Finance in China - the Contemporary Phenomenon of State Capitalism - Coursework Example

FINANCE IN CHINA: THE CONTEMPORARY PHENOMENON OF STATE CAPITALISM Introduction State capitalism is defined as “a system in which political elites control economic activity for political gain” (Zeng, 2013:133). According to Marxist dialectics, capitalism is the antithesis of communism, making state capitalism an impossible proposition. However, this was challenged by the present Chinese model, of which it was said: “Communist China’s version of capitalism is a synthesis of exquisite irony” (Austin, 2011:79). In state capitalism, the state is the principal player in the financial market system. State capitalism flourishes in China, which stands as its showcase and most successful representative. China presently has the second-largest number of Fortune Global 500 companies worldwide, an indication that the state capitalism regime may be conducive to enabling business to flourish despite the limitations imposed on free market forces by state intervention (Mourdoukoutas, 2013). While some authors feel that state capitalism should be credited with the phenomenal progress of post-Maoist China, other authors express opinions to the contrary. Williamson (2012) opposed state capitalism, arguing that “the success of China owes more to past liberalisation of the economy than to the fact that the process is incomplete” (p. 10). By this, Williamson was reasoning that China is comparatively better off with state capitalism because it is relatively more liberal than communism, but liberalism should be pursued to continue the progress (Zeng, 2013). Corroborating this sentiment is Huang (2011) who found that the standard of living of the average Chinese individual was considerably improved, and household income growth enhanced, when the country pursued liberalising, market-oriented economic reforms couples with modest political reform and distancing itself from statist policies. The development of China’s state capitalism The political economy of China provided a unique framework by which China transformed from a state-owned and controlled economy to one that is supervised and regulated by the state in combination with market mechanisms. It was able to accomplish this by combining political, economic and socio-cultural innovations that eventually led to a form of capitalism with “Chinese characteristics” (Xing & Shaw, 2013:88). The rise of state capitalism in China began with the retreat from Mao Zedong’s command economy. Under Mao, economic policy was subordinated to political expediency, and thus little economic progress was made. Two years after Mao’s death, Chinese economic reforms were implemented which represented a sharp break from the Cultural Revolution’s economic and political policies (Pollard, 2011:156). The road from command economy to state capitalism was difficult and uncertain. During the earliest stage, reform began with the “reform and opening” policy in 1978, and focused on the reform of state-owned enterprises and the creation of special economic development zones (SEZ) where joint ventures between SOEs and foreign companies could be established (Wu Jinglian, 2003). Another plan expanded SOE autonomy such that if their production exceeded what they were supposed to produce under the state plan, revenues from the excess would go to the SOE alone which could be used to acquire advanced technologies or incentivize workers and staff by increasing compensation (Liu Hongru, 2008). During this stage, the first regulations standardizing the process by which SOEs could be reorganized as shareholder companies. Thereafter, enterprises became more autonomous, and gradually the plans for production were replaced with contracts. The contract responsibility system shifted the balance of power away from the state and towards senior enterprise management. That being said, government continued to retain majority ownership of all SOEs by passing a law reserving 51% shareholder status for the state (Walter, 2010). State intervention in the Chinese financial sector The stock market Due to the transition nature of the Chinese economy (i.e., from a centralised planned economy to socialist capitalism), the stock markets in the Chinese context function differently than the stock markets in the mature economies. In most transition economies – that is, countries moving from a centralised, state-controlled economy to a market economy – the lack of institutions that support securities markets is an impediment to the effective establishment of a functioning stock market. China is an exception, however. Even in the absence of an effective institutional framework, the Chinese stock market has quickly grown and matured, making China’s case an intriguing study for financial experts. Chen (2013) argues that the Chinese stock market is driven principally by state guarantees, institutional rent-seeking by state-owned enterprises (SOEs), and investors’ speculation in the midst of financial repression. Many of the aforementioned factors are specific to China, therefore the same situation cannot be generalised for all countries; this path is even highly discouraged and should be avoided, since a market which expanded under state control is highly inefficient (Chen, 2013). Another distinctive feature of the Chinese stock market is the announcement effects of seasoned equity offerings, or SEOs. Seasoned equity offerings are sales of stock of ‘seasoned’ companies after the initial public offering (Abraham & Harrington, 2011:26). The manner SEOs affect the equities market is particular to the Chinese environment, because the dominant shareholder in many large firms (e.g. construction firms) is the state. Chinese SEOs are principally motivated by market timing, with only weak evidence supporting financing for investment and growth. There is little empirical proof in the SEO offerings that would support the trade-off and agency theories that characterise mature markets (Bo, et al., 2011). There is evidence, however, that when sales of shares of seasoned companeis were conducted through a private placement, the reaction of the market is more positive than if the shares were sold through a public offering, which tends to have a negative reaction (Shen, 2006). This may be partly explained by agency conflict between manager and shareholders; in China, agency conflict can be severe between controlling and minority shareholders, because the state is typically the controlling shareholder (Huang, 2012). Corporate governance The intervention of government creates constraints that interfere in the workings of free market forces. States tend to intervene with added regulations and tighter oversight, particularly during periods of economic crises. In the presence of financial constraints, firms plan deeper cuts in spending on technology, employment, and capital acquisitions, expended more cash, drew more heavily on credit lines in anticipation of tighter bank controls in the future, and sold more assets with which their operations can be funded. Otherwise attractive opportunities are foregone due to the inability to borrow externally (Campello, et al., 2010). State intervention is known to cause distortions in market activity, but the restraints imposed also aids in practices that infringe upon corporate governance. Jiang, et al. (2010) examined the prevalence of tunnelling in Chinese listed firms, and found evidence of the abuse of inter-corporate loans by large shareholders. Through this practice, funds are siphoned off by controlling shareholders in public listed companies to the detriment of the small shareholders and to the future of corporate operations. Tunnelling has proved viable and rewarding (to the block shareholders) in the Chinese stock market, for the reasons that: (1) due to heritage and design, all listed firms have a dominant or controlling shareholder; (2) the trading of controlling shares in China is highly restricted by the government, which limits the ownership benefits of price appreciation to the controller, thus motivating them to seek benefits by other means; and (3) little recourse is offered by China’s legal system for minority shareholders to seek relief against the misconduct of the controlling shareholders (Jiang, et al., 2010). The latter observation, the lack of formal law and law enforcement, continues to be a general weakness for the Chinese stock market, although China has exerted major efforts to develop a proper formal legal framework over the past 25 years, although it started from a very low level (Pistor & Xu, 2011). Advantages of state intervention in China’s financial markets Allocation of capital strength - Based on China’s recent experience, there are undeniable advantages of state intervention in the financial system. For instance, China’s banking sector to date has served the Chinese strategy for growth very well, by allocating capital towards the crucial investment and export sectors (Gruin, 2013). Others have attributed China’s resiliency in the 2008 global financial crisis to the fact that the activities of banking and financial institutions in China were heavily regulated by the state (Pistor & Xu, 2005; Yevdokimov & Molchano, 2011), Advantage to large-scale construction business - State capitalism appears to have worked well in infrastructure construction; China has set several world infrastructure records, including the Three Gorges dam, the largest hydroelectric project in the world, the largest mobile phone network, and the world’s longest high speed rail network at 6,400 km, all achieved within five years. A number of domestic projects included airports and railway terminals, and Chinese construction companies have undertaken overseas projects (Zeng, 2013). “China State Construction Engineering Corporation has undertaken more than 5,000 projects in about 100 different countries, and earned $22.4 billion in revenues in 2009. China’s Sinhohydro controls more than half the world’s market for building hydro power stations” (The Economist, 2012). The funding of these types of large-scale projects was made possible by state intervention practices. Resiliency during the financial crisis – Arguably, China has been relatively unaffected by the financial crisis. “For the moment, China is more stable and resilient than many realize, and its political leaders have the tools and resources they need to manage a cooking economy and contain the unrest it might provoke” (Bremmer, 2013:9). The active role of government in crafting restrictive financial and monetary regulations is seen by some as the reason for the stability of the Chinese financial system (Ma & Tia, 2012; Radu, 2013). Disadvantages of the state intervention in the financial system Weakness in innovation and productivity - It was earlier mentioned that state-owned enterprises tended to excel in the construction industry (The Economist, 2012). However, the same article reported that state-owned companies tended to do poorly with regard to innovation, particularly when the technology involved is foreign rather than indigenous. SOEs have also been found to be less productive than the private companies competing with them. The implication is that state control may provide the financing required to embark on large projects, but not the insight and entrepreneurial skills necessary to fuel innovation and competitiveness. Distortionary effects - While growth was well served, China’s financial system is rooted in authoritarian control over financial capital, and to address elite concerns over politico-economic instability; as such it will hold back the need and process of rebalancing, which is crucial because of China’s imbalanced trajectory of economic development (Gruin, 2013). Furthermore, state intervention causes distortions in firms’ capital structure. Non-state-owned firms tend to have lower total and short-term debt than state-owned firms in China in the less developed regions. This is due to state-owned firms having easier access to long-term debt, a condition which tends to enhance long-term investment, but impacts negatively on firm performance (Li, et al., 2009). This is affirmed by a study conducted by Bailey, et al., (2011), which found that the issuance of bank loans to a firm had a negative effect on the valuation of that firm in the stock market. This was because under state capitalism, bank loans may be issued for political rather than commercial reasons. More often than not in China, “poorly performing firms are more likely to receive bank loans” to keep them afloat “as subsequent long-run performance is typically poor” (Bailey, et al., 2011:1828). It is typical therefore for stock values for Chinese borrowers to decline significantly at the announcements of bank loans. The negative effect is also more prevalent for firms with high state ownership, with no foreign class shares, that loan from local bank branches, or whose loans are intended to repay existing debt (Bailey, et al., 2011; Pessarossi & Weill, 2013). Tendency towards over-investment - The IMF has raised concerns that over the period 2007-2011, the Chinese have been over-investing by levels ranging from 12% to 20% GDP relative to its steady-state desirable value, and 35% to 49% of GDP over the last 30 years. If China continues to employ the same strategy, money may continue to pour into “white elephant” infrastructure and industrial projects. At some point the mounting debt incurred to finance these unproductive projects will turn bad, triggering another financial crisis. Even now, the property sector is weighed down by bad debts, and there is excess capacity in many industries due to over-investment (Lee, et al., 2012). Black money shadowing the formal banking system - China has gradually been adopting bank reform since the 1997 Asian financial crisis, where the country was first made aware of the need to restructure the financial sector. So far, significant measures have been adopted towards greater transparency and market discipline (Wu & Bowe, 2010). Reforms are necessary to enable China’s financial system to withstand global contagion, to serve a growing and modernising economy, and to be competitive and effective in a global environment (Geib & Pfaff, 2013). In China there is the so-called informal economy also called “black money” – informal networks of banks operating without a license which companies can tap for funds. The “black money” informal market is comprised of hundreds of operations, mostly illegal or in the grey area, eager to make loans to needy firms and able to circumvent the government’s restrictive control. Corporations are able to take out “black money” loans within 24 hours, while it takes 6 months to a year for the firm to get loan approval from regular banks (The Economist, 2007). Continued conflict between socialist ideologues and reformists - From the other end of the spectrum, socialists adopting the Marxist perspective are asking the question as to whether China should not strengthen the socialist elements in its economy, decrying the widening discrepancy between the performance of the state-controlled industries and those elements pertaining to the private economy in China (Xie, et al., 2012). It appears that the Chinese state capitalism model is not as seamless or monolithic as outsiders may perceive it to be, and a dichotomy is emerging between the state economy and private economy. The socialists argue that the government-controlled economy “enable us to make decisions efficiently, organize effectively, and concentrate resources to accomplish large undertakings” (Zeng, 2013:133) and point to the immensely successful infrastructure and construction industry. Instability in monetary policy - Major trading partners are pressuring China to make the yuan a fully convertible currency, which may initially cause it to appreciate in value which in turn may cause a reduction in trade and investment imbalances (since prices for yuan-denominated goods and investments will rise vis-à-vis foreign currencies). However, the liberalisation of the yuan may cause China’s citizens to send their savings overseas, causing the yuan to fall in value instead of appreciating. If this were the case, depositors in China’s banks will withdraw their funds en masse, and investors in yuan-denominated stocks and securities will massively sell their shares. This will create a tightening of credit and funding for companies, particularly the poor performers that relied on subsidies. The result is massive unemployment and social instability such as the West has experienced during the US subprime crisis of 2008 (Bailey, et al., 2011). Another likely possibility in the occasion of the yuan’s volatile appreciation and depreciation is the emergence of stock market and real estate bubbles in China. The phenomenal economic development of China in the past two decades has spurred quick urbanisation and modernisation, together with the rise of asset bubbles. An asset bubble is a “post-industrial macroeconomic state of capitalism in which growth is based largely on appreciation of equity assets” such as stocks and real estate (Song, 2011:4). An asset bubble takes place when the growth in the economy is no longer driven by manufacturing, services or the traditional engines for value creation, but by the rise in prices of speculative assets. As with other countries, the bursting of the asset bubble due to unsustainably high prices may again usher in a period of global instability and economic crisis, particularly with China’s role in global trade (Dorn, 2013; Rana, 2012). Suggestions for further reform China’s financial systems are a work in progress, as evidenced by the unflattering manner bank loans are associated with poor corporate performance (Bailey, et al., 2011), which contributes to the distortion of stock market valuations. China’s financial institutions, particularly banks, therefore carry a high amount of risk, and this is sensed by foreign investors who may have intended to invest in the Chinese banking institutions. The paradox with regard to Chinese yuan is another dilemma which must be addressed by a prudent stewardship of monetary policy, gradually progressing towards eventually developing a free-floating currency. This cannot be attained overnight, because of the destabilization that would tend to result from the volatility that sudden change shall definitely cause. Before monetary policies could be fully liberalised, it is of utmost importance that the banking system be reformed (Bailey, et al., 2011), an indication that the transition will be protracted and full of uncertainty. State capitalism relies to a large degree on partnerships created between government and business. In order to build a solid foundation for such a partnership, business’s profit incentives and government’s social incentives should be aligned. National and local governments must provide business with access to unique resources and capabilities that are under their control, in order for enterprises to be attracted particularly to China’s low income markets. This proceeds from the finding that complementary resources and well aligned interests between enterprises and governments are the success drivers of government-enterprise partnerships (Kostka & Zhou, 2013). Conclusion According to a World Bank/Chinese Government joint report entitled “China 2030: Building a Modern, Harmonious and Creative High-Income Society,” it was found that long-term industrial growth may evade China unless it completes the transition to a market economy, modernise and strengthen its domestic fiscal system, and connect its (China’s) structural reforms to the changing international economy (Richardson, 2013). The contention, therefore, that the Chinese model that appears resilient is a stable and permanent model is largely doubtful, since China’s interventionist policies even now shows a build-up of an asset bubble that may result in another Asian crisis in the future. 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