Understanding China's Economy Requires Looking Beneath the Surface (Pt. II)
Please see Understanding China's Economy Requires Looking Beneath the Surface (Pt. I) ***********************************************
IV. Bank Debts (cont.)
- Funding the Deficit on Social Security Programs
China's funding gap for social security, medical care, pensions, etc., is the government's debt. In the past 50 years or so, the process of China's industrialization and accumulation of state assets have been completed through low wages and the "scissors gap" between the prices of industrial products and agricultural products. The contributions to China's wealth resulting from low wages and the "scissors gap" were mainly provided by urban laborers and farmers.
As these laborers and farmers are getting old and no longer able to work, it is a normal government obligation to provide them with a pension. Though China has gradually implemented a workers' self-funded program, which has solved part of the pension problem, the amount of the government shortfall for pensions is at least several trillion yuan. According to economists' estimates, it may take nearly 40 percent of China's GNP to fund this obligation. If the pensions owed to agricultural workers are included, it's astronomical .
- Raising Money to Avoid a Banking Crisis
China's four major state commercial banks–Bank of China, China Construction Bank, Industrial and Commercial Bank of China and Agricultural Bank of China, have long carried huge amounts of bad loans, which can never be recovered. To maintain the CCP's political power, it is imperative that these four major commercial banks be recapitalized. As a result, a large infusion of capital needs to be poured into the banking system, as this concerns the critical issue of life and death for the country and the Party.
The Chinese Communist regime decided to invite Bank of America Corp. to invest in the China Construction Bank. An agreement was reached, in which Bank of America. would buy a 9 percent share in China Construction Bank for US$ 2.5 billion. In addition, Bank of America has an option to increase its ownership in the China Construction Bank over the next five and a half years up to 19.9 percent at the initial public offering price, and will have a seat on the new board of 16 to 19 directors . The Goldman Sachs Group in the U.S. and Allianz Germany are also planning to jointly acquire part of China Construction Bank's shares with over US$ 1 billion .
The Chinese Communist regime offered preferences to foreign banks to enable them to enter the Chinese banking market one and a half years prior to the completion of China's WTO preparation period in December 2006, in an attempt to relieve U.S. pressure on the appreciation of the Renminbi (RMB). More importantly, the Chinese Communist regime has set a long-term strategy to tie China's banks to American banks, so as to give the Chinese people the impression that the Chinese banking system will never collapse, expecting that they will feel more secure in depositing their money in Chinese banks.
In the meantime, the Chinese Communist regime has significantly increased taxes to offset the losses in the banking system and to fund government deficits. In 2004, China's tax revenues reached 525.6 billion yuan (US $65 billion), an increase of 25.7 percent, which set a record in terms of total revenue as well as the amount of increase. The tax revenues increased at a rate of 25.7 percent, while the GDP increased at a rate of 9.5 percent. That is, the tax revenue increase rate was 2.5 times the GDP increase . Beijing's deficit was still 319.12 billion yuan in 2004 (about US $39 billion) .
Although the Chinese Communist regime has significantly increased its tax revenues and agreed to allow American banks to invest into China's banking system in recent years, the Chinese banking system is still on the verge of an imminent financial crisis. As a result, in the last ten days of June 2005, the State Council issued the "State Contingency Arrangements for Financial Emergencies" regulations. It was an important topic at the 35th China Banking Regulatory Commission (CBRC) meeting held on June 28, 2005. The nationwide distribution of the "Precautions" showed that the Chinese banking system's current situation is so critical that the "Precautions" are already needed. The chairman of CBRC, Liu Mingkang, said that distribution of the "State Contingency Arrangements for Financial Emergencies" by the State Council is to create a rapid response mechanism for any banking contingencies, including bank runs, stock market slumps, bankruptcies, impact of overseas banking, and other banking crises. It is to prevent and reduce the impact of banking crises on society, so as to maintain the stability of the banking system and society as a whole, as well as to safeguard national economic security .
V. Stock Market
The Chinese people have invested as much as 2.45 trillion yuan (about US$302 billion) in China's stock market, but where is the money is now? Some major investors have earned over 600 billion yuan (US$74 billion); the national stamp tax revenue has reached over 210 billion yuan (US$26 billion); brokers have made more than 210 billion yuan (US$26 billion); market makers and institutions gained over 200 billion yuan (US$25 billion); employee share options, transfer right shares (TRS) and other parties gained some 280 billion yuan (US$35 billion); earnings of premiums on options of new shares amounted to some 100 billion yuan (US$12 billion); listed companies took over 850 billion yuan (US$104 billion).
As a result, the dividends for the ordinary shareholders were only about 60 billion yuan (US$7 billion). In other words, tens of millions of ordinary shareholders spent 2,450 billion yuan (US$302 billion) purchasing 202.5 billion "non-tradable" shares. However, the book value of all these listed companies' assets is only about 450 billion yuan (US$55 billion). This is the real situation of the Chinese stock market, and the risk in the stock market is very likely to ripple into the banking system as a whole .
The Chinese stock market was first established in the early 1990s, and it can be divided into two phases with the second half, 2001, being the dividing line. In the first phase, competent authorities always stressed the principle of "stipulating regulations in the process of (the market's) development, and developing in the process of stipulating regulations." But, in practice, the Chinese stock market was developed in an atmosphere lacking regulations. On the one hand, people are obsessed with the achievement that "it took only ten plus years for the Chinese stock market to complete with what the western nations accomplished in several hundred years" On the other hand, they have no choice but to suffer incessant speculation and irregular cases in the stock market.
Before the second half of 2001, not only did 99 percent of Chinese listed companies "engage in accounting fraud," as mentioned by Zhou Xiaochuan, the chairperson of the China Securities Regulatory Commission at that time, but almost all the economic criminal cases have something to do with the stock market. Since the second half of 2001, the Chinese stock market has no longer adhered to the policy of "development and compliance are equally important," the pendulum has now fully swung to the other side and the focus is on efforts to correct the regulations. But a very high price has been paid for their lack of oversight.
Though China's economy is now growing quite fast while global stock markets are gaining worldwide, the Chinese stock market continues to fall. Not only did individual investors suffer tremendous losses, but institutional investors have also failed in the past two years. As a result, the government had no choice but to establish some contingency measures from time to time in order to avoid a financial crisis .
According to statistics, since its inception fifteen years ago, the total capital investment from the shareholders has reached 2.45 trillion yuan (US$302 billion). However, the current market value is only 700 billion yuan (US$86 billion). In other words, 1.75 trillion yuan (US$216 billion) or 70% of the original investment has been lost. According to a report by The Eastern Outlook Weekly, China's stock market index has fallen 50 percent in four years of bear market. The market's value has fallen from 1.7 trillion yuan (US$210 billion) to 700 billion yuan (US$86 billion). In addition, a survey conducted by Sina.com on 25,675 shareholders dated March 30, 2005, revealed that 94.28 percent of the shareholders suffered financial losses. Among them, 67.34 percent of them lost more than 50 percent .
A report actually stated, "The actual goal of China's stock market is not to bring financial profits to its investors, but to raise revenue. Whom is the money collected for? The answer is: for those enterprises that operate in the red, and for the Chinese government." 
On June 2, 2005, the Shanghai Stock Exchange index plunged to 1,008.75, and was on the verge of dropping below the 1,000 mark. China's stock market was on the brink of collapse, which the Chinese Communist Party (CCP) has been reluctant to admit publicly. The Chinese Communist regime ordered the implementation of a measure called "safeguarding (the stock market) with a policy" – The government invested 66 billion yuan (US$8 billion) of public funds to bail out the market. As a result, the market index recovered temporarily and the collapse was averted. However, the problem was simply delayed and would expand into the monetary sector. The CCP would be confronted with an even more desperate collapse if the stock market falls after all. The problem won't disappear.
VI. Real Estate
The mistakes experienced in the stock market are moving to China's real estate.
On the surface, China's real estate market has nothing to do with its stock market. However, a parallel analysis in the market's characteristics reveals that these markets share two common points: (a) Both markets belong to the lagging sectors in China's economic reform agenda, and (b) Defying the general trend that market and non-government-controlled economies hold the predominant position, the rules of the two markets are still "government dominance and preset pricing by government policy." The consistency in the market nature also gives rise to stunning similarity in the issues encountered in the two sectors. Furthermore, as the development of the stock market preceded the counterpart of the real estate market, the similarity illustrates itself, as the real estate market is merely a replica of those associated with the stock market. The major problems can be summarized as follows:
- Sole pursuit of development without proper regulation.
- Irrational market positioning, leading to high potential risks.
- Similar market manipulation strategies.
The unhealthy development of China's stock market went on for 10 years before the market entered the "correction" phase. Judging from the current trend, the timing for the real estate market's "correction" phase should have been much earlier. The pricing level of housing in China is too high considering two evaluation indices, i.e., population density and the ratio of housing prices to household income .
The results of wild real estate speculation can be exemplified as follows:
- Local government was undoubtedly the No. 1 beneficiary. From 2001 to 2003, the overall income to local governments in China from land asset sales reached 910 billion yuan (US$112 billion). In contrast, the figure was only 6.7 billion yuan (US$827 million) in 1998.
- A former construction subcontractor who became a real estate broker in 2002 explained why he decided to change occupations, "The net profit of construction is about 15 percent, but it's in the range of 100-200 percent for the brokerage of real estate."
- In this environment of escalating housing prices, there were more than 100 real estate tycoons who accumulated wealth exceeding 10 billion yuan (US$1.2 billion) in the Beijing and Shanghai areas. What is disturbing is that it is a common practice in China's real estate industry to escape paying taxes.
- As the pricing of real estate is pushed ever higher in all cities, the market is racing towards an imminent collapse. As soon as the real estate bubble bursts, all of the capital will leave China. It is not likely that local economies will recover within a decade. .
If the real estate market collapses, China's banking system will be forced to absorb the loan losses. The banking system would likely be dragged into bankruptcy.
VII. Energy Shortage
- Vulnerable petroleum supply in China
Statistics show that China imported 90 million tons of petroleum between January and September of 2004. This is a 40 percent increase compared to the year before. It is estimated that China imported a total of 120-140 million tons of petroleum in 2004. This represents a net increase of 30-50 million tons in one year, which is equivalent to the average annual yield of the Daqing Oilfield Company LTD before it cut back its production.
The price of oil in the international market has been hovering. At present, China imports three million barrels of petroleum per day and its average annual expenditure on petroleum products reaches US$35 billion. Therefore, every time the price of oil increases, it puts more pressure on China's production costs .
China's enormous energy consumption and heavy dependence on imported foreign energy and raw materials is the result of their global-market-oriented economy and status as the world's factory. According to data published by China, 40 percent of the crude oil consumed in 2003 was imported, and this number will increase to 55 percent by 2008. This percentage indicates the seriousness of China's energy dependence. Once the cross-strait war breaks out, the international oil supply will be cut off and factories in China will be forced to shut down. Since the supply and transportation of international oil is mainly in the hands of the U.S., a conflict with Taiwan could provoke an oil embargo on China. The top executives of the Chinese Communist regime should be aware of the consequences if the oil supply is cut off.
The bid submitted by the China National Offshore Oil Company (CNOOC) to buy Unocal Corp. is one strategy to alleviate China's potential energy crisis.
VIII. Inflation–A Looming Crisis
China's GDP increased by nine percent in 2004. Although the price of housing was still skyrocketing, the industrial production grew by 30 percent. It seems that no particular crisis is imminent.
However, data analysis still reveals a potential crisis. In China, automobile sales have undergone a sudden slide. The sudden nature of the decline was unexpected and baffling. The automobile business turned from a high growth market into a stagnant one. Across the board, all makes and models suffered a sales plunge. The same situation applied to household appliances.
Changhong, a leading company in household appliance manufacturing, confronted big financial losses. All of the major producers of household appliances were faced with plummeting sales. These seemingly independent cases breaking out suddenly are telling us one thing: the factor that drives China's economic growth is still investment expansion, but the return on investments keeps lowering.
Statistics from October 2004 showed that the price of food, raw materials, gold and fuel were all rising while the price of telecommunications, transportation, information, household appliances and automobiles were falling. Judging by the increasing cost of raw materials and decreasing sales price of finished goods, the profit margin of factories must be suffering. The industry couldn't find an effective way other than continued expansion to secure profitability.
What made the situation even worse was that the tax rate increased by 24 percent compared with only a nine percent increase in GDP. A great amount of money was constantly being extracted out of the field of consumer goods at an accelerated pace.
With prices rising and inflation looming, the general public was forced to make investments so as to avoid currency depreciation. Ironically, the stock market, which ought to be the best place for public investment, also slumped. On June 1 2005, the Shanghai Synthesis Index hit a record low of 1008 points. No one could find a suitable place to invest idle funds. The price increase of real estate was no longer news. The price of artists' works had doubled in the recent months. The price of gold was shooting up. Wenzhou businessmen were buying collieries. The price of farmland had also increased by 24 percent. Any market that might hold its value was flooded with idle funds. The economic structure however, was still in disorder.
Not only civilians, but also the large state-owned enterprises were affected as well. By 2006, foreign capital will be allowed to enter China. Major banks, insurance firms and large enterprises were all in need of capital this year to offset prior financial debts and losses. Going IPO (initial public offerings) has become the common slogan among the large enterprises.
Shanghai A Stocks, however, which represent the companies capable of going IPO in China, have turned into a joke in the stock market. Any additional company going IPO triggers a new run of frenzied dumping. The index kept breaking its record low.
China's civilian stock investors evaded new stocks as though they were dealing with a plague. The attempt to use Shanghai A Stocks for "money collection" is destined for failure. As a result, the tycoons thought of another way to collect capital– going IPO in the U.S. and "stealing" money from western investors.
The price real estate in China has been hovering at a shaky high. Although various pieces of exotic news have been continuously released in favor of the market, the game is over for the majority of civilians. No matter if an apartment worth one million yuan (US$123,000), might increase to two million or three million in the future, it means the same thing to most civilians whose monthly wage is merely three thousand yuan (US$370)–they simply cannot afford it.
Civilians no longer need to worry about the housing prices. Instead, all they can do is to stay calm, sit back and watch its evolution quietly. As the housing prices soar, fewer and fewer people can afford it. On the other hand, it is hoped that the price of housing doesn't drop because of the possible turmoil that might ensue if housing prices took a slide.
But where is the capital to sustain the pricing? From half a million to a full million, the profit margin is 100 percent while from 1.5 million to 2 million, the margin shrinks to 33 percent. The latter however, demands far more capital input.
With increasing raw material costs and decreasing finished product prices, business loans are difficult to come by, the tax burden is getting heavier and foreign trade is shrinking. All the analyses come to the same conclusion: business profit is declining, and the inevitable outcome is layoffs. When the supply of labor force is greater than the number of job opportunities, competition must become more intense and wages will be lowered. Can these lowered wages support houses worth millions of yuan? [ 27]
The Chinese economy's outlook depends largely on the health and stability of its banking system.
The Pillars of China's economic development are foreign capital, Chinese people's high savings rate, international trade, and land sales. Then what about their prospects?
Half of the foreign capital in China has been withdrawn and only half of what remain is profitable.  The once very profitable automobile industry is on the brink of losing money. Many companies have started wondering if the potential profits of their investments in China are worth the risks. The Deutsche Welle radio reported that almost none of the German firms surveyed by the radio in a questionnaire were willing to reveal the profitability of their operations in China. Companies in other countries have also shied away from responding to similar inquiries.
According to the findings of research conducted by the independent magazine China Economic Quarterly, the aggregate profit of U.S. firms in China was about US$4.4 billion in 2003. In contrast, U.S. firms' net profit in the same year was US$7.1 billion in Australia (having a population of 19 million), US$8.9 billion in Taiwan and South Korea altogether, and US$14.3 billion in Mexico. Foreign capital can only make a meager profit in China, and it is one of the capital problems that China is encountering. 
The Chinese people's savings rate is as high as 30 to 40 percent, which is an important pillar supporting the rule of the Chinese Communist regime, but how long can this high savings rate be sustained?
There are three firewalls to ensure the stability of China's financial industry. The first one is domestic monopoly, the second is isolation from the outside world, and the third is a high savings rate. All Chinese people's savings are deposited in four state-owned commercial banks which offer no difference in the interest spread between deposits and loans. As to the second firewall: isolation from the outside world, Renminbi (Chinese yuan) is not freely convertible, which makes it a very effective in fending off foreign banks from handling Renminbi-related businesses.
After the first and second firewalls cease functioning in December 2006, the Chinese Communist regime will no longer monopolize the financial markets. The two American banks' entry into China's banking system as mentioned above symbolizes the beginning of the destruction of the first and second firewalls.
Professor Xu Dianqing of Western Ontario University believes that China' high savings rate will start to decrease some time between 2012 and 2015 when the post-reform second generation becomes the dominant demographic constituent of the production, consumption and savings of Chinese society. This financial phenomenon will impact the banking system as a whole.
Professor Xu proposed that the reform of the banking system should be sped up so as to weed out degeneration and corruption between now and 2012. His wish was to help the Chinese Communist regime address its problems so as to extend the dictatorship's rule. The Chinese Communist regime's problems however, go beyond the banking system. The social and political systems are all implicated.
Moreover, the Chinese Communist regime is reluctant or afraid to undertake reforms. The most prominent examples are the relationship between the Central Bank and the Chinese Communist regime, and between the state enterprises and the banks. Those are political issues, but the Chinese Communist regime is unwilling to make changes. 
During the past 27 years since the commencement of economic reforms, these problems kept piling up throughout the premiership terms of Zhao Ziyang, Li Peng, Zhu Rongji and Wen Jiabao. Some problems, such as the stock market and the bad loans in the banking system, have progressed to such a degree that they have become irremediable. It is conceivable that these problems won't be resolved during Wen Jiabao's term of premiership. China's economy could suffer a recession starting from the collapse of its banking sector and precipitating a lack of operating capital for businesses. Should civilian deposits or investments no longer yield a proper return or even lose money, the public's wrath may lead to a nationwide turmoil. China's economic outlook remains dim.
Mainland China's banks have suffered huge losses on bad loans and the governments at all levels face serious debts. The stock market is overshadowed by collapse and diminishing stock values. While a lot of money is tied up due to steep hikes in real estate, domestic capital is secretly sent overseas. Various signs indicate that the monetary chain of the banking system is about to rupture. Given that, the author once predicted that China's banking system might collapse between 2006 and 2008, which would lead to a serious political crisis for the Chinese Communist regime. Recently, the CCP's Politburo Standing Committee has also noticed this threatening prospect. After meeting for several days in a row, an important decision was made to gradually open up the Chinese banking system one and a half years ahead of schedule. Foreign banks will be allowed to invest in local banks and gradually participate in the executive management boards so as to reform China's banking system.
In an effort to avoid fracturing the monetary chain, some commercial banks will become listed companies in the stock market by the end of this year so as to raise funds to offset bad loans. Thereby, the author holds that the onset of China's financial crises will be postponed. Nevertheless, with capital influx from foreign banks, two of the three firewalls that have long been implemented in the Chinese banking system, i.e., "domestic monopoly" and "isolation from the outside world," must be abandoned. It is likely that the capital from foreign banks will gradually change China's economic and political environment, which may push China to take a course similar to the one adopted by countries in Latin America.
Moreover, the third firewall, i.e., the general public's "high savings rate," may gradually decrease after 2010. When these three firewalls no longer exist, the financial pillars supporting the Chinese Communist regime's dictatorship will disappear. By then, the impact from internationally democratic and financial groups may, within the framework of the WTO, gradually change China's political, economic and social environments. It is still too early to predict how these changes will manifest. That subject is beyond the scope of this article. The author will analyze and discuss it in the future.
Wu Fan, editor-in-chief of China Affairs, Chairman of the Board of the Alliance for a Democratic China.
References (all in Chinese)
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