22 THE INTERNATIONAL ECONOMY FALL 2005

The Next Great

Pyramid GameA disturbing inside

peek at China’s

financial mania.

One of the great ironies of 2005 has been to watch the spec-tacle of cash-flush China push former state-owned com-panies out into the market to raise even more paper dollars,part of a ritual whereby this very old, corrupt society seekseconomic validation. Few of the credulous gringos whotoday buy shares in Chinese banks and companies knowthat they follow in a long tradition of western investmentin dubious eastern opportunities. Just as foreign investors

have made and lost great sums in markets like Russia, Argentina, and our belovedMexico, the financial bubble in Chinese stocks is the next great paper pyramidgame waiting to fall.

China spent more than two centuries under foreign colonial rule, but sincethe end of World War II it has sought to regain independence and prosperity evenas Japan, Korea, and Taiwan became the industrial leaders of the world. MainlandChina wants a piece of the pie and it is in a hurry. What makes the situation evenmore ominous in terms of potential financial market system risk is the fact that evenvery senior gringos have such a hard time telling our brash, always certain friendsfrom China when they are off course. Indeed, the speed at which China is press-ing the world for recognition is reminiscent of a young child reading about anexciting subject for the very first time.

Christopher Whalen is technology editor of TIE and a Managing Director ofInstitutional Risk Analytics.

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In September, China Construction Bank (CCB) rana quarter-page advertisement in the Financial Timesseeking a chief risk officer. The ad was like those pub-lished by other global banks announcing an openingfor a senior executive, but the CCB ad was severaltimes larger than normal and placed conspicuously nearthe front of the paper—as though to announce the merefact that CCB was hiring its first real CRO. Generallyspeaking, large financial institutions do not find mem-bers of the C-suite in such an ostentatious fashion, butthen again, CCB and its peers among China’s banks arenot your usual financial institutions.

The size and placement of the CCB ad typifies thestyle of China’s approach to its growing economic

importance. “Everything in China today is louderand more gaudy than ever before,” notes onewestern banker who spent part of his childhoodin that nation. “The entire population of Chinaseems both tone deaf and color blind. Nothingelse could explain the volume at which Chinesemust be spoken and the hideous taste in clotheson display. Material wellbeing has, on the surface,improved over the past decade, but much of whatforeigners see is a garish veneer, the image of howChina thinks it should look in 2005.”

While modern glass buildings grace the mainthoroughfares of China’s largest cities, they failto hide the crammed, dreadful, and repulsive liv-

ing quarters in which the majority of the populationcontinues to dwell. Try as the Chinese government mayto project an image of progress and modernity, cracksare apparent (for those who venture from the two imme-diate blocks surrounding their hotel or the varioustourist attractions). Homeless people, cripples, and beg-gars—groups which were never before allowed to bevisible—are ever-present in the major urban areas.Prostitution, which was unthinkable a few years ago,is now common.

China’s economic opening is an almost manicevent, a source of overwhelming pride and exhilarationfor a nation that spent nearly half a century enduringpolitical purges and communist indoctrination, a bru-

China’s Veneer

“Everything in China todayis louder and more gaudythan ever before,” notes

one western banker who spent part ofhis childhood in that nation. “Theentire population of China seems bothtone deaf and color blind. Nothing elsecould explain the volume at whichChinese must be spoken and thehideous taste in clothes on display.Material wellbeing has, on the surface,improved over the past decade, butmuch of what foreigners see is a garishveneer, the image of how China thinksit should look in 2005,” notes onewestern banker.

While modern glass buildingsgrace the main thoroughfares ofChina’s largest cities, they fail to hidethe crammed, dreadful, and repulsiveliving quarters in which the majority ofthe population continues to dwell. Try as the Chinesegovernment may to project an image of progress andmodernity, cracks are apparent (for those who venturefrom the two immediate blocks surrounding their hotelor the various tourist attractions). Homeless people,cripples, and beggars—groups which were neverbefore allowed to be visible—are ever-present in themajor urban areas. Prostitution, which was unthink-able a few years ago, is now common.

—C. Whalen

AP P

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tal period that left millions dead and many millionsmore scarred personally and economically. The eco-nomic rise of China is almost a relief for people accus-tomed to being tightly controlled, both by the ChineseCommunist Party and by aggressive Western colonialinterests. As the fourth-century Chinese parable states:“In the grass, the trees, everything seems a soldier,” butthat soldier may be either Chinese or foreign.

Because of the importance of China’s economicopening to the collective self image of this nation ofmore than a billion souls, any criticism directed atChinese companies or policies is greeted with tremen-dous hostility—whether the criticism is justified or not.When Christopher Cox, chairman of the Securities andExchange Commission, said in mid-October 2005 thatCCB did not list in the United States because it could notmeet New York’s regulatory requirements, an obviousstatement of the facts, the reaction from Beijing waschilly indeed. When Cox also suggested that CCB’sfinancial health would deteriorate after the share offer-ing in Hong Kong the following week, he was casti-gated by members of the financial media who make aliving writing about “opportunities” like CCB.

Just as many Chinese cities have become reflec-tions of what China’s communist leaders believe off-shore investors want to see, CCB and other Chinesefinancial institutions are likewise facsimiles of westernfinancial institutions, according to foreign bankers andlawyers involved. The formerly state-owned Chinesebanks do not yet have the inner workings or functionsof a bank as defined in the industrial nations, in partbecause virtually all credit and commercial transactionsin China are controlled by the Communist Party.Indeed, if CCB were to actually hire a new CRO whois not familiar with China’s financial and political sys-tem (which are one and the same), that lucky personmight be very surprised by their actual job responsibil-ities—but not as surprised as some of the foreign banks

who are currently shovelingmoney into the furnace by“investing” in China.

Sol Sanders, who has cov-ered Asia as a journalist forthree decades, confirms thefull dimensions of the ongoingfinancial mania in China, akleptocratic free-for-all whichmakes the asset grab by com-munist officials after the fall ofthe Soviet Union seem politeby comparison. Sanders writesthat “No sooner had the Royal

Bank of Scotland taken its $1.6 billion plunge into theBank of China than a deputy chairman received alengthy prison term. In March, the Bank chairman wasremoved for alleged bribery. Shortly before, fifty staffmembers were accused of embezzling $85 million.Earlier this year a branch manager fled the country with$120 million.”

A western banker reports to TIE that ChineseCommunist Party officials are busily stealing much ofthe dollar inflow raised by direct investment, a repeat ofthe classical method refined by the Latin Americandebtor countries in the 1980s to deprive credulous grin-gos of their hard currency. Senior officials, aided andabetted by western bankers, reportedly spirit these funds

China’s leaders do not recognize or

even understand what it means

to operate private banks with private

borrowers and private property

in a market economy

where corruption is not the

dominant factor in everyday life.

When Christopher Cox, chairman of the Securities andExchange Commission, said in mid-October 2005 that CCBdid not list in the United States because it could not meet NewYork’s regulatory requirements, an obvious statement of thefacts, the reaction from Beijing was chilly indeed. When Coxalso suggested that CCB’s financial health would deteriorateafter the share offering in Hong Kong the following week, hewas castigated by members of the financial media who makea living writing about “opportunities” like CCB.

—C. Whalen

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away to the safety of banks in Asia, the United States, orthe European Union, even as the Chinese economy headsfor one of its periodic “adjustments.” These Chinese offi-cials seemingly know that while the country’s foreignreserves amount to some $769 billion as of September2005, the country’s financial liabilities are far greater.

The IPO for CCB and other Chinese banks seem-ingly should be cause for alarm among western regula-tors and bankers, but in fact the opposite is the case.With various foreign banks “invited” to invest in CCB,this to provide further validation of the economic reformefforts of China’s Communist Party, CCB has alreadybeen blessed by the New York banking community,regardless of what the head of the SEC may think. Ofnote, the reason CCB did not seek a U.S. listing is thesame reason why it is not permitted to operate a branchin the United States, because of its links to China’s com-munist government.

Citigroup reportedly was coerced into making aninvestment in CCB after it was threatened with being“shut out” of China’s financial services market. If youbelieve that there are really 300 million bankable con-sumers in China, perhaps investing billions of dollars inCCB or other Chinese banks makes sense. This logiccertainly seems to have convinced the management ofBank of America, which paid $3 billion for a 9 percentstake in CCB. But with little details—such as a lack ofproperty rights or legal due process, and fraudulentfinancial information—still unresolved in China, wewonder how foreign banks can justify investing or lend-ing, at least without treating such commitments as 100percent reserved for loss.

The fact is, CCB and the other “banks” in Chinaare not really financial intermediaries and do not gen-erally extend credit to private companies, according tolocal bankers who work with these entities. As arms ofthe Chinese government, banks reportedly are used pri-

marily to support state-run enterprises (SREs) and pro-vide a slush fund for Communist Party officials andcorrupt managers. None of the classical credit or evenfinancial functions of a western bank are to be foundinside a Chinese state-owned bank, say our sources inthe region, nor do they have any of the most basic inter-nal controls or reporting systems necessary for a trans-parent, prudential operation.

Indeed, according to one western banker based inBeijing, CCB and the other large Chinese banks lendprimarily to SREs, which in turn make small, usuriousloans to private companies—with the requisite bribesto the Communist Party officials involved. All of theknowledge, credit information, and lending experiencethat you would expect to find inside Chinese banks isinstead ensconced inside the SREs, which remain underfirm Communist Party control. When you hear the glibreports in the western media about 10 percent of China’sloan market being non-performing, says our observer,multiply that number by five, seven, or even nine timesand you’ll be closer to the economic reality.

“For state-owned banks, lending to private com-panies isn’t worth the risk since should something gowrong lending to a private concern, the bank officialwould get the blame without adequate compensationfor the risk, whereas if they lend to an SRE, they haverecourse through the authorities should things go bad,”says the banker. “As a result, large state-owned banksdon’t lend to the private sector. They don’t have author-ity to price risk and they really don’t know how.”

If American manufacturers think they

are having a tough time competing

against Chinese manufacturers now,

just wait until the day Chinese

manufacturers have access

to capital at market rates!

“China’s economy is like

the old burlesque comedian

with a loose string that when pulled

disintegrates his suit.”

Continued on page 56

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“Capital, however, is like water,” continues the banker.“Barriers do not stop it, it simple flows around them. So,SREs have become the conduit to private enterprise. SREsborrow money from the banks and turn around and ‘lend’money to private enterprises on a short-term basis at ratestwo to five times greater than the official rates, often timesby creating dummy invoices.” Of interest, this practice isnot a state secret. The Bank of China has spoken about thisissue earlier this year, but cannot address the underlyingcauses of this strange arrangement without a head-longconfrontation with the Chinese Communist Party.

Part of the reason that Chinese banks are restricted fromlending to private business is the question of political con-trol and corruption. By channeling funds through the SREs,local Communist Party officials can select which borrowersgain access to credit on what terms, and extract their shareof the vigorish, but the effect on the financial soundness ofChinese banks is horrendous. Actual credit risk is pooled andcollecting outside of the official banking system, inside theSREs which are, for an practical purposes, affiliates of thebanks. Officials turn a blind eye because the usurious interestrates charged for loans are needed to help prop up the SREsand the entire bankrupt state-owned economy.

More important, Chinese banks really don’t know howto lend or price risk and implementation of international

banking accords such as Basel II will do nothing tostrengthen the weak links in China’s financial system. Andif American manufacturers think they are having a toughtime competing against Chinese manufacturers now, justwait until the day Chinese manufacturers have access tocapital at market rates!

Even though the shortcomings of the Chinese “bank-ing system” are manifest, the western media happilyapplauded for the CCB offering. The Financial Timescalled the IPO “a pioneering listing that is crucial forChinese bank reform.” But reform of what?

Until the Communist Party deigns to allow truly inde-pendent private economic activity, which is a contradic-tion in terms, reforms are meaningless. No amount offoreign investment is going to change the basic fact thatChina’s leaders do not recognize or even understand whatit means to operate private banks with private borrowersand private property in a market economy where corruptionis not the dominant factor in everyday life.

Sanders summarizes China’s economic outlook:“China’s economy is like the old burlesque comedian witha loose string that when pulled disintegrates his suit. That acrash is coming is gospel for many China watchers. At dis-pute is when, which trigger, how big, the political fallout,and how and when economic growth recommences.” ◆

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