I commend the Commission for its work thus far and am honored to testify on “China’s Capital Requirements and U. S. Capital Markets.” Anyone who has been following China since the economic reform movement began in 1978 recognizes the important strides that country has made in moving toward a market economy and reducing abject poverty. But one also recognizes the institutional incompatibility that still exists between remnants of the old central planning system — especially investment planning — and a free‐market system based on private property rights and the rule of law.
With China’s accession to the World Trade Organization (WTO), liberalization will continue. The pace of liberalization, however, will depend on both internal political forces and external influences, particularly U.S. policy. That is why the work of this Committee is so vital.
In thinking about China’s capital markets, one must never lose sight of the fact that the Chinese Communist Party (CCP) seeks to use those markets to “revitalize” stateowned enterprises (SOEs). The real question is whether China can overcome the ideological barrier to large‐scale privatization when that institutional change would end communism and the CCP’s grip on power.
If China is to become a world‐class financial center, it must create real‐not pseudo — capital markets in which the state protects private property rights and lets market participants, not government officials, determine the best uses of scarce capital. Until that time, China’s socialist capital markets will be inefficient and corrupt casinos in which the Chinese people will squander their hard‐earned savings.
The list of questions the Commission has proposed addressing deal primarily with China’s current and future capital “needs” or “requirements,” whether China can meet those needs, and what role U. S. capital markets can play in that process. Those issues are important, but even more important are the questions of what China needs to do to create real capital markets and what the implications of further financial liberalization under the WTO are for U.S.-China relations.
In the following testimony, I shall
- Discuss China’s current capital “needs” with regard to funding explicit and implicit government debt.
- Question the usefulness of the capital‐requirements approach when thinking about how to facilitate China’s future economic growth.
- Take a property rights or institutional approach to analyze China’s financial sector and show that all the major problems China is facing — from the high percentage of nonperforming loans (NPLs) to the large implicit pension debt (IPD) — stem from the dominance of state ownership and the suppression of the private sector.
- Consider the reforms that need to be taken to “normalize” China’s capital markets by privatizing them and how such reforms would benefit U.S. capital markets and improve U.S.-China relations.
China’s Current Capital Requirements
The Commission poses two major questions with regard to China’s capital requirements: (1) How much capital does China need to meet its existing obligations, which stem primarily from the NPLs of the big four state‐owned commercial banks and from the large IPD of urban SOEs? (2) How much capital is required “to facilitate future economic growth”? The first question can be answered directly by looking at the existing data; the second question is much more difficult and I will return to it.
The politicization of investment decisions and the socialization of risk in China under state ownership has led to a massive waste of capital. State‐owned banks have lent primarily to SOEs, starving the emerging private sector of capital, and have based their lending decisions on politics, not on sound market criteria. The so‐called commercialization of the four major state commercial banks — the Bank of China, the Industrial and Commercial Bank of China, the Construction Bank of China, and the Agriculture Bank of China — is intended to stem the tide of bad loans, but ownership still remains firmly in the hands of the state, and the bad debts keep piling up.
Estimates of the true size of the NPLs vary. The official estimate is that about 25 percent of outstanding loans from the big four state banks are NPLs, but that figure is almost certainly too low. Nicholas Lardy of the Brookings Institution has estimated that the cost of bank recapitalization is at least 40 percent of GDP and may be as high as 75 percent, if international standards are applied. He bases his calculation on the Rmb 270 billion in bonds the government has already issued (in 1998) to increase bank capital; the Rmb 1,400 billion in bonds that the asset management companies (AMCs) have issued (in 1999 and 2000), which have an implicit guarantee by the central government; and the Rmb 2,000 to 5,000 billion in NPLs still on the balance sheets of the big four state banks (Table 1).
Compounding the NPL problem of the four state commercial banks is the dismal condition of the three policy banks, the loans in the financial system that cannot be recovered, the insolvency of the rural credit cooperatives, and the undercapitalization of many of the trust and investment companies. The World Bank estimates (in its September 27, 2001, East Asia Brief) that China’s contingent liabilities, or “hidden debt” due to the weak condition of the financial sector, are more than 50 percent of GDP. Moreover, those liabilities continue to grow at a rate of at least 2 percent of GDP per year.
|Table 1: The Cost of Bank Recapitalization in China|
|Policy Action or Condition||Cost (Billions of Rmb)|
|1. Government bond issue to increase bank capital, 1998||270|
|2. Implicit guarantee of AMC debt, 1999–2000||1,400|
|3. NPLs still held by four big state commercial banks||2,000 to 5,000a|
|Rmb (billions)||3,670 to 6,670|
|US $ (billions)||443 to 806|
|Percentage of GDP, 2000||40 to 75|
|SOURCE: Nicholas Lardy, “China’s Worsening Debts,” Financial Times, 22 June 2001, p. 13.
aThe larger figure applies when international accounting practices are used
Implicit Pension Debt
The figures stated thus far do not include China’s IPD, which the World Bank estimates to be nearly 100 percent of GDP (more than US$1 trillion). That is the amount of money China would need today to pay off current and future promised benefits. The existing pension system is clearly not sustainable, and that is why China is moving toward a multi‐pillar system with a public PAYGO component and a private fully funded component. Some individual accounts have been established, but they are “notional” accounts. Funds allocated to them have already been used to help cover the deficit in the PAYGO pillar, which amounted to Rmb 40 billion (US$ 4.8 billion) in 2000 and will climb steadily in the future.
China’s current pension system covers only urban workers in SOEs. Many of those workers are not receiving their promised pensions. Local governments and the central government are already strapped for revenues and cannot afford to bail out pension funds. Raising payroll taxes from an already high level of 24 percent of wages would serve only to further alienate overtaxed workers and reduce actual taxes collected because of noncompliance. What is required is fundamental reform that will give workers secure property rights to future income.
China’s current capital requirements cannot be met within the present system of widespread state ownership. SOEs are parasites that suck the capital out of state‐owned banks and waste it on policy‐directed investment rather than market‐directed investment. Nearly 80 percent of bank lending goes to the state sector, which produces only about 30 percent of industrial output value. If China continues to adhere to market socialism and fails to institute market liberalism, total government debt will continue to grow. Indeed, Lardy estimates that government debt, excluding IPD, could reach 110 percent of GDP by 2008.1
How Much “Capital” Does China Need to Facilitate Economic Growth?
The question of how much capital is required for China’s future economic growth is a difficult one to answer. If one were to ask that question at the level of an individual firm, one could construct a capital budget and project capital needs over time to achieve growth of plant capacity. But one would have to make many assumptions, including that consumers’ preferences for the firm’s product do not change adversely, that demand grows, and, most important, that there are no unexpected changes in the institutional and policy environment. At the level of the national economy, it is virtually impossible to accurately predict capital needs to fuel future growth. Moreover, such an approach diverts attention from the complex nature of a market economy and the real meaning of capital.
The Market Economy as a Complex System
The market economy is a complex network of trust relations held together by a system of property rights and the rule of law. In contrast to central planning, the market relies on millions of individuals pursuing their own interests to generate a spontaneous order based on freedom of contract and private property rights. Government exists to protect individual rights, including the right to own property and to exchange property rights to increase wealth. Property rights are human rights.
In a market economy, no one plans the total amount of saving and investment. Individuals are free to choose how much to save and to invest, and those individual decisions — not government planning — will determine the rate of capital accumulation and future production and consumption opportunities. The institutional, or property rights, arrangement (including tax and regulatory policies) will shape incentives to save and invest and thereby affect future economic growth. For that reason, I shall focus on China’s current institutional arrangement and show that it is the lack of private property rights and the absence of the rule of law that are at the root of China’s financial difficulties.
The Meaning of Capital
The concept of capital cannot be understood in an institutional vacuum. Capital is not merely physical assets (e.g., machines and buildings); it is the net value of those assets and ideas to consumers as determined in private markets in which individuals have the right to specialize in ownership and risk bearing, are free to buy and sell capital values — so that future expected profits can be capitalized into their present values — and are able to prevent others from violating their rights. Physical and human capital mean little if the institutional infrastructure permits property to be plundered rather than protected.
Hernando de Soto, author of The Mystery of Capital, is right when he says, “Capital is that value, that additional value, that comes from things that are duly titled;… capital is also law.“2 Countries are poor when their leaders prevent privatization and fail to abide by the rule of law. Hong Kong is rich because it adheres to the rule of law and has market‐supporting institutions, not because it has abundant physical capital.
The more secure rights to future income streams are, the more confidence individuals will have in the future, the more breadth and depth capital markets will have, and the more liquidity will be created. Likewise, any attenuation or weakening of private property rights — including the rights to use, to sell, and to partition property — will mean less trust, less liquidity, and less wealth. Figure 1 shows that nations with stronger private property rights have a much higher average level of real GDP per capita than countries with less secure rights.
Stronger Property Rights Equal Greater Wealth
SOURCE: Lee Hoskins and Ana I. Eiras, “Property Rights: The Key to Economic Growth,” in 2002 Index of Economic Freedom, ed. G. P. O’Driscoll, Jr., K. R. Holmes, and M. A. O’Grady (Washington and New York: The Heritage Foundation and the Wall Street Journal, 2002), p. 40.
China’s physical capital infrastructure is expanding rapidly, but its institutional infrastructure is still weak. If new value and wealth are to be created, China needs real, not pseudo, capital markets.3 People must be free to choose their own investments, including foreign investments, and state ownership must give way to widespread privatization if China is to develop world‐class financial markets. Injecting more funds into state‐owned banks to lend to state‐owned enterprises is a recipe for disaster.
China’s Pseudo Capital Markets: The Costs of Capital Repression
China’s listing of SOEs on the two major stock exchanges in Shanghai and Shenzhen, as well as listings in Hong Kong, New York, and London, gives the appearance of a vibrant capital market, but the emperor has no clothes. The listed companies are still controlled by the central and local governments. Those companies have no transparent balance sheets or financial reports that inform individual investors about the true profitability of the underlying assets, and the lack of fully transferable shares means that it is impossible to discern real capital values. The stock markets in China are really casinos to raise funds for struggling SOEs, not efficient capital markets.
The CCP’s ideological bias against private free capital markets places a heavy burden on the economy in terms of the value lost to society from the misallocation of scarce capital resources. The repression of the private sector means that the savings of the Chinese people are directed into low‐interest deposit accounts at state‐owned banks or rural credit cooperatives and then invested in SOEs. The SOEs benefit from the low cost of their funds but have no incentive or flexibility to direct capital to its highest‐valued uses.4 Since local protectionism is rampant in China, capital is held hostage by local politicians and mostly wasted on nonviable projects. That is why returns to investment are so low in China.
The costs of capital repression in China are evident in (1) the stock market bubble, (2) the heavy reliance on foreign direct investment (FDI), and (3) the fact that China is a net exporter of capital. What appear at first as strengths of the Chinese market socialist system are upon reflection serious defects. Let us see why.
The Stock Market Bubble
The extremely high price/earnings ratios (P/Es) on China’s domestic stock exchanges — stocks on average are selling at more than 50 times earnings — reflect the low expected earnings of SOEs, not bullishness about the future of those companies. The quality of information about SOEs is poor, and investors rely mostly on gossip to make their “investment” decisions. The 50 million Chinese who gamble in the stock markets do so only because their investment options are so limited. If they could freely invest in foreign markets, their funds would quickly leave China‐unless ownership reform took place. Placing SOEs in the hands of private owners would transform those companies and redirect capital to more productive uses. Earnings would rise and P/Es would fall to normal levels. Without ownership reform, share prices are bound to fall to bring about more normal P/Es.5
The government has been trying to boost share prices by delaying new listings of SOEs, by injecting capital into dying SOEs, and by trying to talk up the markets. But those are stopgap measures and will only worsen the long‐term problems. Delaying fundamental ownership reform will make it more difficult to bring about the institutional changes necessary for long‐run stability and growth.
Heavy Reliance on Foreign Direct Investment
China is the second largest recipient of FDI in the world. In 2000, FDI in China amounted to nearly $41 billion. But instead of reflecting the strength of the Chinese economy, it reflects an inherent weakness‐the inability of private firms to acquire the capital necessary to expand their market share. Private entrepreneurs are not allowed to enter the equity markets to raise capital, and they stand at the end of the line when it comes to bank loans, so they must turn to foreign investors. Those investors acquire the assets of private firms and SOEs through joint ventures. The newly created foreignfunded enterprises (FFEs) increase allocative efficiency when they take over SOE assets, but private domestic firms are not allowed to bid on those assets, so the prices are less than they would be in a competitive open market. Privatization would allow private entrepreneurs to acquire SOEs and to have greater access to the savings of the Chinese people, so more of China’s assets would belong to the Chinese people.
Yasheng Huang of the Harvard Business School has emphasized the above points and concluded that, because of the ideological bias against private enterprise: