iron ore imports were supplied under annual negotiated contracts. But as Chinas steel production exploded, the traditional suppliers were unable to keep up with demand. This opened the way for new entrants, primarily from India, to supply the deficit on a spot basis, with prices negotiated prior to each shipment. The rise of the spot market, which consistently traded at a large premium to benchmark iron ore, encouraged the big suppliMichael Komesaroff is principal of Urandaline Investments (www. urandaline.com.au), a consultancy specializing in Chinas capital intensive industries, and executive in residence at the School of International Affairs, Pennsylvania State University.
10
JUNE 2010
The economy
ers in Australia and Brazil to seek massive annual price increases and to shift more of their sales to flexible pricing. BHP Billiton was the first to complain that it was no longer appropriate to sell against annually agreed prices which, in a rapidly rising market, were obsolete almost as soon as they were concluded. Together with its main rivals, Rio Tinto and Vale, the Australian mining giant began to shift a growing proportion of production to the spot market further confirmation that annual pricing was no longer sustainable. The benchmark system also created damaging market distortions in Chinas steel industry. Since only large state-owned steel mills were allowed to import iron ore at the benchmark price, the big mills were able to exploit this privileged position by on-selling to their smaller rivals at a significant mark-up. In 2007-08 the difference in price exceeded US$100 per ton, providing fat profits for the state champions. The arbitrage was large enough to encourage small mills to deal directly and illegally, under Chinas law with the mining companies. As the recent trial and conviction of four Rio Tinto employees in Shanghai showed, this inevitably bred widespread corruption, with small mills bribing mining company employees to supply them with ore at benchmark prices. The public exposure of this widespread practice was the final nail in the coffin of the contract system. in with the new Chinese protests over the death of the benchmark pricing system have been surprisingly muted. The China Iron and Steel Association accused the foreign suppliers of colluding to exploit Chinese mills, but an official at the Ministry of Industry and Information Technology described the benchmark pricing system as opaque and unhealthy. There is clear support within the government for rooting out corruption and introducing a more transparent and flexible pricing mechanism. In any case, Chinas dependence on imported ore for more than 60% of its pig iron production makes belligerent calls to boycott foreign imports unrealistic. Moreover, Beijings reluctance to aggravate trade tensions means that a reported investigation of alleged monopoly abuse by the three mining giants is unlikely. The immediate beneficiaries of the new quarterly pricing arrangement are the mining companies. The losers are the big Chinese steel mills, which will no longer be able to generate huge profits by selling surplus ore to their smaller rivals at much higher spot prices. Chinese mills will have to adapt to the volatility of flexible pricing, which could pose a risk for companies tempted to speculate on future price changes. But the new system will also bring two major benefits to Chinas steel industry. First, by eliminating the possibility of exploiting arbitrage, the new pricing mechanism will reduce corruption in an industry that is notoriously dishonest. Second, by merging the annual benchmark and spot prices into a single transparent price, the mining companies no longer have an incentive to supply the small mills. This should aid Beijing in its troublesome quest to rationalize its steel industry.

Mining companies are the immediate beneficiaries of the new quarterly pricing system
JUNE 2010
11
The economy
Retail markets
How not to B&Q it

by Paul French
Chinas booming property market should have been good news for homeware retailers, especially in China where most new properties are shell apartments that require decorating from scratch. But profits at Chinas leading homeware retailers have disappointed for years. The UKs B&Q, the biggest foreign homeware retailer in China, reported big losses in 2008-09 and was forced to close 20 stores. Sales turnover at Orient Home, the largest domestic player, has halved since 2007. The problem is a familiar one: intense competition from smaller players has diluted leading retailers market share, forcing the likes of B&Q and Swedens IKEA to slash prices and accept meager profit margins. The homeware market grew steadily over the past eight years, averaging 11% sales revenue growth per annum. But that number is unimpressive in the context of 15% nominal GDP growth and an enormous property boom. One reason for sluggish growth reflects a peculiarity of the Chinese property market: many apartments are bought as investment properties, which then lie empty and undecorated. Another reason is that government statistics fail to capture many sales of furniture and lighting and, especially, more basic decorating products such as paint, ceramics and flooring. Large volumes are sold through small mom-and-pop stores, which frequently open and close along with the housing projects they serve. The China National Interior Decoration Association estimates there are more than 40,000 registered single-store companies engaged in home improvement, but the true figure could be significantly higher. Tough times for the men in orange aprons The biggest reason for the disappointing performance of the big retailers, however, is good old-fashioned competition. The bulk of the homeware sector is made up of independent players, most of whom are warehouse retailers selling an array of brands at bargain prices. Consequently, the chains that rule the homeware roost in other countries the USs Home Depot, B&Q, IKEA have been squeezed in China. Orient Home and Homemart are the only local retailers with more than a handful of stores. Expansion has been painfully slow compared to other markets: Frances low-price homeware chain Leroy Merlin, which entered China in 2004, still only has two stores. IKEA, which has been in China since 1998, only has seven stores (although per-store turnover is three or four times that of their rivals).
Foreign retailers have found profits hard to come by
The foreign chains have found China tough going. B&Q had over 60 stores by 2007 but profits consistently disappointed. When B&Q made losses of 17m in 2008 and 52m in 2009, managers were forced to close 20 stores, scale back a further 17 and halt expansion plans. Sales in the
Paul French is the principal of Shanghai-based retail consultancy Access Asia.
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JUNE 2010
The economy Size does count

Top ve homeware retailers (2009) Sales turnover Rmb bn B&Q 4.9 Orient Home 3.5 IKEA China 3.1 Homemart 2.1 Home Depot 1.6 Total sector 54.0 Top ve share of total 28% Store numbers 43 25 7 14 12 3,780* 3% Rmb m/ per store 114 140 446 150 133 14 11%
Source: Company reports, China Chain Store and Franchise Association, Access Asia, GaveKal Dragonomics estimates *Registered homeware stores
fourth quarter of 2009 jumped 29% to Rmb1.2 bn on the same period the year before, and B&Q expects to restore profitability by 2011. But B&Qs overall performance over the past two years was dismal, even allowing for the property slowdown in 2008. Home Depot, which finally entered the fray in 2007 after acquiring underperforming Tianjin-based homeware chain HomeWay, has fared little better. The worlds biggest homeware stores attempt to catch up with B&Q remains stalled at 12 outlets. The resignation of Home Depots China president Chen Yaodong in 2009, after just two years in the job, suggests a management shake-up. IKEA, by comparison, has done better, firmly establishing itself as the homeware shopping choice of Chinas aspirant consumer class. IKEAs cavernous stores in Beijing and Shanghai are packed even by Chinas sardine-tin standards. But these flagship outlets have only just begun to deliver expected returns, years after opening. And success has come at a cost, with sales revenue growth consistently lagging sales volume growth thanks to brutal, aggregate price cuts in excess of 40% since 2000. Even a three-course meal of smoked Norwegian salmon, Swedish meatballs and chocolate cake in IKEAs cafeteria only costs around US$4. In Beijing, out-of-work migrants clutching their own Styrofoam cups have started to frequent the caf, enjoying the bottomless drinks on offer for free. The conundrum for IKEAs managers is: how much lower can prices go before they become a charity store? Too many home marts The wooden spoon, however, goes to Beijing-based Orient Home. The only retailer to have grown more slowly than the overall homeware market over the past eight years, sales per store slumped badly in 2008-09. The growing popularity of independent brand aggregators hit Orient Home harder than more than the foreign chains, which offer stronger brands. Per-store sales revenues slumped to Rmb115m in 2008, down from Rmb251m in 2006-07. Orient Home could do worse than study the tactics of its major Chinese rival, Homemart, the only retailer to record growing sales turnover even as it closed stores. Over the next few years, the big foreign and domestic chains will continue to fight over a minority share of the homeware market. The bulk of the IKEAs relative success stems from slashing its prices
JUNE 2010
13
The economy
market, especially in Chinas hundreds of smaller cities, will remain dominated by tens of thousands of independent warehouses, wholesalers and mom-and-pop outlets. The performance indicators of the major chains improved slightly in 2009, but their performance was sluggish given the pace of the wider Chinese urban property market. The top five retailers share of the market shrunk from 44% in 2007 to just 28% in 2009, as brand-aggregating wholesalers became more competitive. And with the booming property market set to cool once again, the tough times are only likely to get tougher for Chinas big homeware retailers.
14
JUNE 2010
The economy
Property
Relax its different this time

by Rosealea Yao For Chinas millions of property investors, 2010 is starting to feel eerily like 2007-08. The last time policy makers used a series of administrative measures to cool the sizzling property market, they succeeded catastrophically: house price expectations fell, transactions ground to a halt, construction collapsed, and Chinas economy tanked. In mid-April, the State Council issued a slew of new policies designed to price speculators out of the market, raising the down payment for second homes from 40% to 50% and hiking mortgage rates for investment properties by 10% above the benchmark rate. Beijing restricted families from purchasing second homes in the city, and other cities have a free hand to take whatever measures are needed to deflate incipient bubbles. The initial evidence suggests that a property correction is likely. Property sales in Beijing, Shanghai, Guangzhou, Shenzhen, Hangzhou, Tianjin, Nanjing and Suzhou all fell sharply in early May. Some developers even cut prices, albeit moderately. Are we about to witness a re-run of 2008? It will almost certainly be a tough year for investors but we believe policies are better targeted this time round. Measures are designed to pop speculation at the top, while making housing more affordable at the bottom. Crucially, a concerted attempt to construct new public housing will shore up construction volumes. Beijing shows its teeth Two major things are different compared to the last round of tightening. First, the government now views growing public discontent about the cost of housing as a serious political issue. Beijing has a poor record of cracking down on price-ramping and property speculation over the past decade, and now desperately needs to show its teeth without killing the market. The latest round of tightening polices suggest that Beijing is, for the first time, willing to tolerate slightly lower GDP growth in order to win this battle. Second, these policies are carefully targeted at increasing supply even as they restrict investment demand. The State Councils mortgage rate hike on investment purchases triggered the recent freefall in transaction volumes, but this is just one part of a broader package of policies that includes boosting land supply, putting a ceiling on land prices, and increasing investment in public housing. The Ministry of Land and Resources says 1.85 bn sq meters of land will be available for residential development in 2010 three times the average actual residential land supply in 2004-09 (although the government has a poor record of releasing much of the land announced in its annual supply targets). Moreover, far more land is being sold at government-set prices rather than via public auctions,
Rosealea Yao is the Beijing-based research manager for GaveKal Dragonomics.
JUNE 2010
China plans to make three times more land available for development
15
The economy
thereby preventing developers from bidding up prices. The final-price premium fell sharply in several cities in recent months. In Shanghai, the premium over the initial floor price fell from 155% in January and 133% in February to just 15% in March and 17% in April; Tianjin, Nanjing, Changsha and Qingdao also saw substantial falls. The era dominated by so-called land kings big, often state-owned developers who use their financial muscle to price everyone else out of the market is ending. Progress on providing public housing looks more likely at last Most important of all, we finally expect to see progress on the public housing front. Despite many promises over the past ten years to boost the volume of affordable housing for low-income families, Beijing has consistently failed to make this happen. Because cities have no public housing authorities, policy makers relied on the private market to take up the slack. Property developers have little interest in building low-margin homes when they can make fat profits on luxury apartments. This time, however, the central government is putting unprecedented pressure on state-owned property developers to build public and other low-cost housing, and we think they will listen. The government is offering implicit guarantees that developers will make a modest return on their investment, and most state-owned developers we talked to said they could break even on most public housing projects. On April 19, every province-level government signed a memo with the Ministry of Housing and Urban Rural Development promising to fulfill local public housing targets. Construction of 5.8m units of public housing is due to begin in 2010, roughly 30% of all new starts and nearly double the total in 2009. Shoring up construction The upshot of all these measures is that we are likely to see a significant price correction in the commercial housing market (as opposed to the subsidized/public housing sector). There is some risk that the present tightening policies will not be sufficient to dampen speculative investment demand, or that property speculators driven out of overpriced markets like Shanghai and Beijing will inflate bubbles in second-tier cities where the tightening policies are not so strictly enforced. But this will prompt further tightening from the central government, which is determined to end the housing bubble. As a result, construction volumes in the high-end commercial housing market will slow, but the big increase in public housing will pick up the slack. For 2010 as a whole, floor space construction volume should rise by about 10% year on year (moderately lower than the 13% recorded in 2009), and further construction growth of around 10% is likely in 2011. But construction growth in the second half of 2010 will be weak on a year-on-year basis: given the 32% year on year increase in construction volume in January-April, 10% growth for the full year implies that that construction volume in the May-December period will be about 25% below the year earlier level. This should cause a dip in industrial production and commodities imports, but both should stabilize at sustainable growth rates of around 10% by the first quarter of 2011.
16
JUNE 2010
The economy
Capital markets
The bear roars but financial futures soar

by Chao Gupiao Chinas A share market is wallowing in its second bear market in just over two years. China may have survived the credit crisis and bounced back quicker than any other major economy, but the Shanghai Composite index is reeling 24% below its recent peak in August 2009, and 57% below the giddy heights reached in 2007. From best performing market in 2009 to worst performing market of 2010 it has been a dreadful year so far. Back in August the market realized that the lending binge orchestrated by the central government would eventually come to an end, and fears of tightening brought investors back to their senses. This year has witnessed a non-stop flow of administrative measures to try and rein in the property market, and the world economy has not recovered as investors had hoped. All of this has taken its toll on stock prices. The big fear among investors is that liquidity is drying up. Since the securities regulator restarted the IPO pipeline in July 2009, the flow of new listings has been relentless. Over 250 companies floated in the past year, raising over Rmb370 bn. If you include the 150 plus companies that made rights issues and secondary placements, the cash value swells to a liquidity-draining Rmb815 bn. And wait there is more! Nearly every Chinese bank has announced some kind of fund-raising plan, with the big four listed state-controlled banks (including Bank of Communications) preparing to issue secondary shares and convertible bonds worth Rmb287 bn. In addition, Agriculture Bank of China hopes to raise US$10 bn from the A share market (and a further US$20 bn in Hong Kong). Bizarrely, the very worst of Chinas state banks is likely to conduct the largest IPO of all time! But thats politics, not economics, folks. Back to the futures In April, China launched its first financial futures contracts for 15 years. China already has three active exchanges trading commodity futures, but the potential impact of financial futures which allow investors to bet on changing interest rates, bonds and indices worry the authorities far more. With the volume of CSI 300 index futures already exceeding trading of Hang Seng index futures in Hong Kong, perhaps the regulator was right to be cautious. Shanghai is trading over 150,000 contracts daily, with a notional value of over US$20 bn bigger than daily trading on the entire domestic equity market. Your commentator admits he was overly skeptical about the outlook for financial futures, and has duly eaten a portion of humble pie. But it is worth noting that all the big numbers in China can easily lead you astray. Given that only investors with minimum assets of Rmb500,000 can apply for a futures account, this is certainly not a mom-and-pop market.
Chao Gupiao is the alter-ego of correspondents in Chinese capital markets.
JUNE 2010
China launched its first financial futures contracts for 15 years
17
The economy
Instead, it is driven by institutions, corporates, big hands (manipulators) and filthy rich individuals. The number of futures trading accounts only numbers in the tens of thousands, but the volumes being traded are enormous. Why? The first reason is that, unlike in the stock market, day trading is allowed. Investors can buy and sell, and get in and out of the market, all day long. Stock positions, in contrast, must be held overnight. The leverage of the contract also allows far bigger exposure, as investors must only fund 20% or so of the contracts value, compared to 100% of a stock investment. The financial futures market has enjoyed an unexpectedly strong start Yet the number of contracts traded only tells part of the story. The real indicator of success is open interest - ie the number of open positions at any given time. If an investor buys a contract in the morning and sells it in the afternoon, the volume traded is two contracts. But as no position is left open, the open interest is zero. If the buyer holds his position overnight, the open interest becomes one. Shanghai may be trading twice as many futures as Hong Kong, but the open interest of CSI 300 futures is US$1.4 bn, compared with over US$10.3 bn for HSI futures. By way of comparison, around US$7 bn of S&P 500 futures are traded daily, with an open interest of over US$85 bn. The CSI 300 future is almost entirely used for intra-day speculation, partly because tight limits on individual accounts make it difficult to hedge a meaningful position. But it is early days, and financial futures have enjoyed an unexpectedly good start. Lets hope we get through the first cris is relatively unscathed and dont have to wait another 15 years before the next contract is launched!
18
JUNE 2010
The big idea Fiscal and financial reform

Economic rebalancing
Twin peaks: fiscal and financial reform

A major theme of recent discussions of Chinas economy is the need for rebalancing a shift away from an investment- and export-intensive growth model that created excess industrial capacity, big trade surpluses and bloated corporate profits, to a more domestically-driven growth pattern where consumer spending plays a bigger role. The house view on this hot topic is straightforward. We believe that Chinas external imbalance a current account surplus that peaked at over 11% of GDP in 2007 mainly reflected domestic structural problems. The undervalued exchange rate that obsesses foreign analysts was decidedly secondary. The path to rebalancing therefore lies in comprehensive domestic reforms, including increased social service spending (to reduce household precautionary saving), deregulation of service markets (to encourage more private investment in non-tradable sectors), infrastructure investment (to better integrate domestic markets) and financial and fiscal reforms to discourage excessive investment in heavy industry and real estate. If these reforms occur and some are already underway then exchange-rate policy can play a useful supporting role. If they do not, currency revaluation by itself will accomplish little. As made clear by our discussion of the sources of excess saving (December 2009) and in The end of surplus labor (March 2010), demographic factors are crucial. Over the past 15 years a superabundance of young workers created an unusually slack labor market, so that real wages grew more slowly than the economy as a whole. This meant the household income share of GDP steadily declined, while returns to capital increased, filling corporate and government coffers. Over the next decade, a sharp decline in the supply of young workers will reverse the trend: wages will tend to grow faster than GDP, and the household share of national income will begin to rise again. This will boost consumer spending and reduce the current account surplus which has already fallen to around 5% of GDP, less than half its peak level. This natural, demographically driven shift will be beneficial. But it also throws up new challenges. Higher wage and consumption growth will increase inflationary pressure. Monetary policy will need to be tighter; and scarcer capital will need to be allocated more efficiently. Yet since Chinese financial markets are essentially tools of fiscal policy, improvements in capital allocation through the financial sector cannot occur without major fiscal reforms. In this final installment of our rebalancing series, we assess the challenge of restructuring Chinas financial and fiscal systems. As the articles make clear, the scale of the task is daunting. But China has overcome equally daunting challenges before, and there is at least an even chance that it will defy the skeptics again. Arthur Kroeber Restructuring Chinas fiscal and financial systems is a daunting task but far from impossible Economic rebalancing requires structural reforms at home not a revaluation of the renminbi
JUNE 2010
19

Fiscal reform
Paying for the harmonious society

by Christine Wong
One of the defining motifs of the Hu Jintao and Wen Jiabao administration is its pledge not only to safeguard Chinas rapid growth but also to rebalance the economy, improve public services, reduce regional inequalities and promote fairness. Chinas leaders agree they need to shift investment from capital-intensive industry toward services, and boost domestic consumption. Under the banner of the harmonious society, adopted at the fourth plenum of the 16th Communist Party Central Committee in September 2004, Beijing has pumped resources into expanding the social safety net to include rural citizens and into improving social services provision both crucial moves if China is to become a more consumption-driven economy. Fiscal transfers to local governments have risen more than five-fold since 2009 ... The reforms have been impressive. To reduce the burden on farmers, all rural fees were eliminated in 2003, and agricultural taxes abolished in 2006. Basic education is now offered free of charge, and more than 90% of the rural populace is covered by health insurance. Urban citizens, too, are beneficiaries of expanded health insurance coverage and free basic education, with some benefits being gradually extended to rural migrants. To improve health care provision, a comprehensive health reform program was launched in April 2009 with initial funding of Rmb850 bn. These policies have been supported by massive subsidies from the central government: fiscal transfers (excluding tax rebates) from the center to local governments increased from Rmb435 bn in 2002 to Rmb2.4 trn in 2009. By any measure, this is a laudable effort to reshape the nation in a more humane image. Yet the efficacy of these ambitious policies is threatened by Chinas dysfunctional fiscal system, which is unsuited to financing social expenditures in a reliable and equitable way, and is itself the root cause of the inequalities and under-provision of public services that Beijing wants to reverse. The attempt to build a harmonious society will not succeed without wholesale fiscal reform. Today, the constraint to improving public services in China is no longer predominantly a shortage of funds; the main challenge is how to channel resources effectively to where they are needed. China needs to build an inter-governmental fiscal system with the capacity to assign fiscal responsibilities to the appropriate level of government, and then to coordinate the flow of resources to meet expenditure needs. ... but remain far from being big enough to meet local expenditure needs Lots of unfunded mandates As in most countries, many public services in China are provided by local governments. For the majority of the Chinese population, services such as basic education, health care and social welfare (including pensions) are provided by rural local governments at the county and township levels.
Christine Wong is senior research fellow in Contemporary Chinese Studies at the University of Oxford. 20 CHINA ECONOMIC QUARTERLY
JUNE 2010

The flaw in Chinas system is that, in theory, local governments are also supposed to finance these vital and costly services yet the revenues they are assigned come nowhere close to meeting their expenditure burden. Fiscal transfers from central government, which are supposed to alleviate revenue disparities across regions and to fill local financing gaps, do not perform these functions well. Local governments finance 80% or more of basic health and education expenditures. The financial responsibility for costly social services was thrust on local governments as an unintended byproduct of reforms to shore up central government revenues during the first half of Chinas market transition. Government revenues fell from one-third of GDP in the late 1970s to just 10% by 1995, as lifting price controls and entry barriers to industry destroyed profits at state-owned enterprises. This crisis forced the central government to make changes to all components of the fiscal system, from tax policy and tax administration to budgeting and treasury management. Because the fiscal picture was so dominated by the steep decline of revenues during these years, fixing the system focused on reviving central revenue collections. The fiscal needs of local governments were often overlooked. Previously, under the planned economy, costly basic services were assigned to lower tiers of government but financed by higher level governments through the revenue-sharing system. But reforms aimed at improving revenue mobilization and hardening budget constraints for local governments delinked revenue assignments and local spending requirements. When the so-called tax sharing system was introduced in 1994, it ended negotiated revenue-sharing and most of the taxes collected locally were sent to the central coffers. To ensure that local governments could carry
How to build a harmonious society

Program Rural minimum living stipend (dibao) New rural cooperative medical scheme Launched 2005 Policy objective Provide income support for the poor Provide insurance for rural , families to reduce nancial risks caused by illness Policy content All households with incomes below the local stipulated minimum can apply for a top-up. (Potential beneciaries: 37m) Designed mainly for inpatient services; risk-pooling is at the county level. Minimum funding was initially set at Rmb30 annually per participant, and ratcheted up to Rmb100 by 2009. Central government pays 40%; local governments pay 40%; and participants pay 20%. (Potential beneciaries: 700m) Government provides funding to replace school revenues previously collected from miscellaneous fees, and provides a subsidy to boarding students from poor families. (Potential beneciaries: 148m) The urban benet cap will be raised to 6x average per capita income, up from current 3-5x. Annual rural per capita subsidies will rise from Rmb60 to Rmb100. (Potential beneciaries: 1.3 bn)
2005
Free rural compulsory education
2006
Eliminate out-of-pocket costs of basic education and boost rural school spending
Comprehensive health 2009 reform program
To provide medical insurance to at least 90% of the population by 2011
Source: Author
JUNE 2010
21
The big idea Fiscal and financial reform The fat get fatter
Richest and poorest provinces share of national total, % 1990 Five richest provinces Population 13 GDP 21 Fiscal revenue 18 Fiscal expenditure 12 Five poorest provinces Population 17 GDP 11 Fiscal revenue 8 Fiscal expenditure 10 1998 12 23 12 15 17 10 6 10 2006 13 28 16 18 17 9 4 9
Five richest: Shanghai, Beijing, Tianjin, Zhejiang and Jiangsu Five poorest: Guizhou, Gansu, Yunnan, Anhui and Guangxi Source: China Compendium of Statistics (1949-2004), China Statistical Yearbook (2007)
on their work, the central government created a system of tax rebates, to give back the bulk of the recentralized revenues. Because the rebates are returned to localities where the taxes were collected, however, they accrued more to rich regions. Transfers intended to help poor regions were, in contrast, greatly reduced. During the mid-1990s, when transfers excluding tax rebates fell to 1% of GDP, poor regions were essentially left on their own. As Chinas coastal provinces grew faster than inland provinces and income differences widened, the fiscal system played no palliative role. The result was large and growing regional disparities in public service provision. In 2004, per-student spending in primary schools was nine times as high in Shanghai, the richest province, as in Guizhou, the poorest. Even within a single province, the disparities could be large: in 2003 the richest county in Liaoning spent 14 times as much as the poorest. Through the 1990s, China spent too little on education, health and social welfare Throughout the 1990s, local fiscal restraints meant that China spent too little on education, health and social welfare. The World Bank estimated the shortfall in Chinas social expenditures at more than 5% of GDP in the mid-1990s. In education, public expenditures were below 3% of GDP throughout the 1990s, compared to 4.5% in Vietnam. The failings of the intergovernmental fiscal system doomed citizens in poor regions and rural areas to low quality and inadequate public services. Nearly two decades after the 1986 Education Law mandated nine years of compulsory education, a 2004 Ministry of Education survey found that 17% of Chinas rural counties could not provide it. Cash-strapped local governments and public institutions increasingly turned to user charges, penalties and fines to plug the gap in budgetary shortfalls, leaving citizens to pay for schooling, health care and even police services out of their own pocket. In the 1990s, with public finance covering only half the costs of public education, school fees were a heavy burden, especially for rural families. The price of harmony The harmonious society program intends to reverse or alleviate many of the problems created in the 1980s and 1990s: inequalities and underinvestment in social services, exorbitant user charges, weaknesses in safety
22
JUNE 2010

nets, etc. The targets are ambitious. They affect huge numbers of people, and they mostly aim to benefit low income households. The problem is that they are being implemented under the existing intergovernmental fiscal system, which means they blow big holes in local budgets. Take the policy to promote free rural compulsory education, under which the central government abolished miscellaneous fees for the first nine years of education in rural schools in 2006. New funds are injected from central and provincial coffers to replace revenues previously collected from fees. But the vast majority of the costs still fall on county budgets, which must fund the biggest component of costs teachers salaries. Since the new policy calls for upgrading the quality of teachers, counties must take on an additional burden. In 2007, county governments paid Rmb227 bn to finance the new system, a 37% increase on the year before. The picture is similar for other social programs. Under the new national health insurance scheme county governments bear the costs of collecting premium contributions from several hundred million households and managing their individual accounts. Since they also bear the financial risk of reimbursements exceeding contributions, at the outset many counties limited reimbursement rates. Following a central government edict in 2009 that counties must disburse a minimum of 85% of contributions, some counties reportedly ran a deficit in the first quarter of 2010. Since their introduction, harmonious society policies have brought substantial and tangible benefits to the populace. The benefits reach well into the poorest regions and over the most vulnerable populations. These are remarkable achievements in such a short time. But policy makers refusal to reform the dysfunctional intergovernmental fiscal system means that programs intended to reverse the underfunding of rural services have, paradoxically, created additional financial strains on rural local governments. The combined share of revenues for county and township governments has remained flat over the past decade, while their share of expenditures has grown steeply. Central transfers fail to provide enough funds where they are really needed. Transferring responsibility Transfers play many important and indispensible functions, and are used in all countries, but they have well-known adverse effects on incentives and efficiency. Because the 1994 tax sharing system locks in such a huge discrepancy between local revenues and local expenditures, China has relied on central-local transfers to an extent far greater than in other countries. In 2009, transfers (excluding rebates) were equal to 7% of GDP, absorbing two-thirds of central government revenues, and they funded fully 40% of sub-national expenditures in aggregate. At the provincial level, the share of expenditures funded by transfers ranges from below 10% to more than 70%; at the county level, the dependence on transfers is even higher. Other countries shy away from relying too much on transfers because of their high administrative costs. The reliance on transfers, especially those earmarked to achieve a particular objective, is
China relies on center-to-local transfers far more than most countries
JUNE 2010
23
The big idea Fiscal and financial reform County burden

Distribution of scal expenditures for rural compulsory education 2006 2007 Rmb bn Share Rmb bn Total 198 284 Central 15 8% 37 Province 16 8% 21* County 166 84% 227 Share 13% 7% 80%
*Estimated, based on 2006 proportion of provincial funding. Source: Chinese Statistical Yearbook for Education Finance, 2006; Chinese Statistical Yearbook 2008, China Finance Yearbook 2008, and Xie Xuren, Budget Report to the NPC, March 2009
especially costly, with stringent requirements for information, monitoring and supervision. The heavy reliance on transfers is ill-suited to Chinas highly decentralized administrative structure, where the central government is unusually small and so has limited capacity to ensure transfers are distributed equitably and are used for their intended purpose. The Ministry of Finance has only 1,000 or so staff. In 2006, only 15 people looked after subnational finance an extraordinarily small number given the size of the country, the highly decentralized fiscal system and the huge program of transfers. Fine-tuned control is well-nigh impossible for the earmarked grants, which totaled more than Rmb1.2 trn in 2009. Instead, the central government relies on provinces to implement national policies in their territory. Provincial bureaucracies are themselves small, and must delegate authorities downward to the next level municipalities. The result of this nested hierarchy is that once central transfers reach the provincial treasuries, the central government has no ability to monitor the use of the funds. Chinas long chain of government means many funds are diverted from their intended final user Under this set-up, the central governments ability to influence outcomes is attenuated. When it injects resources to support rural local services, these resources pass through the provinces and municipalities, then to the counties and, finally, to the service providers. Relying on arms-length, level-by-level transmission and lacking the staff and mechanisms for monitoring and enforcement, the system is prone to leakages and policy distortions, as documented each year in the National Audit reports. For example, an audit of 54 counties in 16 provinces for the period 2006 and first half of 2007 found that, in 29 counties, some 45% of the funding allocated for a subsidy program was diverted or withheld by the education departments. While corruption and malfeasance were sometimes involved, these problems probably also reflected divergent central and local objectives. A better way to budget Fundamental reform of the fiscal system is long overdue. The current expenditure assignments are largely inherited from the planned economy, and many are unsuited to the highly decentralized, mixed economy that China has become. With growing population mobility, many formerly local public goods have taken on significant inter-local or even national
24 CHINA ECONOMIC QUARTERLY
JUNE 2010

characteristics, so the responsibility for providing them should be moved to higher levels of government. For example, the assignment of health care, education and pensions to local governments hinders their provision to Chinas 170m migrant workers. Indeed, the recent extension of some benefits to migrant populations required central government funding ie a partial recentralization of these functions. Because local governments have insufficient revenues to fulfill all the tasks assigned to them, they rely excessively on central transfers. But the transfer system lacks mechanisms for financing social expenditures reliably and equitably. Reforming the intergovernmental fiscal system will require fixing three interrelated problems. First, some expenditure assignments need to be moved to higher levels of government. This process should start with refocusing government expenditure on public goods and key national objectives. County and city-level governments should not be responsible for financing cyclical expenditures on safety net functions, such as pensions and welfare, and costly services that exceed the financing capacities of local governments, such as education. Second, revenue streams need to be reassigned so that local government revenues more closely match local expenditures. Increasing revenue autonomy would improve incentives and accountability for local governments, including allowing responsible local borrowing (transparently via direct bond issuance and bank borrowing, as distinct from the current opaque and indirect system of local government investment companies). Finally, central-local transfers need to be distributed more equitably and effectively. The solution is to reduce local governments reliance on transfers, improve the transfer mechanism, and increase the monitoring and reporting capacity of government at both the central and the provincial levels. Central and provincial government should finance social welfare, pensions and education directly
JUNE 2010
25

Local government debt
Big rock-candy mountain

by Victor Shih Since late 2008, local governments have unveiled an astonishing Rmb20 trn of investment proposals In late 2008, Chinas central government announced an Rmb4 trn fiscal stimulus package to combat the global financial crisis and offset a severe recession in Chinas export sector. The program stood at 13% of Chinas 2008 GDP, similar to the previous Keynesian push, the Go West campaign, which pumped around one-eighth of 2000 GDP into infrastructure investments in western China (although in both cases the spending was spread out over several years). But central government stimulus was just the beginning: local governments then jumped in with an additional Rmb20 trn in supplementary investment proposals. These local investment goals seemed fantastical because local revenue in most of China fell short of covering the normal operational expenses of local governments, let alone financing grand investment schemes. Even in 2007, a year of record economic growth, local governments collectively ran a deficit of Rmb1.5 trn; in 2008, the provincial fiscal shortfall was over Rmb2 trn. So how could central and local governments collectively finance stimulus programs totaling over Rmb24 trn (US$3.5 trn) in the midst of a global recession and still maintain the consolidated government budget deficit at a reasonable level? Local borrowing, back from the dead The answer lies in more than 8,000 local-government investment companies (LICs), which finance well over three-quarters of the central and local stimulus projects, mainly by raising loans from state-owned banks. These companies are the reincarnation of the trust and investment companies of the 1990s, which helped local governments raise funds from both domestic and overseas investors. Most trust and investment companies were closed in the late 1990s because of Beijings concerns over their irresponsible borrowing behavior. But local revenue shortages, and the incentives for local officials to promote investment, saw the rebirth of these firms as LICs, sometimes called difang rongzi pingtai or local financial platforms. Panic in late 2008 over the severity of the export contraction led Beijing formally to endorse a surge in LIC creation and borrowing, notably in a March 2009 notice from the Peoples Bank of China (PBC), which encouraged local governments to establish LICs to absorb loans from banks to provide credit support for central investment projects. Local governments could borrow up to Rmb24 trn by 2012 much of which they will never be able to repay The surge of borrowing by LICs since late 2008 has enormous implications for Chinas economic future. I estimate that LICs had borrowed roughly Rmb11.4 trn, mainly from state banks, by the end of 2009. If banks honor all lines of credit now open to local authorities, LICs may take on an additional Rmb12.7 trn in debt by the end of 2012. Since local authorities abilVictor Shih is associate professor of political science at Northwestern University and the author of Factions and Finance in China (Cambridge, 2008). 26 CHINA ECONOMIC QUARTERLY
JUNE 2010
The big idea Fiscal and financial reform Mother of all stimuli
Estimate of Chinas scal/monetary stimulus (2008-10) Figures in Rmb bn except where indicated 2008 Fiscal decit Business as usual (BAU) 111 Actual/projected 111 Net new bank loans BAU 4,200 Actual/projected 4,930 Bond nance BAU 708 Actual/projected 882 Stimulus Fiscal decit 0 Net new bank loans 730 Bond nance 174 Total 904 Stimulus, % of GDP Fiscal decit 0.0% Net new bank loans 2.3% Bond nance 0.6% Total 2.9% Total stimulus, Nov 2008-Dec 2010
Source: GaveKal Dragonomics estimates
2009 100 950 4,250 9,630 850 1,600 850 5,380 750 6,980 2.5% 16.0% 2.2% 20.7% Rmb bn 11,723
2010 100 789 4,850 7,500 1,000 1,500 689 2,650 500 3,839 1.8% 7.1% 1.3% 10.2% % of GDP 15.4%
ity to repay this massive debt largely depends on their ability to sell land, the interests of local governments and real estate developers are increasingly fused. In any case, it is likely that local governments will be unable to pay back much of this debt, leading to a big pile-up of non-performing loans and necessitating another bailout of the banking system down the road. How big a problem? Getting a firm handle on the size of LIC debt is difficult, in part because of the sheer proliferation of entities. The oldest local finance corporations are chengtou gongsi or urban development and investment companies (UDICs), which have traditionally financed much urban infrastructure and have handled many stimulus projects. But cities, rural counties and even development zones have incorporated a host of other LICs to finance public goods such as highways, railroads, power plants, harbor facilities, rural roads and irrigation systems. The main purpose of LICs is to circumvent regulations which forbid local governments to borrow. Local governments incorporate LICs by injecting some capital usually land and these corporations can then raise bank loans using the land as collateral. More frighteningly, in many cases LICs were shell entities without even land assets; these LICs borrowed on the basis of implicit or explicit local government guarantees. Massive borrowing through LICs thus exposes local governments and ultimately the central government to a huge off-balance-sheet debt. The Chinese media, citing various government sources, have published several estimates of the size of LIC debt. In early 2009, a Ministry of
JUNE 2010
LICs exist to get round rules banning local governments from borrowing
27
The big idea Fiscal and financial reform Definitely, a borrower be

Estimated local-government debt Actual (Dec 2009) LIC debt, Rmb trn (end-2009) 11.4 GDP, Rmb trn 33.5 Bank loans outstanding, Rmb trn 40.0 Consolidated government revenue, Rmb trn 6.8 Local government revenue, Rmb trn 3.3 LIC debt as % of: GDP 34 Bank loans outstanding 29 Consolidated government revenue 167 Local government revenue 351 Projected (2010-12) 12.8 Projected total (Dec 2012) 24.2 47.1 61.7 10.4 5.0 51 39 232 488
Assumptions: Nominal GDP growth: 12% p.a. in 2010-12; Bank loan growth: 19% in 2010, 14% p.a. in 2011-12; Government revenue growth: 15% p.a. in 2010-12. Source: Author calculations
Finance researcher warned that LIC debt totaled over Rmb4 trn. In mid2009, Financial News reported that LICs borrowed some Rmb5 trn in the first half of 2009 alone. Later in the year, a government scholar told the Economic Daily News that urban investment companies owed banks some Rmb6 trn. That figure has since become the official line. But in April 2010 an official source told the 21st Century Business Herald that LIC debt was well over Rmb7.5 trn at the end of 2009. Most estimates of LIC debt probably underestimate the scale of the problem Private analysts have also tried to estimate LIC debt. The usual way was to assume LIC debt was a significant share of medium- to long-term bank loans outstanding, which totaled Rmb22 trn at end-2009. Assuming that a quarter of it went to LICs, their debt would total around Rmb5.5 trn. But this is probably a low estimate: medium- and long- term loans grew by an astonishing Rmb6.7 trn in 2009 alone, making up two-thirds of net new loans. Given the heavy reliance on infrastructure construction for growth, it would not be surprising if a disproportionate share of this Rmb6.7 trn went to LICs. Moreover, LICs finance a range of businesses, such as hotels, which absorb a significant number of short-term working capital loans. Too much debt, not enough revenue In my own research, I have used a more systematic approach, and this method suggests the true scale of the problem is bigger than most official and private estimates. (For details on the calculation see How to count to 11 trillion.) Outstanding LIC debt at the end of 2009 was Rmb11.4 trn, or 34% of GDP. Funds committed, but not yet disbursed, under existing credit lines come to another Rmb12.8 trn, or 38% of GDP. If all of those funds are actually drawn down over the next three years, total LIC debt outstanding will rise to more than Rmb24 trn, or around 50% of GDP, in 2012 (assuming nominal GDP growth of 12% a year). The risk of this occurring is real: thousands of public infrastructure projects were initiated last year, and banks promised to finance these
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How to count to 11 trillion

My effort to calculate gross LIC debt began with the compilation of hundreds of bond rating reports and regulatory filings made in 2009. But since less than 5% of the more than 8,000 LICs have issued stocks or bonds that would require such filings, I then used internet search algorithms to uncover more than 700 public announcements of government-bank cooperative agreements (zhengyin hezuo xieyi or GBCAs). GBCA notices provide a more comprehensive view of local debt than bond rating reports. First, GBCA announcements offer a sense of how much bank credit is flowing to local government entities and bank credit is by far the biggest source of LIC finance. And since GBCAs are promises of future provision of credit, they also provide a sense of potential future local debt over a three-year horizon. A typical GBCA specifies a credit line that a bank grants to a local government via that governments local investment companies (LICs).The LICs can draw on this credit line over a two to four year period. In the first half of 2009, for instance, banks granted the Chongqing municipal government credit lines totaling Rmb600 bn. In some cases, the GBCA announcement contains specific information about which projects or LICs will receive the loans. If the credit line is granted to a specific LICs or to construction of a basic facility, specific infrastructure project or a key construction project, the entire amount counts as LIC debt. About half of GBCA announcements do not specify loan recipients, so additional assumptions are required. I assume that one-third of a credit line granted to a province or a municipality ends up in LICs providing public goods. This is a conservative estimate: in reality, it appears that about half of recent local-government credit lines are used for public infrastructure. But some jurisdictions, such as Zhejiang and Shenzhen, divert a large share of their credit lines to privately owned small and medium enterprises or to industrial firms. Counting only one-third of announced credit lines also takes into account the fact that some credit lines may be reduced, cancelled or not fully drawn down. Beware the debt triangle Most credit lines are open for two to four years. I therefore assume that most of the credit lines issued before January 2008 had been tapped by January 2010. This is reasonable, given the spectacular increase in infrastructure investment (and hence demand for credit) in 2009. I further assume that the small number of GBCAs announced before January 2004 were all repaid by the end of 2009. Some of the loans issued to LICs between January 2004 and end2009 may have been repaid; but most analysts agree that the vast majority of LIC loans are medium- to long-term loans with maturity of at least five years. The potential over-counting of LIC debt issued and repaid in the past five years is balanced by my decision simply to ignore all LIC debt issued earlier than 2004. In other words, my estimate of current LIC debt outstanding at the end of 2009 is the sum of: a) gross LIC bond issuance and b) credit lines received by local governments before January 2008, discounted as described above. Future debt of LICs includes all lines of credit announced from January 2008 onward, again discounted as described above. Even this estimate is not comprehensive. Internet searches may not capture all GBCA announcements, and only a subset of GBCAs is reported in the media. We have almost all recent GBCA announcements between the China Development Bank and provincial governments, and about half of the GBCAs between the major banks and the provinces have been reported. But for smaller joint stock banks, and GBCAs arranged by municipal, county or district governments, reporting is very sporadic. It is not clear how much borrowing we miss, because provincial GBCAs often include onward credit lines to sub-provincial units. Smaller banks often take part in syndicated loans or credit lines to provinces, which are reported. In richer provinces cities and even municipal districts enter into their own GBCAs. For example, although there is no record of a GBCA between the China Construction Bank (CCB) and Zhejiang Province, internet searches reveal that the CCB granted six municipal governments in Zhejiang credit lines of over Rmb300 bn in 2009. It is possible that other CCB credit lines to Zhejiang municipal governments went unreported. A final concern, revealed by the small handful of LICs for which we have comprehensive balance sheets, is that a significant chunk of LIC borrowings are IOUs to one another or to their parent governments socalled triangular debt. In this analysis I have ignored triangular debt. This can be justifiable because some local state-owned enterprises (SOEs) generate healthy cash flows which are used to subsidize LICs. Cross subsidies between local SOEs and LICs do not increase the net debt of a given locality. But analysts need to be aware of triangular debt because, to the extent that the cash flows of SOEs are already pledged to service old LIC debts, they are not available to service new debts. Thus the net cash flow position of many local governments, and their ability to sustain ever bigger debt loads, may be weaker than appears at first glance.
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The big idea Fiscal and financial reform Paying the piper
Servicing cost of LIC debt 2009 617 9.0 18.9 Scenario A 2012 1,307 12.5 26.4 Scenario B 2012 1,307 14.7 31.0
Annual interest cost, Rmb bn Interest cost as % share of: Total government revenue Local government revenue
Assumptions: All open credit lines are fully drawn down, interest rate of 5.4%; Annual government revenue growth of 15% (scenario A) or 9% (scenario B) Source: Author calculations
projects to completion. Unless the central government implements a harsh macroeconomic retrenchment that stops bank financing for thousands of projects, LIC debt will grow well beyond the current level. LIC debt is already three-anda-half times larger than local revenue The scale of this debt is formidable in comparison to fiscal resources. In 2009, total revenue of all levels of government was Rmb6.8 trn, only about 60% of the total LIC debt. If all future LIC credit lines are drawn down, LIC debt by the end of 2012 could be more than double, or even triple total fiscal revenue in that year, under reasonable assumptions. The comparison with local government revenue the main cash flow for repayment of LIC debt is even more alarming. Current LIC debt outstanding is at least 3.5 times current local revenue, and the debt-revenue ratio could rise to over six times by 2012. Moreover, only a small percentage of local revenue is actually available for debt service: all provincial governments have run deficits since the late 1990s, and local authorities devote most of their revenue to paying the wages of local civil servants and demobilized soldiers. Even if localities defer paying back the principal, interest costs could soon become a crushing burden. Assuming banks charge LICs an interest rate of 5.4%, approximately the benchmark one-year loan rate, the current servicing cost of LIC loans is 19% of local revenue and 9% of total government revenue. If all credit lines are drawn, the servicing cost rises to Rmb1.3 trn by 2012, at which point it will consume between a quarter and a third of local government revenue. At that point, many provincial governments, especially in inland areas, will run into liquidity problems requiring intervention from Beijing. If property markets crash and land prices fall, local authorities will not be able to service their loans Until now, local governments have relied on revenues from land sales to finance interest payments, which worked fine as long as land prices kept going up. But because interest costs are rising fast, local governments will need to generate at least as much land revenue as they did in the record year of 2009 (Rmb1.5 trn) for the next decade to keep up. And if the real estate market tanks and land prices stagnate or fall, local authorities would be unable to service their loans. Tighten policy, reform the fiscal system If bank lending to LICs continues on its current trajectory, local debt will become an enormous problem by 2012. The most effective method for forestalling a local debt crisis is a determined macroeconomic tightening.
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Prohibiting banks from funding projects that are less than 25% complete would drastically slow the accumulation of local debt and probably lead to a relatively modest and manageable build-up of non-performing loans (NPLs) on bank balance sheets. Confining ourselves to the current LIC debt outstanding, if we assume that half of this debt is not problematic, one-quarter will generate NPLs at a 30% rate and the last quarter NPLs at a 50% rate, the overall NPL rate on LIC debt would be 20% and total NPLs would be Rmb2.3 trn or about 7% of 2009 GDP. This amount can probably be absorbed through a combination of write-offs by the banks and assumption of the liabilities directly by the central government, which could finance that liability through issuance of long-term bonds. Given that the central governments
At the bad-debt coal face

For a sense of how local government borrowing works on the ground, we recently took a trip to Shizhu, an agricultural county in Chongqing municipality. Lying about 280km east of Chongqings urban center, Shizhu is famous for producing a herb used in traditional Chinese medicine to cure diarrhea. In 2008, total county revenues were Rmb1.24 bn, of which Rmb869m, or 70%, were subsidies from the central government. Locally generated tax revenue was just Rmb200m, and the county generated another Rmb143m from land sales and other one-off sources. The subsidy revenue was all earmarked for specific programs, and most of the locallygenerated revenue went to pay administrative overheads. In total, only about Rmb90m was uncommitted income the county could apply to new services or programs. Like many rural counties, Shizhu is a big borrower. In addition to Rmb219m in direct loans (mainly from the World Bank and other policy lenders), it has borrowed Rmb650m indirectly through two local government investment corporations (LICs), which held bank loans at a 6% interest rate. With total liabilities of Rmb870m, about two and a half times locally generated revenue, and nearly ten times its minuscule uncommitted revenue, Shizhu clearly has no way to pay back its debt principal. But its uncommitted revenue is enough to cover its annual interest payments of around Rmb50m. In mid-2008, Chongqing party secretary Bo Xilai persuaded the Export and Import Bank to lend Rmb5 bn to Chongqing to help the municipality absorb export processing industries moving inland from the coast. The funds were divided among 16 poor counties, each of which would get about Rmb300m. Shizhus share was given to one of its LICs. Although the cash was ostensibly for development of export-processing industries, the Shizhu LIC is using it mainly for primary land development for Shizhus second industrial zone. It did not get the full Rmb300m at one go, but receives funds in dribs and drabs based on the projects demonstrated progress. But the Shizhu LIC is not really the borrower; it is merely the entity spending the money. The true chain of transmission is more complicated. Exim Bank signed a loan contract with a Chongqing municipality LIC, which then sent the funds down to county-level development companies, including the Shizhu LIC. But since the Shizhu LIC has no cash flow, responsibility for servicing the loan lies with the Shizhu country government. And since Exim Bank knew that the Shizhu government cannot repay the loan principal, it got two guarantees to cover principal repayment, one from its own captive guarantee company, and another from a state-owned guarantee company in Chongqing. These guarantee companies in turn demanded comfort letters from the Shizhu county government, peoples congress and finance bureau promising that county revenues would be used to repay the loan. Just what will result from this complicated transaction is not clear. LIC transactions of this type backed solely by local guarantees, rather than real collateral were banned in early 2010, but the Shizhu LIC says its industrial zone will be ready by early 2011. When we visited, a couple of bulldozers were hard at work leveling the ground. Nearby, two six-story residential buildings were half-complete; these will house villagers whose old homes were destroyed to make way for the zone. When asked how many companies will invest in the zone, the project manager looked annoyed and said he had received three expressions of interest. It will certainly be some time before Shizhu rivals Shenzhen as an export zone. GaveKal Dragonomics staff
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explicit debt is less than 20% of GDP, a resolution of bad LIC debts half financed by central government bond issuance would leave China with a modest debt-to-GDP ratio by international standards. But if the current momentum of local debt expansion is not stopped, the problem will grow much faster than the economy or fiscal resources, making it much more difficult to resolve in 2012. A tax on property values would be a major first step to restoring local governments to solvency In the long run, off balance-sheet financing must be put back on the balance sheet. This is not possible now because local governments run chronic deficits. Therefore comprehensive fiscal reform must aim to restore local governments to solvency. The first step would be to institute a tax on property values, which would mainly accrue to local governments. This would reduce the reliance of localities on land sales and give them a stable and rising source of income to cover current expenses. Once this is in place, cities could be allowed to issue municipal bonds with floating rates above central-government bond rates to finance long-term expenditures. So far, however, the government has opted for neither bold macroeconomic retrenchment nor fiscal reform, but has contented itself with mild constraints on bank lending to LICs. Seeing a lack of resolve from Beijing, several provincial governments have announced new fantastical investment drives this year, as officials are anxious to complete prestige projects in time to secure their promotion prospects at the 18th Communist Party Congress in the autumn of 2012. Hubei and Chongqing alone want to invest Rmb7 trn by the end of 2012. Beijing has taken steps to slow down lending to LICs, but stronger measures are needed to shrink the debt mountain In fairness, Beijing has prohibited the use of local-government guarantees for LIC loans, and the China Banking Regulatory Commission and National Audit Office are conducting a systematic audit of LIC lending. Credit lines shown by the audit to be insufficiently collateralized will be cancelled unless sufficient collateral can be posted by September 30. Although this is a worthy effort, the risk is that in the months before the September deadline localities and banks will find new ways to paper over problem loans enabling local governments to continue their projects and banks to avoid embarrassing write-downs. Until the central government takes a clear stand and follows it up with strong measures, the local debt mountain will continue to grow.
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Capital market reform
Market? What market?

by Carl Walter and Fraser Howie Everyone knows that capital is mispriced in China. In the long run, capital and risk need to be priced better if China is ever to generate economic growth out of efficiency improvements rather than the brute accumulation of capital and labor. For this pricing to occur, the banks must be reformed to become commercial allocators of capital, and true capital markets have to be developed. What is the likelihood of this happening any time soon? Very low. Banks have no incentive to allocate capital because the administered interest rates set by the Peoples Bank of China (PBC) guarantee them a comfortable profit margin on loans. They therefore lend almost exclusively to borrowers who offer the most reliable security (state enterprises and, more recently, home mortgage borrowers) and make no effort to chase potentially more profitable, but also more risky, lending to privatesector firms. Bond markets the most effective mechanisms for pricing capital have expanded greatly in the last two years. But Chinas bond markets are illusory and play no role in pricing capital. Bond prices are set not off a market-determined yield curve, but off the administered bank loan rates set by PBC. While the primary market is substantial, the secondary market (which is where, in a real bond market, prices are set on a daily basis) is trivial. The only debt market with any depth is a short-term money market whose main purpose is to enable speculators to raise funds to punt on initial offerings in Chinas casino-like stock market. The root cause of Chinas stunted capital markets is political. The bond markets, like the banks, are part of a closed system entirely controlled by the party-state. Prices are set by the party-state for the principal purpose of minimizing the financing cost of the central government budget deficit. So long as the financial system remains a tool of fiscal policy, and the price of capital is determined by the fiat of the party-state to satisfy its budgetary needs, Chinas capital markets and financial system more generally will remain deformed, and will not be true markets. Alpha and omega: the banks and administered interest rates The basis of the entire Chinese financial system is the state-owned banks that control 76% of corporate finance. And the basis of pricing in the capital markets is the set of benchmark bank lending rates determined by the PBC. These are the central facts of the Chinese financial system
Carl Walter and Fraser Howie are the authors of Privatizing China (Wiley, second edition, 2006), a history of Chinas stock markets, and of the forthcoming Red Capitalism: The Fragile Financial Underpinnings to Chinas Extraordinary Rise (Wiley, October 2010).
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China must price capital better to generate growth from efficiency improvements instead of brute accumulation of capital and labor
Politics underlies the stunted development of Chinas capital markets
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and, until they change, the development of mature capital markets is all but impossible. The PBC sets benchmark loan and deposit interest rates for every maturity from one month to five years. The loan benchmark is a floor rate and the deposit benchmark is a ceiling rate. The most widely used benchmark is the one-year loan rate, which applies to working capital loans. Since June 1999 the spread between the one-year loan rate and the one-year deposit rate has been virtually constant at between 300 and 360 basis points. This guaranteed spread assures bankers substantial profits just for waking up in the morning, and eliminates any incentive to price risk. In theory, loan interest rates were deregulated in 2004, enabling banks to lend at any rate above the benchmark and down to a 10% discount to benchmark. But banks have made no use of this ability to price risk: actual market lending rates follow the benchmarks in lockstep, and the proportion of loans made at or below benchmark rates rose from a low of 40% in mid-2005 to over 60% today. Adjustment of interest rates plays almost no role in monetary policy For most of the past 15 years adjustment of interest rates has played no significant role in monetary policy. PBC sets policy mainly with an eye to deposit rates: the idea is to ensure that retail depositors get just enough of a return to leave their money in the banks and keep the banks flush with liquidity. Banks fund themselves overwhelmingly from this captive market of retail depositors. There is a wholesale interbank funding market, and a benchmark interest rate in that market, the Shanghai Interbank Offered Rate (Shibor) which was introduced in 2007. Modeled on the London Libor quote, Shibor is calculated daily across eight maturities. But in reality, Chinas money markets are thinly traded and play no role in the pricing of capital. The only Chinese money market with any depth is the seven-day repurchase (repo) market, in which Chinese government bonds (CGBs) are used as collateral for short-term fund raising. The interest rate on this contract is quite volatile, showing that the demand for capital is being driven by supply and demand. Is this the basis of real capital pricing?
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Unfortunately, no: the main function of the seven-day repo is simply to finance stock-market speculation. The wildly speculative bidding on initial public offerings (IPOs) on the Shanghai stock exchange forces investors to put together the largest amount of funding possible to secure an allotment in the share lottery. In IPO subscription lotteries, massive amounts of capital often in the tens of billions of dollars are frozen to secure allocations of shares. Much of this capital is raised by repo transactions. The peaks in the seven-day repo rate correspond exactly to the peaks in IPO frenzy, when demand for money to put into share lotteries is highest. The stock market: more fun than Lotto So the short-term money market is not a mechanism for capital pricing but simply a way for speculators to gamble on stock-market IPOs. What about the stock market itself does it perform any capital pricing function? Again, the answer is no. From the governments point of view, the purpose of the stock market is to enable state-owned companies to raise low-cost capital. Any market in which state and private companies freely compete for capital, and are valued based on their ability to provide a return on investment, is not desirable. From the investors point of view, the stock market is a vehicle for speculation in quest of quick (untaxed) capital gains. As is obvious even to infrequent observers, speculation is a central fact of Chinas economy. The artificially fixed returns on bank deposits, loans and bonds mean that the only available investment alternatives are real estate and shares. Since the stock market is run deliberately to avoid valuing companies on fundamentals, stock investors must be purely speculative. And the main speculative game is to get into IPOs early, via the lottery; reap big gains on the first day of trading; and get out. From 2000 to 2008, the average first-day price jump for IPO stocks was never less than 45%, and was frequently well above 100%. It is not uncommon for as many as 70% of the shares allocated in an IPO to be flipped on the first trading day. Before 2006 these first-day jumps were virtually guaranteed by the fact that IPO prices were set administratively (and consistently too low) by the China Securities Regulatory Commission (CSRC) when it approved listings. And for years, CSRC has effectively promoted the first-day jump mentality by slowing down or suspending IPO approvals in order to reduce the supply of new shares when stock prices are low. CSRC appears to think its role is not to create a better-functioning market, but to manage the stock-price index through control of the supply and demand for shares. But even after the switch to an apparently more market-driven IPO pricing system, the first-day jumps continue, because ultimately the allocation of IPO shares comes down to a lottery, with no mechanism to allocate all investors some token minimum amount. The result is vast oversubscriptions, sometimes running into thousands of times the CSRC appears to see its role as managing the share index not creating a better-functioning market
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number of shares available, as speculators all hope to strike it rich in the lottery. The fact that the widely trumpeted change to a market-driven IPO pricing system had zero impact on market behavior is a sobering reminder that apparently bold capital market reforms often lead nowhere in China, because the deep structures and incentives remain unaffected. Not surprisingly, this market is dominated by big-time speculators with access to money-market funding; the mom-and-pop Chinese retail investor is largely a myth. It is true that China now has 124m stockmarket trading accounts, 99% of them in the name of individuals. But half of those accounts simply reflect the fact that investors must open separate accounts to trade in the Shanghai and Shenzhen markets. And clearing house data show that 55% of all accounts hold no shares and have not traded for over one year. At most, China may have 10-20m active retail investors, and the real number may be even less. The recently launched index futures market already trades more than the equity market and has become one of the most liquid contracts in the world yet it has fewer than 30,000 open accounts. The captive bond market At the end of the day, however, it is the bond market where the price of capital is really set in mature economies. And here, on the surface, the news seems better. Since 2005, vibrant bond markets have been created by the same group of reformers who promoted bank reform, led by PBC governor Zhou Xiaochuan. Aiming to reduce excessive risk concentration in the banks, they took over the moribund interbank market for government debt and introduced products modeled after those available to corporations internationally. But huge issuance volumes, thousands of market participants and a growing product range disguise the fact that Chinas debt markets remain captives of two unchanging realities: that interest rates are controlled by the party-state, and the buyers of bonds are all ultimately banks. Chinas bond market has no means for measuring and pricing risk All the trappings are there: like highways, new airport terminals or CCTVs ultra-modern office building in Beijing, China has bond markets because the party-state believes such markets are a necessary symbol of economic modernity. So there are ratings agencies (five), regulators (at least seven) and industry associations (at least two) with overlapping authority and little respect for one another. China also has many of the same debt instruments one might see elsewhere: government bonds, commercial paper, medium-term notes, corporate bonds, subordinated debt, asset-backed securities, and so on. These products are traded for cash, repoed out, sold forward and hedged through swaps. What is lacking is the engine of true bond markets: risk and an ability to measure and price different levels of it. In China the party-state has made sure that it, and not a market-driven yield curve, provides the definitive measure of a risk-free cost of capital, and this measure is based ultimately on the funding cost for bank loans. Consequently, in the primary market (that is, the original issuance of bonds) it is common
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practice that underwriting fees and bond prices are set with reference to PBC benchmark loan rates, and not to true demand. And while Chinas primary bond market is now fairly large, the secondary market where informed investors buy and sell bonds based on changing perceptions of the riskiness of the borrower is virtually non-existent. As a result, bond prices wind up being nothing more than a pale reflection of PBC benchmark interest rates. And since more than 70% of bonds are bought by banks which hold them to maturity, there is little difference in practice between bonds and bank loans. Nice market youve got. Pity no one trades in it So why does China have a bond market at all? The answer is that bond markets evolved because the national budget needs to be financed. Starting in the 1980s, the Ministry of Finance started to issue CGBs to cover its budget deficits. Initially, these bonds were sold on a compulsory basis to companies and individuals. In 1994, MoF stumbled on a market pricing formula that combined underwriting by large institutions (mainly banks) with just enough of a secondary market to enable investors to exit their positions. Since then, MoF has issued an ever-increasing flow of CGBs in what superficially appears to be a market. But the reality is that the CGB market and the more recent corporate bond markets built on top of it are thinly disguised loan markets. There are 24 primary dealers, of whom all but two are commercial banks (the others are CITIC Securities and China International Capital Corporation). Bond interest rates are set lower than the rate that would reflect actual demand. Thus, anyone who buys a bond when it is issued would take a loss in a secondary market trade. So the primary buyers mainly banks simply hold the bonds until maturity, like loans. The result is a bond market without trading. And what is a market without trading? It turns out that that a market without trading is a market without meaningful prices. In theory, bond interest rates are subject to PBCdetermined mandatory minimum spreads (depending on credit rating) above the CGB rates for each tenor. In practice, bond issuers and buyers
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Chinas bond market was set up to finance the national budget
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usually ignore these spreads. The issuer tries to get an interest rate on its bond lower than what it would have to pay for a bank loan of the same maturity. The bank, meanwhile, will compare the price of a corporate bond to the rate it would charge the same company for a loan. Generally, issuers entice banks to buy their bonds at lower rates than would be charged for a loan, in return for guaranteeing the banks other bits of lucrative business. In any case, the reference for bond pricing is not the supposed spreads over the CGB yield curve, but PBCs benchmark loan interest rates. Chinas bond market has no meaningful yield curve The whole idea of a yield curve is fictional in China anyway. Yield curves are determined by high-volume trading, which enables clear price levels to be set for different types of issuers at various maturities. Snapshots of a days trading in the Chinese corporate bond market look like something created by random machine gun bursts against a wall. In one arbitrarily selected trading day last December, two five-year AAA-rate bonds traded at lows of less than 2% and highs of close to 5%. How could this possibly occur? The answer is that there was barely any trading. On that December day, the entire China interbank bond market recorded only 1,550 trades this in a market with 9,000 members and Rmb1.3 trn in underlying bond value. The CGB market was even more comatose: it recorded only 52 trades that day, and days when no CGBs trade at all are not uncommon. In contrast, in the US Treasury market there are on average 600,000 trades each day, comprising US$565 bn in trading volume more than 20 times the typical days trading volume in Chinas interbank bond market. In short, Chinas bond markets enable a lot of bonds to be issued, but they do nothing to price risk. Bond prices in the primary market are set in relation to the PBCs benchmark loan rates, not in relation to risk-free CGBs whose yield curve is purely imaginary in any case, because the bonds trade so infrequently. Prices in the thinly-traded secondary market simply reflect the liquidity premium investors must pay on a given day to sell their bonds into a saturated market.
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Dont hold your breath To summarize: Chinas capital markets produce enormous issuance of stocks and bonds, but very little in the way of valuation of companies, bond trading or pricing of risk. This suits the party-state fine, since it gets lots of cheap finance for the government deficit and for the state companies it controls. As long as the name of the Chinese economic game is simply mobilizing lots of capital to build infrastructure, housing and basic infrastructure, this primitive financial system can persist. But at some point economic growth will have to start coming from efficiency gains, and it will be necessary to have a financial system that prices risk. The way to do this is conceptually easy but politically hard: deregulate interest rates, force the banks to earn a living instead of feeding off their guaranteed spread, and allow more private-sector and international participation in stock and bond markets so that trading volumes increase and the accuracy of capital pricing rises. The party-state will not like this because it views control of financing channels, and of the price it pays to finance its own government deficits, as central pillars of its regime. The single lesson that the party-state has learned from the whole series of sovereign debt crises from the 1994 Mexico peso crisis to the 2008 financial meltdown and todays problems in Europe is that open financial systems create vulnerability. Therefore we are unlikely to see substantive capital-markets reform any time soon only incremental measures that lead nowhere, like the reform of IPO pricing and the creation of the interbank bond market in recent years. In the meantime, substantial risk is building up in the big state-owned banks, about 30% of whose balance sheets now comprise securities investments (mainly bonds) whose prices in a true market would be much lower than the prices at which they were bought; this should occasion the need for provisioning against market losses. Total securities investments by the biggest four state banks comprised Rmb9.2 trn at the end of 2008, more than four times the banks combined capital. In addiJUNE 2010
The government sees open financial systems as a major source of economic vulnerability
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tion to a buildup of non-performing loans from last years lending spree, potential losses on these mispriced securities investments pose a threat to the long-term health of Chinas banks. Let the buyer beware.
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Miscellany
Rural consumption
Little bang for the farming buck

by Tom Miller Improving the lot of Chinas 700m-plus farmers is, officially, the central mission of Chinas current government. For each of the past seven years, the first policy document of the year the so-called No 1 central document has focused on rural problems. In addition, building a new socialist countryside is a core policy of the 11th Five-Year Plan (200610). Checking the growing wealth disparity between Chinas cities and its countryside is not only a social and political concern, it is also a pressing economic challenge. China cannot rebalance its lopsided, investmentheavy economy until rural households begin to consume more goods and services. The potential is enormous: Chinas rural population is equal in size to those of the United States and Western Europe combined. But the countrys farmers currently spend just US$600 each a year, of which half goes on largely subsistence purchases of food and clothing. Government policy over the past five years has focused on raising net rural incomes via abolishing land taxes and expanding the social safety net and boosting access to affordable consumer goods. The central government claims that rural subsidies on household appliances and vehicles are beginning to bite: sales of subsidized household appliances reached nearly 21m in the first four months of 2010, and rural consumers bought 1.9m subsidized motorcycles and 560,000 motor vehicles in the first quarter. Whether this is evidence of a step-change in rural consumer behavior, however, is doubtful. Even Chinas flawed retail statistics, which consistently inflate personal consumption levels, show that real rural consumption growth slowed in the first quarter. Urban household consumption growth has outpaced rural consumption for the past three years, and urbanites spend nearly four times more than their rural cousins. The fact of the matter is that rural incomes and hence rural consumption levels remain extremely low. Flatland economy Village life in Dazhangshan, a six-hour drive south of Beijing in Hebei province, shows why claims that rural consumption is taking off are premature. Set in the dusty flatlands of the water-starved North China Plain, Dazhangshan is a fairly representative northern Chinese village. Both per-capita annual income (Rmb4,000-5,000) and consumption (Rmb3,000-4,000) match the national rural average. The villages 2,000 residents, almost all of whom are cotton farmers, live in brick courtyard homes running off a single main road, which was cemented for the first time two years ago. During the spring planting season, when powerful winds blow across the plain and whip top-soil off the freshly ploughed fields, villagers wrap towels around their heads in a vain effort to keep out
Tom Miller is managing editor of the China Economic Quarterly.
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Claims that rural consumption is taking off are premature
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the dust. From November to March, when agricultural work grinds to a halt, they play mahjong and do their best to keep warm. Villagers say that policies to ease the financial burden of farmers have made a big difference to their quality of life. The situation for farmers is much better than it used to be, says Li Hongchun, whose family has worked the desiccated yellow-brown soil of the North China Plain for centuries. He points to the abolition of the land tax in 2006 and improved education and healthcare provision. Every villager used to pay tax of Rmb120 per mu of land, but they now receive a per-mu subsidy of Rmb60, which works out as a net annual gain of nearly Rmb400 per household. Today, all children receive the first nine years of compulsory education for free, and the village primary school is colorful and well maintained. The handful of villagers aged over 80 already receive a modest allowance under the rural pension scheme, which is due to be extended to over 60s in the coming years. Crucially, villagers confirm that Chinas Rmb850 bn medical reform plan, which aims to provide all rural residents with basic health insurance by 2011, is having a positive impact. Health check-ups at the local hospital in Nangong city (15 km away) are now free of charge, and villagers are entitled to reclaim 60% of subsequent treatment costs. Posters in the villages advertise special health promotions, such as free consultations for epilepsy sufferers in the prefecture-level city of Xingtai (two hours away), including Rmb300-600 per month of subsidized treatment. Although treatment can be patchy insurance only covers basic healthcare Beijings attempt to introduce a national health service is a big step forward. People used to be too scared to go to hospital if they were ill because they worried they couldnt afford the medical fees, Li says. A chief aim of better social welfare is to stop farmers saving so much One of the chief aims of increased social welfare spending is to persuade farmers not to squirrel away all their earnings. The high rate of precautionary saving a typical rural household saves 25% of its income every year is a considerable drag on consumption. Villagers say they are beginning to spend more, but mainly on daily items, especially food and drink. Typically, breakfast and dinner are a simple porridge made of millet, perhaps with fried vegetables or buns of steamed bread. Lunch, the main meal of the day, might be pork and noodles, served in a rich, meaty broth. Back in the 1960s, we didnt have enough money to buy meat at Spring Festival. But now we eat meat every day! says Li Hongchuns younger brother, Li Hongqi, over a glass of baijiu (Chinas popular grain spirit). Villagers enjoy fresh vegetables imported from south China in the winter, in addition to the monotonous traditional diet of pickled cabbage. Building the new countryside Chinas farmers also have more cash to spend on renovating and rebuilding their homes: per capita floor space of rural houses nationwide rose from 25 sq meters in 2000 to 32 sq meters in 2008. Farmers in Hebei spent Rmb700 per head on housing in 2008, accounting for nearly onequarter of individual expenditure. In Dazhangshan, Li Hongqi and his
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Miscellany Keeping up with the Zhous

Ownership of durable consumer goods per 100 households (2008) Hebei (rural) China (rural) China (urban) Washing machine 82 49 95 Refrigerator 38 30 94 Air conditioner 7 10 100 Bicycle 185 98 n/a Motorcycle 63 52 21 Car n/a n/a 9 Mobile phone 72 96 172 TV set 121 109 133 Computer 4 5 59
Source: NBS
elder brother Li Hongda recently demolished their 82-year-old mothers house, which was traditionally constructed out of packed earth, and are spending Rmb30,000 on building a larger, brick structure. They are doing the bulk of the work themselves, but hire occasional laborers for a daily fee of Rmb50. Almost all houses in Dazhangshan are now made of brick or stone. In neighboring Tianzhuang village, a whole row of houses was recently rebuilt from scratch, and piles of bricks and sand are a common sight throughout the province. In theory, the governments 13% rural subsidy on household appliances means that these new homes will soon be filled with shiny DVD players, refrigerators and air-conditioners. Every household in the village can buy three subsidized items by showing their residence permit at designated markets in three nearby towns. Yet, despite Beijings contention that the scheme has been a roaring success, few villagers seem interested in taking advantage of the subsidies, which are due to end in 2010. We already have a TV and a washer, and we wont replace them unless they break, says Li Hongchun, reflecting a common sentiment. Farmers in Chenxiata village, 3 km down the road, say that only half of the households in the village own a refrigerator, while air-conditioning is a luxury few can afford. Sowing not shopping If farmers dont need something, they wont buy it, says a shop assistant selling Haier air-conditioners in Nangong, a windswept county town that functions as an urban center for local rural communities. Farmers are spending more than they did a few years ago, but the household appliance rebate scheme has not had much impact. Business is always slow in the spring, she says, because farmers are too busy sowing their crops to go shopping. For all the governments talk of a rural sales explosion in the first quarter of 2010, big domestic appliance brands slashed prices during the May Week holiday in an aggressive bid to pull in rural customers. Gree lopped Rmb700 off the price of its air conditioners, on top of the governments 13% subsidy. Villagers in Dazhangshan seem unmoved by advertisements for cut-price appliances, saying they will only buy new washing machines and refrigerators when their children get married, as modern wedding tradition dictates. Few villagers are interested in taking advantage of government subsidies on household appliances
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Government attempts to boost sales of low-cost motor vehicles have been more successful. In 2009, Beijing lowered the tax rate for small cars from 10% to 5% (this year the rate edged up to 7.5%) and introduced rebates for trading in old vehicles for newer, more efficient ones. Two years ago, there were almost no non-farm vehicles in Dazhangshan. Today there are eight Hafei minivans, each costing around Rmb40,000; two secondhand sedans, including an old Volkswagen Santana; and a new Xiali, a cheap domestic car. Most of the locals from surrounding villages who came to celebrate Dazhangshans traditional temple fair in late April arrived on bicycles and motorbikes, but a sprinkling of friends and relatives drove new BYDs, Geelys and Chery QQs, even a Ford Focus. Motorcycles and tractors remain by far the most common form of motorized transport in the village, but the rural market for low-cost cars and minivans is gathering momentum. Flogging on the cheap The vast majority of consumption in the villages of southern Hebei, however, is of low-cost consumer goods. The handful of village stores in Dazhangshan sell cheap packaged food and drinks (processed sausages, sweets, milk powder, baijiu) and household items (thermos flasks, plastic bowls, shampoo, towels). Two shops even double as restaurants, where a meal washed down with a bottle of watery beer costs around Rmb10. In the evening, local traders sell fresh vegetables from the back of their minivans and village pig-breeders hang fresh pork from metal hooks on the street. Almost everyone in Dazhangshan owns a cheap mobile phone, and China Mobile maintains service centers in most sizable villages. The spring fair, which turns the village into a bustling market place, provides a useful gauge of local attitudes to consumption. As farmers take a break from the fields and children get the day off school, local entrepreneurs set up makeshift stalls flogging food, toys, clothes and household goods. At the small village temple dedicated to Guanyin, the Buddhist goddess of mercy older villagers light incense, kowtow before the shrine, and chant above a cacophony of clanging symbols. Younger villagers walk the bustling streets and check out the deals on offer. One roadside market doing a brisk trade offers all goods at Rmb2 each: plastic mugs, childrens books, knives, plugs, screwdrivers, tin saucepans. Other stalls sell shirts, sweaters and shoes for Rmb10-35, while fruit sellers offer a rare treat of strawberries, bananas and pineapple. Children pester their parents to buy flimsy plastic toys and lick ice creams at Rmb1 a pop. Village-level consumption is rising, but not fast enough to excite big consumer brands In villages across China, consumption is rising but it is far from the level needed to excite many big domestic brands, let alone foreign retailers waiting for the rural market to take off. Li Hongqis sparsely furnished home shows just how far an average rural family is from becoming an urban-style consumer. Built around a high-walled courtyard to keep out the dusty spring winds, the floors are made of rough brick and the walls smoothed with tamped earth. Cement is better because it doesnt flake and fall off, but you have to pay for it, he explains. An old television flick-
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ers in the corner, and the main room is lit by a single fluorescent light tube. The furniture consists of a small wooden table and two chairs; an old sofa; a wardrobe; and a flimsy foldable table with stools. The only decoration is a free supermarket calendar showing images of Chinese fighter jets. Like all the houses in the village, water is collected from a tap in the yard. The lavatory is an earthen pit, hidden behind a wall. Dazhangshan, like the vast majority of Chinese villages, remains poor. As incomes rise, villagers are eating better, improving their living conditions, and leading more comfortable lives. In the aggregate, the sheer size of Chinas rural population means that small increases in household consumption look impressive. For makers of cars, and some cheap goods, the rural market is no longer a black hole. But rising aggregate spending does not mean that Chinas 700m-plus rural residents have become genuine consumers. The central government only recently began to introduce the reforms needed to bring down precautionary saving, and farming incomes remain too low to stimulate casual spending. Moreover, the shrinking size of the rural population means that rural consumers will never drive aggregate consumption. Roughly 75% of the total increase in Chinese consumption over the next 10 years will come from urban areas, thanks to higher urban consumption levels and a growing urban population. Millions of todays rural consumers will spend more, but as urban citizens. For consumption to become a genuine engine of economic growth, China needs to look to its cities. Urban consumers, not rural consumers, will drive aggregate consumption
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Shanxi coal consolidation
Mining a richer seam

by Gavin Bowring
The arid and mountainous province of Shanxi, located 400 km west of Beijing, is Chinas coal capital. The province churns out more than a quarter of domestic coal production, including nearly two-thirds of Chinas coking coal, a vital ingredient in steel making. Coal mining accounts for as much as two-thirds of Shanxis economy, and local highways rumble not only with coal trucks but also with Hummers driven by big-spending coal barons. Thousands of local mines, many of them small and privately owned, have brought great wealth to these entrepreneurs. But policy makers blame poor supervision in many smaller mines for thousands of accidents and hundreds of fatalities. A year ago the provincial government began a forced consolidation program with the target of cutting the number of individual mines by 60%, and the number of coal enterprises by 95%. The consolidation aims to improve safety, increase efficiency and ultimately boost production. Safety and efficiency gains may occur, though this is debatable. What is almost certain is that increased economies of scale and mechanization will lead to a dramatic increase in the provinces coal production over the next five years. But private mine owners many of them entrepreneurs from east Chinas Zhejiang province have cried foul, claiming the program was an effort to expand state ownership and crush the private sector. A close look suggests that while consolidation has led to a much higher level of state ownership, the main motivation was to increase productive capacity and reduce mine deaths, not a desire to roll back private enterprise. Safer and better The consolidation push, which formally began in April 2009, had strong central backing. Wen Jiabao personally promised to improve mine safety, and the man leading the consolidation push is provincial governor Wang Jun, a former coal miner and State Council-appointed president of the State Administration of Work Safety. His deputy, Li Xiaopeng, is the son of former premier Li Peng and the former head of Huaneng, a centrallycontrolled state owned enterprise (SOE) and Chinas largest electricity producer. The targets are ambitious: cut the number of operating mines from 2,600 to 1,093 by the end of 2010, raise the minimum per-mine production capacity from 300,000 tons to 900,000 tons, and make seven provincial SOEs responsible for 75% of provincial coal output, up from 35% in 2008. The main mechanism is a requirement that smaller mines sign contracts agreeing to be absorbed into bigger mining groups or pledging to meet the minimum production requirement. The immediate impact of the program was the closure of many small mines, and a sharp reduction in provincial coal output. But by the end of
Gavin Bowring is an analyst at GaveKal Research.
Shanxi wants to cut the number of mines by more than half by the end of 2010
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2009 many smaller mines were allowed to re-open, and for the year as a whole provincial coal production fell by just 3%, to 594m tons. Provincial officials say production will leap to 700m tons in 2010, though most private analysts predict a more modest increase. It is probable that consolidation will eventually improve overall mine safety (see Fixing the death-traps). Officially, mining accidents fell 40% in 2009, but this drop also reflected the temporary closure of small mines that will reopen within larger, consolidated mine groups. On efficiency, the evidence is less clear. The government claims that private mines are less efficient than state ones, in part because of lower mechanization: the official line is that for every ton of coal extracted, small mines in Shanxi waste another four tons an estimated 1.4 bn tons of coal a year. Private miners dispute those figures and argue that they only dare dig the best quality coal, because of uncertainty about the provinces constantly shifting coal-industry policy, whereas state producers can increase volumes by mining lower-quality coal. Private miners also claim that state-owned firms enjoy lower freight and tax rates which artificially improve their performance. and more state-owned The consolidation program brought howls of protest from private mine owners, who say they have been forced to sell up for less than their stakes
The basics
Shanxi key economic indicators (2009) Registered population, m 34 Urban, m 16 Rural, m 19 GDP, Rmb bn 737 Agriculture 7% Industry 55% Services 39% GDP per capita, Rmb 21,500 Retail Sales, Rmb bn 281 Utilized FDI, US$ bn 1.4 Urban property, Rmb/sq m* 2,700
Source: CEIC *Average price
Fixing the death-traps

Chinas coal mines are among the most dangerous in the world. Despite an improvement in casualty figures 2,631 miners died in mining accidents in 2010, down from a peak of 6,995 in 2002, according to official figures safety standards remain dire. One recent example occurred in April 2009, when flooding killed 153 miners at the state-owned Wangjialing mine in southwest Shanxi. Although Wangjialing made big headlines, many deaths still go unreported. This is especially true at smaller mines in remote areas, where victims families are either cursorily compensated or even threatened in order to prevent the incident from being reported. While the trend toward fewer fatalities is almost certainly for real, the true number of annual mine deaths is probably higher than official figures. Shanxi has a high accident rate even by Chinese standards. Natural and geological factors are partly to blame: the provinces mines have higher levels of gas than the national average, and coking coal mines have a greater tendency to suffer gas explosions. Very few mines in Shanxi are open-cast; most are shaft mines at depths of 300-800 meters, which are at greater risk of collapsing or flooding. But human errors, poor management and negligent oversight exacerbate the high casualty rate. Despite disagreement over the respective safety records of state-owned and private mines, figures support the governments claim that state-run mines are safer. Small private mines have fatality rates up to 10 times higher than large state-owned mines relative to the amount of coal produced. Small mines accounted for roughly 30% of Chinas domestic coal supply yet almost 70% of casualties in 2009. Shanxis state-owned mines claim that, unlike private mines, they pay a safety insurance fee of Rmb30 for every ton of coal produced. These fees are one reason why operating costs at big SOE mines are higher than for small mines. According to a recent estimate, SOEs pay total costs of around US$100 per ton of coal produced, compared to US$95 for private miners. Some private investors argue that the government merely uses the safety issue as an excuse to expropriate their property. Even if they had a perfect safety record, they say, they would still be forced to consolidate. As small mines, they are subject to the whims of local government, having to renew their mining licenses from at least six different government agencies each year and paying miscellaneous fees to keep the authorities happy. The uncertain, short-term nature of the operating environment means they are unable to run their mines efficiently
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are worth. SOE acquirers do not pay a current market price, but a fixed multiple of the price paid when the mines were originally privatized (2.5 times for mines privatized before 2006, and two times for mines privatized later). For owners that bought their mines during the original privatization, this formula yields a decent profit, even if well below full market value. But some late entrants bought shareholdings in Shanxi mines at five times or more the original privatization price, and these investors are now saddled with big losses. Many of these entrepreneurs come from Wenzhou in Zhejiang province, a light manufacturing hub famous for producing some of Chinas most enterprising businessmen. Zhejiang investors plowed roughly Rmb50 bn into more than 450 mining companies in Shanxi, in the belief they could turn over a quick profit before consolidation began. Private coking mines generate margins of 3040% even after taxes, bribes, railway access and overheads are included. We knew that consolidation was coming, but the rules of the game changed so frequently that we were barely allowed to commence production, moans one Wenzhou investor.
Filthy lucre
Shanxis coal barons are easy to spot in the city center of Taiyuan, the provincial capital. On any given night, rows of Maybachs, BMWs, Land Rovers and other luxury vehicles park outside the best hotels and restaurants. Many of these cars have Beijing or Tianjin license plates, evidence that Shanxis coal millionaires often take their wealth outside the province. As consolidation forces private miners to look for investments elsewhere, the Shanxi government is encouraging coal barons to reinvest within the province. Provincial officials recently opened Rmb650 bn of investment projects to private capital in infrastructure, environmental protection, tourism, utilities, municipal functions and agriculture. But most coal barons prefer to invest their sooty banknotes in lucrative property developments, with Beijing, Xian, Tianjin and tropical Hainan island the current favorites. Following in the infamous footsteps of Wenzhou entrepreneurs, Shanxi coal barons literally turn up with carloads of cash, ready to purchase whatever property takes their eye. For those coal barons who stay in provincial Taiyuan, there are several shopping malls catering to their luxury tastes. Grade A retail space in the city may be nonexistent, but hundreds of designer Western brands share space with less flashy fare, often crammed into modest stalls. A Gieves & Hawkes polo shirt in Taiyuan is a snip at US$700, while a suit jacket is a cool US$6,000 all eminently affordable, of course, for a successful Shanxi coal baron.
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Not only are the compensation terms inadequate, the Wenzhou investors claim, much of the contracted compensation has yet to be paid. One investor says he had only received 40% of the agreed amount by the end of 2009, below the 80% stipulated in the contract. In some cases, SOEs simply do not respond to requests for further payment. On their part, Shanxi officials consider Wenzhou investors as out-of-town speculators who know nothing about mining. They seek to apply the methods they use in playing the countrys property market here in Shanxi. Look whats happening to the property market, says one SOE employee. The closure of hundreds of small privately-owned mines has become embroiled in a wider debate about guojin mintui (advance of the state and retreat of the private sector). Some analysts think the economic slowdown in 2008 gave Beijing an excuse to sponsor the advance of SOEs over their private competitors via forced takeovers and state-driven lending. Shanxi officials vehemently deny this. First, they say private owners have the option to retain a small shareholding within the larger consolidated entity. Second, private owners are allowed to consolidate their own mines into larger joint-stock companies, so long as they reach the 900,000-ton minimum. Officials say that, post-consolidation, roughly one-third of the 1,000 mines will still be state-private partnerships. Practicality, not ideology On balance, it appears that policy makers were motivated less by an ideological commitment to state control than by a desire to boost output and improve safety through the creation of larger and more mechanized mines. But this does mean sweeping away the vast majority of private mine owners. Officially, the number of coal companies operating in the province dropped from 2,200 to 130 in 2009. Of these 130 companies, 50% are shareholding companies and 20% are state-owned; only 30% remain fully private. Yet the consolidation process is far from complete: the best estimates suggest that only one-third of consolidation contracts Privately-owned mines have borne the brunt of the closures, leading to accusations of a state-sponsored takeover
Vinegar to envy
Aside from coal, Shanxis most famous export is earthy, dark-brown vinegar. The vinegar tradition dates back over a thousand years, combining Shanxis core crops sorghum, millet, peas and barley which are fermented together with a natural agent. The best vinegars, which are usually five to eight years old, are so good that locals like to knock back a shot, much as they would down a glass of grain spirit. The pained facial expression this pungent, sour brew produces has helped create the Chinese expression to drink vinegar a feeling of jealousy, often associated with love life. Despite its sourness, Shanxis vinegar is alkaline, not acidic. Containing 18 amino acids, including those humans cannot produce themselves, it is reputed to have considerable medicinal value. Modern business strategies require vinegar producers to promote the myriad medicinal values of vinegar, making it the ultimate cure-all. Mixed with other foods, it can supposedly reduce bloodcholesterol (just add peanuts and rice), reduce blood pressure (add soya beans) and prevent diabetes (mix it with eggs). It can be applied to brighten ones skin (add wheat seed), washed in hair to help keep it shiny and used to bathe tired feet; it can prevent arthritis (add wheat and iron sand), colds and flu (add garlic); and it can heal stomach aches and cure insomnia. The only surprise is that, despite its metaphorical association with love, Shanxi vinegar is not billed as an aphrodisiac.
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signed have been fully carried out. Aside from private miners haggling over compensation, county and city governments are also negotiating with the provincial government and big SOEs over who will get the tax income from the consolidated mines. And the physical consolidation process itself is complicated: lumping a series of small mines together under single ownership does not, at a stroke, create a functioning megamine. Some small mines will be kept open to preserve jobs Indeed, the government allowed some supposedly consolidated mines to recommence production in late 2009 on an individual basis. Where half a dozen small mines are due to be merged, officials may allow one or two to resume production independently if they meet certain production capacity and technical capacity criteria. The highways in Shanxis Luliang county, which had a high proportion of small private mines before the consolidation process began, are again teeming with coal trucks. For many mines the 900,000-ton capacity regulation remains unattainable, and the government will continue to make exceptions to this rule. Some small mines in poor, remote villages are likely to be spared consolidation altogether, in order to preserve employment. Once the dust settles, most private analysts believe the ultimate effect of the mechanization and increased economies of scale brought about by consolidation will be a huge increase in Shanxis coal production capacity, which is projected to nearly double to 1.2 bn tons per year by 2014. Other coal-producing provinces, such as Henan, are beginning to follow suit. Consolidation has not been pretty, but it looks likely to create a much bigger and stronger industry.
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Solar power
Black hole sun

by Matthew Forney China has done for solar panels what it once did for Barbie dolls export them so cheaply that no other country can compete. And whats good for toy firms selling buxom mini sex symbols is good also for power firms generating solar energy. In the past 15 months, surging production of solar equipment in China, much of it from companies listed overseas, drove the cost of solar panels down by half even as demand picked up. Chinas hyper-production has gone a long way toward narrowing the still large gap between the cost of solar power and burnt-carbon power. Thats the good news. Unfortunately, the worlds bureaucrats who create markets for solar power are more fickle than Barbie-adoring girls. In the past three years, abrupt changes in subsidy levels, particularly in Europe, have conjured up solar power markets where none existed but also decimated markets that looked promising. Throw in the disruptive power of massive exports of Chinese solar materials, the plunging euro, stiffer financing terms, a recession-induced decline in power demand and other hangovers from the global financial crisis, and the worlds nascent industry for solar energy looks in disarray. Here comes the sun slowly One variable that would add a welcome dose of stability would be Chinas steady growth not just of exported solar materials but of domestic solar power generation. Such a market could stabilize demand for solar panels, flatten the peaks and troughs of a highly cyclical industry and move the world toward its goal of grid parity, meaning equal costs for producing solar and fossil-fuel energy. China did something similar with wind power when the government promoted the broad deployment of wind turbines, which has driven the price of Chinese wind power down to less than twice that of coal-fired power. Chinas solar power, by contrast, still costs around four times the price of energy from coal plants. The question investors around the world are therefore asking is, will the Chinese government take a page from the European playbook and stimulate demand for solar power? The answer is yes, probably, but not for several years. For now, China is copying the approach it used when it created Special Economic Zones as laboratories of capitalism in 1979. It is running walled-garden test projects, scrutinizing the results and learning from mistakes. Within the next decade, China wants to generate 20 gW of solar power, which is roughly equivalent to the worlds total installed capacMatthew Forney is president of Fathom China, an independent company that conducts due-diligence research on firms and executives in China.
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Chinese eclipse
Chinese production of solar components 2008 Solar cells shipped (mW) China 2,600 World total 7,900 Chinas share 33% Polysilicon produced (tons) China 4,800 Rest of world 35,855 Chinas share 13% 2009 4,011 10,700 37% 20,000 69,000* 29%
*Estimate Source: NDRC, Morgan Stanley estimates
China will likely stimulate demand for solar power but not for several years
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Chinas top solar firms (2009) Cell/module production Product mW Suntech Power (STP) Cells and modules 704 Yingli Green Energy (YGE) Silicon, wafers, cells, systems 525 JA Solar (JASO) Cells 509 Trina Solar (TSL) Wafers, cells, modules 399 Canadian Solar (CSIQ) Modules 300 Solarfun Power (SOLF) Cells, modules 254 Renesola (SOL) Silicon, wafers n/a China Sunergy (CSUN) Cells, modules n/a GCL Poly Energy (3800:HK) Silicon, wafers, power generation* n/a LDK Solar (LDK) Silicon, wafers n/a
Source: NDRC, companies
Market cap US$ bn 1.3 1.4 0.9 1.3 0.5 0.4 0.5 0.2 2.7 0.8
*Traditional
ity today and would meet 1% of Chinas energy needs. Many doubt that China will hit that target without major government intervention. And that intervention does not look forthcoming. If we pay high subsidies for the high cost of solar power but we still cant resolve the specific underlying problems, then were just making energy for the sake of making energy, Shi Lishan, vice director of the New Energy Department of the National Energy Administration (under the National Development and Reform Commission; NDRC) told Chinese media in April. Shi, who holds Beijings solar portfolio, added that the government must control the scale of development of installations. China wont want to emulate Spains sky-high subsidy model Such caution comes from an urge to avoid becoming Spain. The Spanish government in 2007 followed a path blazed by Germany and introduced a crucial subsidy called a feed-in tariff a long-term subsidy paid by an electrical grid to cover the difference between the cost of solar power and the cost of a cheaper alternative, usually coal-fired energy. The goal is to create a subsidized market, then lower the subsidy as companies achieve greater scale and prices fall. Germany helped pioneer solar feed-in tariffs, which is why it produces around half the worlds solar power. But Spain miscalculated. Its feed-in tariff was so high that it guaranteed windfall profits to anybody who could scrape together enough money to erect solar panels under a Spanish sky and wire them to a grid. Spain shot past Germany in 2008 as the worlds biggest market for solar panels. So badly had Spains government failed at math that even projects using inferior equipment located in shaded valleys still made money. And because Spain had neglected to cap the scale of its subsidies, it had to promise consistent payments over the next few decades to everybody who finished a project within the feed-in tariff s time frame. Shiny, happy silicon For Chinese makers of solar equipment, Spains feed-in tariff seemed like nothing but boon. Developers who had been negotiating over pennies to buy Chinese solar panels were suddenly asking us to put containers of them on airplanes and fly them to Spain, recalls Gary Cicero, CEO of
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CEP Solar, a Beijing-based consultancy. Everybody was making so much money, they didnt care. Chinese makers of solar panels couldnt produce fast enough. The price of refined polysilicon, a key component that China scarcely manufactured at the time, soared eightfold to US$400/kg, and desperate Chinese factories still stockpiled all they could. And then, of course, the lights went out. Spain scaled back its feed-in tariff so far that its solar panel installations fell by a factor of 15. The Spanish massacre was followed immediately by the global financial crisis, and funding for new projects vanished. Chinese panel makers who were producing at full capacity using silicon bought on extortionate spot markets suddenly had no buyers. Even worse, Chinese silicon refiners, such as GCL, brought huge new capacity into play and drove the price of silicon down to US$50/kg. That left panel makers with warehouses stuffed full of product that cost many more times to produce than any client would ever pay. The write-offs began. The share price of Chinas high-flying solar champion, SunTech, plunged by 90% from the winter of 2008 and has yet to recover. Others tumbled along with it. The good news for China was that Europes solar industry muddled through, thanks mostly to German demand, and developers became more cost sensitive. They noted that Chinese panels are 10-20% cheaper on a per-watt basis than US and European panels, and theres no real quality difference, says Ethan Zindler, head of North American research for Bloomberg New Energy Finance. Panel-makers in OECD countries are losing market share to Chinese makers, with the exception of those that have proprietary technology, such as Arizona-based First Solar. On the whole, panel-manufacturing will shrink in the OECD world, says Lutz Weischer, research analyst in the Climate and Energy Program at the World Resources Institute in Washington. Prices will fall further as China ramps up production at every level of the supply chain in magnitudes beyond anything imaginable elsewhere in the world. That supply chain starts with the raw material, high-purity polysilicon, which is used to produce ingots or wafers. These ingots or wafers are then used to make solar cells, which are assembled into modules. The final step is clicking modules together to create complete systems. For example, Hong Kong-based GCL Poly, one of the worlds biggest producers of refined silicon, plans to move downstream into ingots/wafers. That means buying precision machines that can slice a silicon ingot into thin wafers, which are then sold to companies that turn them into cells. The worlds biggest maker of wafer-slicing gear is Meyer-Burger in Switzerland, and you cant order a machine from Meyer-Burger until the end of next year because its entire production run is going to GCL, says Dennis She, vice president of Nanjing-based ET Solar Group, which makes solar modules. Feed-in fury Expectations of glutted supply lines have Chinese companies fearing an imminent crunch similar to the one they barely survived when Spain vanished from the market. With markets almost exclusively in Europe,
JUNE 2010
The global financial crisis sent demand for new solar projects into freefall
As China increases production, the price of solar panels will inevitably drop further
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the falling value of the euro damages Chinese bottom lines. Germany will decrease its feed-in tariff by up to 16% in July, and the day that happens, developers will try to cut their costs by an equivalent amount. The United States is in no position to expand its solar programs. Our best hope, says ET Solars She, is to try to increase sales in the Czech Republic and Italy. And maybe in Turkey. The third quarter will be tough. NDRC has decided not to soak up excess production by setting a nationwide feed-in tariff Yet with Spains debacle fresh in mind, Chinas energy policy makers at NDRC have decided against soaking up excess Chinese products by issuing a nationwide feed-in tariff. That worries industry proponents in Jiangsu province, the epicenter of Chinas solar equipment industry. A feed-in tariff would be the best way to push the market, but NDRC declines, says Wang Peihong, professor in the College of Energy and Environment at Southeast University in Jiangsu province. Instead, NDRC has agreed to feed-in tariffs for six projects in western China. The most prominent, a 10 mW development in the Silk Road oasis town of Dunhuang, is being developed by a trio of companies led by Belgiums Enfinity. Announced in July 2009, the project should return 8%, a middling sum, and even that is attainable only because one of the developing partners, Best Solar, will provide modules at production cost. The feed-in tariff for the project is the first in China ever to be decided by tender, and many observers had hoped the winning bid would become a benchmark for more feed-in tariffs across China. That hasnt happened, although optimists have high hopes that NDRC will hold another round of bidding this year for projects with a feed-in tariff. With NDRC in no apparent hurry to promote solar power, others have stepped into the breach, with unexpected results. The Ministries of Finance and Construction in July 2009 announced their Golden Sun project, which provides an estimated US$1.5 bn to subsidize 50% or more of the construction costs for solar projects in nearly every province. The goal is to provide much-needed experience to power companies across China, none of which has ever dabbled in solar, and the result should be
Still cloudy for foreign firms

A rare solar company that can compete with Chinese firms is Arizona-based First Solar, the worlds leader in thin-film technology. First Solar shocked the industry last fall by agreeing to build the worlds largest solar installation in the Chinese province of Inner Mongolia. The memo of understanding was even signed by Wu Bangguo, the third most powerful man in the Communist Party. Yet key details in the 2 gW project remained elusive. Had a binding deal been signed? Would First Solar transfer technology to China? Most important, how much would China pay for the energy? Chinese photovoltaic companies suggested the deal was political posturing. It had been announced as the US accused China of unfair trade practices and just before the Copenhagen environmental meetings. A promise to buy American green technology meant good PR on both counts, and with no money down. In May, First Solars president, Bruce Sohn, acknowledged that Beijing had failed to set a feed-in tariff by the end of a 2009 deadline, saying: Were missing clarity in a key area: clarity about what the price per kWh will be. Without a set price, First Solar could lose money on every kW of power it produces if it produces any at all.
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an impressive 640 mW. But because the projects will generate electricity at uncompetitive rates, developers have sought return on their investment by squirreling away as much of the construction subsidies as they can. That has often meant substituting inferior-quality materials or jacking up expense costs not the type of skills the program was intended to nurture. Golden Sun is beset by corruption, complains Wei Qidong, secretary general of the Jiangsu Photo-Voltaic Industry Association. Other programs have been a hodge-podge of subsidies and feed-in tariffs that may offer more value as windows onto how China works than as spurs of solar power. The arid western province of Ningxia built four large-scale projects, then somehow negotiated a feed-in tariff with NDRC only to discover that extreme dust and pollution means every one of the 160,000 panels may have to be wiped clean by hand four times a year. Silicon producer GCL Poly built an enormous 20 mW plant with a feedin tariff provided from the Jiangsu provincial government because the province thought it would be reimbursed by NDRC. When no reimbursements came, Jiangsu suspended future feed-in tariffs. Back to the dirty black stuff Then theres foot-dragging at State Grid Corp, which delivers electricity across the country and sees solar power as a nuisance. The problem is that in China, 70% of energy comes from coal-fired power plants. Grids prefer coal plants because they provide a steady stream of electricity. Feeding in solar power on sunny days means turning down coal-fired furnaces, which is not easy for the simple reason that coal burns for a long time. (Europe and the US employ more natural gas, which, like a stove flame, burns at adjustable intensities.) The only reason Chinas grid can handle solar power at all is that the amounts of solar energy generated are so small, says Bai Jianhua, a top economist at the State Grid Corp. A view of Chinas future solar development hangs on the corner-office wall of Gu Huamin, president of GCL Engineering, Chinas biggest installer of solar systems. Its a framed, computer-generated image of the companys new greenfield headquarters. The complex includes a 50-story office tower of reflective glass linked to an array of smaller buildings, all connected to a neighboring solar farm that will satisfy all the companys power needs and demonstrate the glorious impact that solar power can have on China right now Actually, no. Solar power is way too expensive, says Gu, so the panels will provide maybe 15% of our energy. The rest will come from coal-fired power plants. Chinas national power distributor views solar power as a nusiance
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Miscellany
Books I
Inside the Party

by Arthur Kroeber The Party: The secret world of Chinas Communist rulers by Richard McGregor Allen Lane, 2010 Richard McGregors The Party is the first account for a general readership of the Chinese Communist Party, and it will surely become indispensable. If you read only one book about China this year, it should be this one. And if you do not read this book, you probably do not understand China today. The big red machine It is widely understood, in a general way, that the Party runs China. But understanding usually stops there. Most people ignore the details even, surprisingly enough, some foreigners who have lived and worked in China for years. McGregor, a superb reporter who spent a decade in China, the last four years as chief of the Financial Times Beijing bureau, gives us the details. Combining tenacious investigation, well-chosen anecdote and sharp analysis, he teases out the Partys sticky and ubiquitous filaments in government, business, the military and the media. Of particular interest are his descriptions of the shadowy departments of Organization and Propaganda, which control respectively the personnel and communications apparatus that undergird the Partys rule. Through its Organization Department, the Communist Party controls appointments to every body and company of importance in the country His key metaphor is the red machine the bright red telephone, with a four-digit number and linked into a private, encrypted communications network, that sits on the desk of almost every official or executive of viceminister rank and above. For its user, the red phone symbolizes inclusion in the elite group of a few thousand people who oversee one-fifth of humanity. But for outsiders, the special phones epitomize a Party that operates a closed, impenetrable system of power extending well beyond the confines of government. Bosses of big state companies, newspaper editors and heads of research institutes have red phones. This reflects the reach of the Partys Organization Department, which controls the appointments of senior officials throughout the country. A comparable department in the United States, McGregor writes: would oversee the appointment of the entire US cabinet, state governors and their deputies, the mayors of major cities, the heads of all federal regulatory agencies, the chief executives of GE, Wal-Mart and about fifty of the remaining largest US companies, the justices on the Supreme Court, the editors of the New York Times, the Wall Street Journal, and the Washington Post, the bosses of the TV networks and cable stations, the presidents of Yale and Harvard and other big universities, and the heads of think-tanks like the Brookings Institution and the Heritage Foundation. Not only that, the vetting process would take place behind closed doors, and the appointments announced without any accompanying explanation about why they had been made.
Arthur Kroeber is editor of the China Economic Quarterly. 56 CHINA ECONOMIC QUARTERLY
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Add in the military for the Peoples Liberation Army is the army of the Communist Party, not of the Chinese government and one has a picture of a network of influence and control without parallel in the political system of any other major state. A genius for adaptation Yet if the Party were obsessed purely with control, it would have long ago collapsed like other communist regimes. The reason it has not is that its obsessions run equally in two other directions: creating a strong economy, and adapting its mechanisms of governance and control to the more complex realities such an economy creates. The Partys genius, McGregor observes, has been its ability to maintain the authoritarian powers of old-style communism, while dumping the ideological straitjacket that originally inspired them ... somehow managing to hitch the power and legitimacy of a communist state to the drive and productivity of an increasingly entrepreneurial economy. The breadth of the Partys legitimacy is a crucial point. Contrary to the simplistic Western view that the Partys legitimacy rests solely on its ability to deliver rapid economic growth and therefore that the political system risks crumbling when economic growth slows in fact the Partys right of rule rests on four pillars: economic growth, social stability, national pride in Chinas resurgence as a great power, and tight control of a historical narrative asserting that only the Communist Party could possibly have achieved these things. Ignoring this complex reality, many Western observers see Chinas authoritarian political system and dynamic economy as fundamentally at odds, and so forecast either political collapse or economic stagnation. McGregor portrays the political and economic systems as complementary. The Party and its leaders profit from business success, institutionally through an increase in the value of Party/state-controlled assets, and individually via pervasive corruption. Private business leaders, like their counterparts everywhere, have proved happy to be co-opted in exchange for a predictable and profitable investment environment. A telling example is Edward Tian, a successful US-educated internet entrepreneur who reluctantly allowed himself to be recruited to head a big state-owned telecoms firm. After several years Tian left, but with greatly increased respect for the system. I feel I could justify this system now and understand how it has worked for 1,000 years, Tian told McGregor. Ten years ago, I would not have had a similar feeling. Similar is the story of a training session given in 2008 to 35 top private businessmen at the Central Party School, the Partys intellectual nerve center in Beijing. The session left the entrepreneurs more respectful of the vast and difficult jobs that Party and government officials perform, and more committed defenders of the system that enables them to reap such large profits. Crucial to the success of this co-optation strategy is a willingness occasionally to allow private business interests to triumph over those of state-owned Business leaders accept co-optation in return for a profitable business environment The Partys genius hitching the power of a communist state to the productivity of an entrepreneurial economy
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Miscellany
companies. One instance was the destruction of the monopoly held by state-owned Chinalco in the production of alumina, the raw material for aluminium. A half-dozen private companies stole Chinalcos technology and set up rival plants, cutting Chinalcos share of the domestic market in half in less than three years. Several of these companies had set up strong relationships with local governments hungry for investment and jobs, giving them the political protection needed to escape serious punishment. Where control is essential, the Party enforces it absolutely; elsewhere, it allows wide leeway This tendency for local, more narrowly economic interests to circumvent the grand ambitions of central planners and big state companies illustrates an essential feature of the Chinese Party-state: the decline of absolutism. The Party discriminates between areas where its total control is essential (media, the military, political organization) and areas where it is not (most of everything else). Where it is essential, absolute control is enforced ruthlessly. But where possible, leverage and moral suasion substitute for direct control. Individuals, officials and companies have wide leeway to do what they want, until they cross certain red lines. As a result, China is no longer a totalitarian state guided by a master plan; rather it is a set of competing bureaucratic and entrepreneurial agendas bound together by selectively enforced Party discipline. State companies are not just dumb agents of Beijing; they are a school of ravenous fish selfishly snapping up opportunities, yet never straying too far from the main stream. Policy works not by local officials slavishly obeying every central diktat, but like a system of canal locks: each locality takes what they want out of the policy waterway. Feigning compliance with the centre, they then let the policy stream flow downward to the next level of government. Flexibility and dynamism are permitted, but central control of the essentials is secure. Secrets and lies Over the past three decades the Party has realized the dream that eluded a prior century and a half of Chinese reformers the creation of a fuguo qiangbing, a rich and powerful nation. One might think that this success would increase the Partys confidence and openness. Yet in fact its paranoid secretiveness has not lessened. The Party maintains no website. Its key units such as the Propaganda and Organization bureaux inhabit unmarked buildings and use unlisted telephone numbers. Media are forbidden to report on Party activities or even list the members of key Party committees that make crucial national policy decisions. The Partys front men in Hong Kong refuse to confirm whether or not they are Party members. When Hu Jintao visits foreign countries Chinese protocol officials insist that his role as head of the Party go unmentioned. State-owned company prospectuses are deliberately crafted perhaps to the point of outright falsification to omit any mention of the fact that the Party committee, not the board of directors, appoints the chief executive and controls all the crucial top-level functions. Why such secrecy? The simple explanation is that the Party has been corrupted absolutely by its absolute power; secrecy has become a self-
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justifying mode of operation from which escape seems ever less possible. The Partys secrecy, McGregor notes, has gone beyond habit and become essential to its survival, by shielding it from the reach of the law and the wider citizenry. This is no doubt true. But a subtler and no less dispiriting explanation emerges from the final chapter, centering on the decades-long effort by Xinhua news reporter and amateur historian Yang Jisheng to document the true history of the great Chinese famine of 1959-62, which killed nearly 40m people. Yangs extraordinary book Tombstone was finally published in Hong Kong in 2008. But it remains banned on the mainland even though the events described took place a half century ago, even though Mao Zedong and the other leaders whose idiotic policies created the catastrophe are all dead, and even though the Western demographer Judith Banister accurately calculated the extent of the famine (and presented her findings to an incredulous official audience in Beijing) in 1984, a full quarter of a century ago. The reason for this apparently needless suppression of historical truth is that, according to Australian sinologist Geremie Barme, the Chinese state is based on a series of lies, not just about Mao, but the collective leadership he has come to represent. This is the fourth pillar of political legitimacy mentioned above control of the historical narrative asserting that only the Communist Party could have brought about Chinas current wealth, stability and sovereignty. Questioning any part of this structure of lies, no matter how remote, risks bringing down the whole edifice. A Chinese century? Not with this Party The ultimate cost of this culture of secrecy and lies will be considerable. Contrary to the wishful thinking of liberals and democrats, it is unlikely to prompt an economic or political crisis: the Partys adaptability, and commitment to ever-improved standards of administrative competence, are too strong for that. But the corrupting culture of secrecy about the present and lies about the past mean that the Partys China will continue to inspire suspicion and fear abroad, and crush creativity at home. Yang Jishengs own prognosis is bleak: It is impossible for China to become a superpower if historical truths are repressed. A nation that dares not face up to history will have no future. The Party is an impressively successful organization. After it abandoned ideology for pragmatism, its economic and governance reforms helped raise hundreds of millions of people from destitution to a comfortable life. But in the realm of values it offers little to its own people or the rest of the world, and obstructs the renaissance of a once-great Chinese civilization, which is a shame. One of the common phrases used to justify the Partys rule and role in history is meiyou gongchandang jiu meiyou xin zhongguo (Without the Communist Party, there would be no new China). This might or might not be true. But as McGregors book powerfully shows, with the Communist Party in its present form, we will certainly not see a Chinese century.
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The Partys record of adaptability and improving administrative incompetence make an economic or political crisis unlikely
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Books II
On the road, with Chinese characteristics

by Tom Miller Country Driving: A Journey through China from Farm to Factory by Peter Hessler Harper, 2010 In a memorable scene from his excellent new book, Country Driving, Peter Hessler sits down to dinner with a farmer and his family in their mountain cottage. Looking around at the bizarre paraphernalia a feral pig fetus floating in a jar of alcohol, a Buddhist shrine, posters of the Denver skyline and a Peoples Liberation Army tank, two bottles of Johnnie Walker whisky, and a pair of Ming dynasty cannons pilfered from the Great Wall he admits to a momentary sense of bafflement. How could anybody hope to make sense of this world? he asks. That is a puzzle not only for foreign journalists but also, Hessler shows, for individual Chinese trying to find their niche in a rapidly changing society: In the West, newspaper stories about China tended to focus on the dramatic and the political, and they emphasized the risk of instability, especially the localized protests that often occurred in the countryside. But from what I saw, the nations greatest turmoil was more personal and internal. Hesslers interest is not in the big China news we read over breakfast economic stimulus plans, geopolitical shifts, human rights atrocities, environmental devastation but in the complex lives of ordinary individuals. His local, on-the-ground reportage rings far truer than imposingly titled doorstoppers that profess to explain what China is and where it is going. Cars symbols of a society in transition The car marks the tribe Nominally linked together by a series of car journeys, Country Driving comprises three unrelated sections. The first describes two long road trips across northern China, as Hessler traces the fragmentary course of the Great Wall westwards from Shanhaiguan on the Bohai Sea to the desolate wasteland of the Gobi desert. On the way he meets a cross-section of Chinese society farmers, local government officials, laborers, truckers, auto engineers, policemen, hitchhiking migrants, shopkeepers and meditates on the wider historical and social themes these encounters raise. In the course of the book, religious belief, land rights, rural education, healthcare, ethnic identity, cartography, industrialization and modernity all fall under his microscope. Hesslers anthropological eye reveals car owners as symbols of a society in transition inexperienced, careening this way and that, pushing ahead and bending rules. His taxonomy of car brands and their drivers perceptively identifies the distinct tribes of modern urban China. The strongest section follows the fortunes and growing material wealth of Wei Ziqi, an uneducated farmer from a small mountain village two hours north of Beijing. Over five years, Hessler becomes a close friend of Wei and his family, and the narrative edges from journalism towards memoir the genre Hessler employed with distinction in River Town, his account of two years spent in a grimy city on the Yangtze. Set against a timeless
Tom Miller is managing editor of the China Economic Quarterly. 60 CHINA ECONOMIC QUARTERLY
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rural backdrop of the shifting seasons, Hessler recounts Weis attempts to step beyond the confines of traditional village life, as he grabs new opportunities brought by better roads and Beijings auto boom. But Weis growing wealth and contact with urban life has ugly consequences as his family struggles to adapt to the transition to modernity. And when Weis son becomes chronically ill, the indifference of urban health professionals to their rural patients reveals the brutality of the social and economic gulf between the city and the country. The final section is set in the new factory town of Lishui, 75 miles northwest of Wenzhou in Zhejiang province. Hessler witnesses the construction of an industrial zone from scratch, as local development officials level 108 mountains and hills with dynamite. He follows the fortunes of two entrepreneurs, Boss Wang and Boss Gao, and their workers in a factory making nylon-coated rings for bra straps. The setting reveals the resourcefulness, resilience and internal politicking of entrepreneurs and migrants attempting to profit from the raw capitalism of Chinas southern factory towns. One memorable portrait is of the nouveau riche son of a farmer-turned-property developer, later indicted for illegal money-raising: He wore black Prada loafers, black Prada trousers, and a red and black Versace shirt. He carried a gold-plated Dupont cigarette lighter that cost over six hundred dollars Every once in a while [he] leaned over and spat directly on the carpet, rubbing it in with his Prada loafers. Roadside peacocks Country Driving displays a keen awareness for the absurd, conveyed with verve and masterful economy. At every stop, Hessler writes of driving to meetings with provincial officials, you were served with tea and statistics. Driving along the desert border between Ningxia and Inner Mongolia, he picks up a sad young man sporting a thin crooked moustache that crossed his lip like a calligraphers mistake. In one hilarious passage, Hessler interprets Chinese drivers liberal but nuanced use of car horns much as a naturalist might explain the complex calling and behavioral rituals of a flock of honking geese. His description of the physical helplessness cultivated by young, attention-grabbing urban women reaches for another ornithological analogy: In the entire animal kingdom theres no more striking vision than a xiaojie [young woman] running to catch a cab. Its like the mating dance of a peacock: plumage everywhere, a stunning profligacy of flash and color, so much movement combined with so little obvious purpose. Towards the end, Hessler laments feeling like a drive-by journalist, listening to sad stories before I got back on the expressway. Happily, his account of driving across China is anything but superficial: it is humanistic, sympathetic, sensitive and patient. Above all, it is literate: the authors sound grasp of both spoken and written Chinese brings a depth of cultural understanding often lacking in accounts by foreign reporters. Country Driving is a welcome return to form by one of the most thoughtful China watchers of the past decade.
Country Driving has a keen awareness of the absurd that pervades much of life in modern China
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Published by GaveKal Dragonomics
GaveKal Research Suite 3903, Central Plaza 18 Harbour Road Wanchai, Hong Kong www.gavekal.com
GaveKal Dragonomics 15D Oriental Kenzo Ofce Bldg 48 Dongzhimenwai Dajie Beijing 100027 China www.dragonomics.net

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China Economic Quarterly

Volume 14 Issue 2 June 2010

Financial reform Making capital work

China Economic Quarterly

Vol 14 No 2 June 2010

The big idea Fiscal and nancial reform

CHINA ECONOMIC QUARTERLY

CHINA ECONOMIC QUARTERLY

Structure of GDP, 2009

Source: NBS, GaveKal Dragonomics estimates

GDP growth, Q1 2010

Source: NBS, GaveKal Dragonomics estimates

Contributions to GDP growth, pp

Source: NBS, GaveKal Dragonomics estimates

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The iron rooster spiffs up

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Planes, clean trains and automobiles

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Death of the annual mating ritual

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How not to B&Q it

Foreign retailers have found profits hard to come by

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The economy Size does count

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Relax its different this time

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The bear roars but financial futures soar

China launched its first financial futures contracts for 15 years

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Twin peaks: fiscal and financial reform

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Paying for the harmonious society

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How to build a harmonious society

Free rural compulsory education

Comprehensive health 2009 reform program

To provide medical insurance to at least 90% of the population by 2011

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China relies on center-to-local transfers far more than most countries

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