January 30, 2011 10:37 pm

The weakness beneath China’s rise

Red Capitalism
By Carl Walter and Fraser Howie
John Wiley & Sons, 19.99 ($29.95)

The financial crisis has delivered a heavy blow to the American model of capitalism. Chinese officials do not hesitate to trumpet the point as they rejoice in the shift in the balance of economic power to Asia. Yet there are questions about how well their own model stands up to scrutiny. In Red Capitalism Carl Walter and Fraser Howie, both long-standing experts in Chinese banking and securities markets, ask quite a few; and their conclusions are unflattering.

There are, in effect, two Chinese economies. One is dominated by foreign-owned and family-run private companies that generate phenomenal growth mainly in Guangdong and the Yangtze River Delta. These two areas, which operate a free market form of capitalism not unlike Britain’s in the 19th century, attract 70 per cent of China’s foreign investment and contribute more than 70 per cent of exports, albeit with the help of a manipulated exchange rate.

Then there is the slower-growth economy dominated by state-owned enterprise, which still provides some social security for its workers. This is a bank-based model, even if the stock exchanges of Shenzhen and Shanghai are dominated by minority stakes in state-owned companies.

While the state-owned system has many of the trappings of western financial models such as stock exchanges, bond markets, interbank markets and so forth, Walter and Howie argue that this is just camouflage. On the exchanges, initial public offerings merely redistribute capital among state entities with occasional leakage to retail investors. The government bond market mainly shuffles paper between different arms of state enterprise at officially administered interest rates no different from those charged by banks. Capital allocation is controlled by the Communist party.

If the book has a hero, it is Zhu Rongji. While premier, he opened up state-owned enterprise to foreign capital and to increased market discipline. The big four banks, saddled with non-performing loans that state enterprise had declined to service, were recapitalised. This reform programme was taken forward after Mr Zhu’s departure in 2003 by officials at the People’s Bank of China against fierce opposition from the Ministry of Finance.

Come the global crisis in 2008, a huge stimulus package driven by frenetic bank lending swept away 10 years of reform. Having set up its own sovereign wealth fund, China Investment Corporation, in competition with the central bank’s fund, the Ministry of Finance used it to claw back control of large chunks of the banking system. The collapse of Lehman Brothers thus robbed the reformists of credibility and influence.

Parts of this story are familiar, but the authors bring to it an impressive wealth of analytical detail and political nous. They conclude that the system is endemically weak and that the big banks will come back repeatedly for capital without further reform. They worry that public sector debt, which they estimate at 76 per cent of gross domestic product at the end of 2009, will increase inexorably because so much growth depends on debt-financed capital investment.

That debt dependence, they argue, ensures there will be no meaningful reform of interest rates, exchange rates or material foreign involvement in the financial markets for the foreseeable future. The reality is that state-owned monopolies and oligopolies do not want change or foreign competition. Why would they, ask Walter and Howie, when they and their family associates and retainers can plunder the country’s markets and amass huge profits? Business interests, they suggest, are now the de facto rulers of China’s government.

This is quite an indictment. One question is whether the authors scaremonger too much about the economic consequences of financial fragility and public sector debt. With growth at anything like the current rate it should not be too difficult to carry a weak banking system and manage the debt burden – which, in fairness, Walter and Howie acknowledge. The difficult trick, as Japan has found, is to establish more efficient capital allocation based on market price signals once the long catch-up period is over.

Another question is by what standards should China be judged. The authors frequently appear shocked by the country’s derogations from market-based capitalism. Yet in most of these failings China is no different from numerous other developing countries. That said, China is bent on superpower rivalry; reserve currency status for the renminbi is a glint in the party’s eye. Red Capitalism puts a powerful case that its economy and financial system are not fully equipped to support such aspirations.

The writer is an FT columnist

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