Mr. Chairman and Members of the Commission:
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” state-owned 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
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.
Nonperforming Loans
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.
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.
FIGURE 1
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 foreign-funded 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:
There have been huge losers in the Chinese reform process, notably private entrepreneurs
who have foregone business growth opportunities [by not being able to raise
capital or to acquire SOE assets] and lost control over their businesses [through
joint ventures]…. These foregone benefits are financially equivalent to
actual losses. Thus, the argument for gradual reform is a political one, not
an economic one.6
What is needed is to allow private Chinese firms the same rights as foreign
firms, but that change will not occur without political reform.
Net Capital Outflows
Although China has attracted large net inflows of FDI, those inflows of private
capital have been nearly offset by the outflows of portfolio and other investments
(e.g., trade credits and loan repayments). Moreover, when one takes account
of China’s large accumulation of foreign reserves (now approaching $200
billion) together with the substantial illegal private capital outflows as seen
in the errors and omissions component of the balance of payments (which amounted
to nearly $50 billion over the last three years and more than $100 billion from
1991 through 1998),7 one sees that China’s
current account surpluses have been financing net capital outflows.
In a recent article in the Cato Journal, John Greenwood, chief economist at
Invesco Asia, Ltd. gives a detailed view of this phenomenon and argues that
for a poor country like China, it makes no sense to be a net exporter of capital.
Indeed, by holding such large stocks of foreign exchange and using them to acquire
foreign assets (e.g., U.S. Treasury securities), China is misallocating capital
and denying its citizens the right to earn higher returns overseas. According
to Greenwood, “The accumulation of foreign assets by the [Chinese] government
in place of the private sector amounts to the backdoor nationalization of what
would otherwise have been potentially profitable overseas investments by private
individuals and businesses.”8
The fact that China denies its citizens the right to freely invest abroad or
at home provides them with a strong incentive to find higher returns illegally.
The lack of capital freedom is a major cause of corruption in China.
It is also true, as Huang points out, that
foreign exchange reserves are China’s claims on dollar assets. When FDI
inflows are financing the growth of China’s foreign exchange reserves,
that amount of FDI is not used productively to develop the Chinese economy….This
is surely a strange outcome. The Chinese are striving to give up the ownership
of their economy only to use the capital surpluses to invest in low-yielding
government bonds in America.9
The combination of discrimination against the private sector (as evidenced by
China’s high dependence on FDI), the ban on full convertibility of the
renminbi (which has been maintained by capital controls), and the undervaluation
of the renminbi (as evidenced by the large accumulation of foreign reserves)
indicates that China cannot get out of its current financial situation without
ending its repression of capital and allowing greater capital freedom.
Creating Real Capital Markets in China: The Benefits of Capital Freedom
Piecemeal reform has helped China move slowly toward a more open market. China’s
entry to the WTO will help speed the pace of reform and bring about greater
liberalization. Foreign banks will have greater market access, and foreign companies
will gain direct distribution rights for the first time. But the real challenge
for China will be to allow its own citizens full private property rights, including
the right to raise capital in the financial markets, the right to establish
fully funded pensions, and the right to full convertibility of the renminbi.
Unless there is widespread privatization, China’s citizens will remain
handicapped in their efforts to improve their lives and futures.
Reform Measures to Increase Capital Freedom
Creating real capital markets in China will require the following measures:
Some of those reform measures have already been initiated and will be advanced
by China’s accession to the WTO; others, such as privatization, need to
be pushed much further.
Selling off SOEs to privatize pensions would be a step in the right direction.
Private pensions would create new capital that could help China grow in the
future. Moving to a fully funded pension system is economically feasible. According
to Peking University economist Zhao Yaohui’s estimates, the cost of moving
to a fully privatized system—the transition costs plus the costs of funding
individual accounts—would be 15.8 percent of payroll compared to the current
24 percent.10 Full privatization is gaining
support and may become politically feasible in the near future. But the obstacles
are still substantial.
Individuals would have a strong incentive to participate in a fully funded system,
whereas they have little incentive to participate in the current PAYGO system.
As Zhao notes:
The best alternative in solving the financial crisis is to give individuals
incentives to participate. The best way to give incentives to individuals is
to put all pension contributions (from employer and employee) into individual
accounts and make sure that the investment earns competitive returns. This gives
individuals the property rights to these accounts. Otherwise, individuals would
be better off saving and investing the money on their own.11
If SOEs were transformed into private companies in which individuals held saleable
shares, the stock market would reflect more accurately the present values of
the listed companies, and P/Es would come back to normal levels. Chen Mingxing,
senior researcher with the State Information Centre, recognizes this fact and
has recommended more rapid ownership reform. As the China Daily’s Business
Weekly reported,
“Chen said that the government should leave the adjustment of share prices
to market forces, but put more effort into establishing a marketplace that is
‘just, fair and transparent,’ and reforming the ownership systems
at the listed companies.”12
By failing to create real capital markets, China is failing to take advantage
of the gains to be had from specializing in ownership and risk bearing. The
socialization of risk under the current system of state ownership reduces incentives
to innovate and create wealth. The value of Chinese firms is below what it could
be if capital were free to flow to its highest-valued uses—and there is
no way to discover those uses without competitive markets, which depend on private
property rights. That is why China has had to rely so heavily on foreign capital
to fuel the growth of the economy.
Benefits of Capital Freedom
Privatizing state-owned banks and allowing interest rates to be set in private
capital markets would depoliticize the allocation of bank credit and increase
investment returns to the private sector. Allowing both Chinese and foreign
investors access to China’s capital markets would put China’s vast
pool of private savings to better use than they are under the current discriminatory
system. One of the key lessons from the Asian financial crisis, as Federal Reserve
Chairman Alan Greenspan has observed, is that “diversity within the financial
sector provides insurance against a financial problem turning into economy-wide
distress.” Thus, “the difficult ground work for building the necessary
financial infrastructure—improved accounting standards, bankruptcy procedures,
legal frameworks [to protect property rights] and disclosure—will pay dividends
of their own.”13
Privatizing SOEs and state-owned banks and creating private markets for distressed
assets would help China solve its NPL problem. Moreover, as Greenwood, emphasizes:
If China’s capital markets and its industries were normalized (through
deregulation, proper implementation of the rule of law, the encouragement of
private markets, and extensive private ownership), then China’s balance
of payments would no doubt undergo a major transformation. The balance of payments
would witness a switch from current account surplus and capital outflows to
current account deficit and capital inflows. 14
He recommends, as a first step in that direction, “the adoption of a progressively
more flexible nominal exchange rate regime.” Such liberalization need not
create instability provided China continues to liberalize on other fronts and
maintains domestic monetary stability. The renminbi would then gradually appreciate
against the dollar, and the current account would gradually move into a deficit
position as exports slowed and imports increased.
The benefits to China and to foreigners from liberalizing the financial sector
are great: China would achieve a more efficient use of its capital and attract
new investment; the Chinese people would have an important part of their human
rights—the right to own property—protected by law; and foreigners
would be able to deal with private firms and offer more options to China’s
savers.
Implications for U. S.-China Relations
Improving capital freedom in China by securing property rights and liberalizing
capital markets and capital flows would increase wealth in China and increase
the demand for U.S. goods, services, and investment. As China’s internal
markets expand (because of privatization and liberalization), so will U.S.-China
trade. Increasing economic freedom is a win-win strategy—both the United
States and China can gain.
As economic ties strengthen between China and the United States, as well as
China and other nations, the increase in economic interdependence will help
lessen the chance of conflict. Expanding the private sector will help shrink
the relative size of the state sector and exert pressure for political liberalization,
as has happened in Taiwan.
Empowering China’s workers by allowing them to have property rights in
their pensions will create a huge positive force in favor of private enterprise
and capital freedom, just has happened in Chile.15
U.S. investment firms and insurance firms would benefit from such a regime change.
China is a rising power that the United States must watch closely. Economic
liberalization has not yet had a substantial impact on the political regime.
But that can change. China’s accession to the WTO will accelerate capital
freedom and, with it, political reform. Indeed, leading intellectuals are advocating
laws to protect property rights, and one can even read about the importance
of property rights in the China Daily. For example, that government-backed newspaper
recently carried articles that stated:
China's adoption of a genuine rule of law—protecting life, liberty, and property— would benefit both the Chinese people and the United States. That is why one of China’s leading liberal thinkers, Liu Junning, when asked about the future of China, replied, “Whether China will be a constructive partner or an emerging threat will depend, to a very great extent, on the fate of liberalism in China: a liberal China will be a constructive partner; a nationalistic and authoritarian China will be an emerging threat.”18
Conclusion
Private property makes owners responsible for their actions. What China needs
is a system of property rights that assigns liability to individuals, not to
the state. That means a system of rights that also allows individual owners
to benefit from allocating resources where consumers—rather than CCP officials—want
them. The main barrier to large-scale privatization in China has been the fear
of the rulers that privatization will mean the end of Party rule, and they are
right. They hold on to Marxist ideology in the hope that the people will listen,
but more and more people are beginning to see the benefits of private property
and free trade. The United States can best help the Chinese people gain political
freedom by first supporting economic freedom. Isolating China would only further
empower the hardliners.
At base, capital value depends on freedom. By opening markets and sharing ideas
(e.g., through student and faculty exchanges, conferences, etc.), and standing
by our founding principles, the United States can help to promote peace and
prosperity in China and at home.
Thus, in closing, I recommend that the Commission in its report to Congress:
Free trade and privatiztion can help normalize China and transform it into
a modern economy and a civil society under the rule of law. China will then
have one country and one system. The United States must be patient and not lose
sight of the long-run benefits of a firm commitment to the principles of market
liberalism and capital freedom.
Footnotes
1. Nicholas Lardy, “Fiscal Sustainability: Between a Rock and a Hard Place,”
ChinaOnline, 16 June 2000 (http://www.chinaonline.com).
2. D. Fettig, “An Interview with Hernando de Soto,” The Region, 15
June, pp. 23, 26. Published by the Federal Reserve Bank of Minneapolis (www.minneapolisfed.org).
3. See James A. Dorn, "Creating Real Capital Markets in China," Cato
Journal 21 (Spring/Summer 2001): 65-75 (http://www.cato.org/pubs/journal/cj21n1/cj21n1.html).
4. See David D. Li, "Beating the Trap of Financial Repression in China,"
Cato Journal 21 (Spring/Summer 2001):77-90 (http://www.cato.org/pubs/journal/cj21n1/cj21n1.html).
5. See Zhang Dingmin, “Ownership Reform to Deflate Stock Bubbles,”
Business Weekly (Supplement to China Daily), 30 October – 5 November 2001,
p. 15.
6. Yasheng Huang, “Internal and External Reforms: Experiences and Lessons
from China,” Cato Journal 21 (Spring/Summer 2001): 62 (http://www.cato.org/pubs/journal/cj21n1/cj21n1.html).
This article is based on his forthcoming book, Selling China: The Institutional
Foundations of Foreign Direct Investment during the Reform Era (New York: Cambridge
University Press, 2002).
7. See Dong Fu, “Beyond the Border: Capital In and Out of China” ()
4 April 2000, and William Dudley, “The Emperor’s New Clothes,”
in The 2001 Guide to Foreign Exchange (London: Euromoney Institutional Investor
PLC, 2001), p. 15. Published with the September 2001 issue of Euromoney.
8. John Greenwood, “The Impact of China’s WTO Accession on Capital
Freedom,” Cato Journal 21 (Spring/Summer 2001): 92 (http://www.cato.org/pubs/journal/cj21n1/cj21n1.html).
9. Huang, p. 51. He notes that about 40 percent of China’s reserves are
invested in U.S. Treasury bonds.
10. Zhao Yaohui, “The Feasibility and Benefits of a Fully Funded Pension
System,” paper presented at the Cato/CCER conference on "China’s
Pension System: Crisis and Challenge," Beijing, 8 November 2001, p. 3 (forthcoming
in the Cato Journal).
11. Ibid., p. 1.
12. Zhang, p. 15.
13. Alan Greenspan, “Lessons from the Global Crises,” remarks before
the World Bank Group and the International Monetary Fund Program of Seminars,
Washington, D.C., 27 September 1999, p. 10.
14. Greenwood, p. 93.
15. For a discussion of the Chilean pension system and its importance for China,
see José Piñera, “Empowering People: What China Can Learn
from Chile,” in China in the New Millennium: Market Reforms and Social
Development, ed. J. A.. Dorn (Washington, D.C.: Cato Institute, 1998).
16. Zi Xun, “Nobel Theory No Panacea for China,” Business Weekly (Supplement
to China Daily), 30 October–5 November 2001, p. 15.
17. Meng Yan, “Draft Law to Protect Property,” China Daily, 3 September
2001, p. 1.
18. Liu Junning, “The Intellectual Turn: The Emergence of Liberalism in
Contemporary China,” in China’s Future: Constructive Partner or Emerging
Threat? ed. T. G. Carpenter and J. A. Dorn (Washington, D.C.: Cato Institute,
2000), p. 60.