China’s surge from basket case to the world’s factory is simply breathtaking. But the powerful rise has outpaced institutions that Westerners see as prerequisites to capitalism.

Shanghai photos over 20 years.

The growth story: China has become the 2nd largest economy by GDP. China also reportedly surpassed Japan with the 2nd largest stock markets by market capitalization. It is already the largest manufacturer in the world, ending a century of leadership by the USA. It is the largest car manufacturer in the world, producing 18m vehicles in 2010. Depending whom you ask, China may surpass the US as the largest economy within 20 years, or may be about to do so on a PPP basis. 

Infrastructure: To visit China for the first time is to be stunned by infrastructure _ big buildings, first world roads, modern metros, high speed trains and maglevs, high bandwidth Internet in rural areas. Beijing opened 5 new subway lines in 2010 with eight extensions recently started. (The new China subways are the most advanced I’ve seen, from variable fares using RFID tickets, TVs with arrival times and ads, sometimes tunnel wall ads synchronized with the car’s motion. And everyone talking on cell phones everywhere, giving the sound level of a high school cafeteria).

Top-down vs. bottom-up, inside vs. outside the system: China showers FDI (foreign direct investment) and state-owned enterprises (SOEs) with favors. If you are a big foreign company, the government will bend over backwards for you _ they will build infrastructure, provinces will compete to offer you incentives. You might think they are the best capitalists in the world _ listen to Steve Wynn. But if you are an entrepreneur, you live in a different world of bureaucratic interference and hurdles. Contrary to a common perception, China is not a triumph of market liberalization and entrepreneurship. It is the highly selective application of market incentives in a politicized, state-centric economy.

One way to look at it is hard infrastructure vs. soft infrastructure (from Capitalism with Chinese Characteristics, by Yasheng Huang of MIT). Compare for instance Lenovo vs. Infosys. Infosys had no problem starting off as an Indian company, funding, IPOing locally. But then they had to spend their IPO money building a campus so they could have decent power, telecoms. Lenovo on the other hand was started by Chinese engineers but incorporated and funded in HK to get access to a proper legal foundation and capital markets. They took the back door out of China to get the legal/financial infrastructure and came in the front door to get all the benefits showered on FDI.

Rule of law: For a start, red tape: you have to get government approvals for everything. Some sectors are simply off limits for startups and reserved for SOEs. Moreover, you might enter a sector and find SOEs want in and now you have to compete with them and some of your activities might be deemed illegal. Laws are written to provide significant discretion to authorities. Thus, there is always scope to find you might be doing something illegal. Authorities keep a heavy thumb on entrepreneurs _ as long as you’re creating jobs and not generating a fuss you will be fine, but it’s a very bad idea to attract the attention of the government.  If you run afoul of the wrong people, you will not get recourse from the legal system, even risk being held hostage. See this article on the difficulty of being straight shooter.

Corruption: If you want to work with the authorities (not that you have a choice), you will pay bribes and need to play the ‘guanxi‘ game. When the National People’s Congress is in session, officials are plugged in at Cartier or other luxury goods stores almost the way you register for a wedding, and the lines might run out the door. As noted above, if you are considered noncompliant, you might get arrested or held hostage. Since you can’t beat them, you have to join them and pay the bribes, in which case you are exposed and have no recourse to justice in a system with 99% conviction rates and the death penalty for corruption.

Corporate governance: In this relatively corrupt environment, it’s no wonder that businesspeople are sometimes known to cut corners. Due diligence on partners and investments might turn up management family members renting real estate to the company at inflated prices; connections to local authorities allowing the company to use prison labor; all kinds of fraud and financial shenanigans. Danone found that its local partner had factories it didn’t know about turning out Danone products. Inside the system, the party names senior management of SOEs. If you’re a CEO, you are a senior party cadre, and you care what the more senior party people think. (Edit: in fact the senior decisionmaker is typically not the CEO, but the party secretary) You care not a whit about the nominal supervisory board thinks, less about what the investors and analysts think (beyond not losing face for the party). There is no market for control. There is no M&A. Shareholder value is not exactly maximized, more like ‘Marximized.’

Hidden economy: Corruption and taxes mean that according to Credit Suisse-sponsored research, personal income could be as much as 90% higher than official statistics indicate, and 200% higher for the top decile. (Discussion in The Economist)

Bogus official statistics: It’s hard enough to measure things in a developed economy, what with hedonic adjustments and imputed rent and whatnot. But the gray economy screws up China’s official statistics. Even worse, the top leadership’s targets are well-known, and woe betide the apparatchik or provincial official who fails to meet them. 8% has often been mentioned as the magic number China must grow at to stay on track (read _ not cause social unrest threatening the CCP’s hold on power). Strong centralized leadership’s can make things happen through pure political will, but in a manifestation of Goodhart’s law, this makes economic statistics rather meaningless. In a remarkable display of candor, the man in line to be the number two in the administration after 2012 publicly admitted as much, and said he focuses on rail traffic, electricity consumption, and bank lending for the best and most up to date picture of the economy. 

Financial markets: The stock market is a sham and casino. They took a bunch of dowdy state-owned assets, called in Goldman and others to take them public and make them ‘national champions’ like China Mobile and PetroChina. And Western institutions bought them and thought China would eventually make a transition to a real emerging market and eventually developed market. However, only small slivers of companies float and the rest is state-owned, control is not for sale, stockholders can’t influence management and just get whatever crumbs are allowed to fall off the table. The markets are unconnected to the real economy, trading on political winds.  But with inflation outstripping interest rates, and no tax on capital gains, and a population that is known to appreciate a good gamble, stock market and real estate speculation are rampant. The game may be rigged, but it’s the only game in town. 

Banking: Some Chinese may think their banking system is a world-beater, after it weathered the financial crisis and boasts the world’s biggest bank by market cap, ICBC. But the banks and financial system are even more screwed up than a lot of Western banks, which is a very impressive achievement. They never fully cleaned up the non-performing loans (NPLs) to SOEs from the last debacle 15+ years ago. Reformers attempted to do an RTC type cleanup, list the banks and move them toward international accounting standards and credit standards, but it was abandoned incomplete. After Lehman blew up and exports tanked, the party just told local governments to spend and banks to make USD trillions in loans, and a lot of that lending will yield no cash flow soon if ever. Banks have exposure to ‘Asset Management Companies’ (AMCs) which are essentially SIVs where they stuffed NPLs with government blessing. Of course the new lending hasn’t gone bad yet, so it drove down NPL ratios and the banks are posting record profits. But defaults seem inevitable, and banks will end up with massive challenges from NPLs old and new; inflation and interest rate risks of a highly volatile economy; and structural weakness with political meddling, poor corporate governance and complex and opaque arrangements. Of course, since they’re state-backed they can sweep problems under the table more or less indefinitely. Even if the Emperor has no clothes, he is still the Emperor. This is all from Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl E. Walter and Fraser J. T. Howie. It deserves a post of its own, which I hope to return to.

Bonds: The bond market is basically a Potemkin village _ rates are set based as much on political clout as anything else. Banks hold bonds to maturity and they don’t trade, so they are basically bank loans by another name. Regulation is a hodgepodge of overlapping political fiefdoms. In an instructive incident, reformers tried to create a bond futures market. But in an episode known as the ‘327 scandal‘ a brokerage took a position opposite the government. When it was squeezed by the government and attempted to cover its position, its trades were canceled, resulting in the firm going bust and being sold. The futures market was then shut down.

Major monetary policy tightening: As the economy has been overheating, with soaring inflation and rampant real estate speculation, the government has tried to tighten policy by hiking reserve requirements. It is difficult to determine the impact on rates, which are politically set and still below inflation. It will be important to watch the rate of loan growth to see if tightening measure fail to cool the economy, or overshoot to a hard landing.

FX and exports vs. domestic consumption: The government did achieve the primary objective in their response to the financial crisis, resuscitating growth despite plummeting exports. Policymakers are at least paying lip service to a transition to a more consumption-led economy. But they are dependent on exports, such a switch would be a long term project, and they are reluctant to let the currency appreciate. While on the street the currency seems somewhat undervalued on a PPP basis, a couple of years of inflation will fix it. At this point, currency ‘manipulation’ consists of blocking the massive hot-money inflows that would result from a floating regime. There are some tariffs, but the current account is mostly liberalized post-WTO, and you can buy pretty much anything imported, at pretty much the same price as in the USA. (Although probably a higher likelihood that it might be a fake local copy). 

Intellectual property: The Chinese fundamentally don’t really get the concept and reform just enough to get foreigners off their backs. Markets contain posters saying certain brands are not allowed to be sold, but that just means the fakes aren’t displayed in the front window, or displayed with brand name covered up. You can’t walk in the door, or in close proximity, or in fact anywhere at all without being offered cut-rate ‘brand’ merchandise of varying quality, from pure crap up to indistinguishable from the real thing. (iPhones running Android crack me up though).  BYD, now partly owned by Warren Buffett, markets a car that is a close copy of a Toyota, and dealers have been known to slap on a Toyota logo, something BYD spokesmen said made them uncomfortable. Reportedly the government surveyed imports sold in legitimate stores, but never released the results since a large percentage were fake.

Conclusions: Until proved otherwise, a safe working assumption is that any Western-style institutions like stock and bond markets, contracts etc., are veneer on a fundamentally party-driven economy. The party priorities are 1) retaining power and avoiding unrest 2) enriching themselves and buying real estate abroad against a possible future purge 3) last, developing China beyond what is strictly necessary for the first 2. The party will never float the currency, allow Western-style corporate governance, or political liberalization. Opposition to reform and liberalization has, if anything, been strengthened by the financial crisis in the West. Some elites actually believe their own BS, and that the ‘Beijing Consensus’ is a superior model and their companies and banks are world-beaters.

Despite immaturity it’s impossible to be bearish on China. A highly motivated, literate, very competently managed people has ‘stood up’ economically, to use Mao’s words in 1949. But it’s hard to invest. Invest in the publicly held ‘national champions’ and you will get whatever crumbs fickle political winds blow your way. Invest outside the system, you need very thorough due diligence, possible local political connections and ‘guanxi’, you will lack an exit strategy, and you will still be at the mercy of politics. The best strategy is to find foreign companies that give exposure to  Chinese trends. This might mean everything from raw materials to Western luxury goods manufacturers (see above). An area that bears further research is the numerous suspect and fraudulent companies have come to market in the US through reverse mergers, such as this one that was recently suspended from trading _ although it’s late in the game this area may still be fertile for shorting.

Possible further reading:

Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise, by Carl E. Walter and Fraser J. T. Howie
Capitalism with Chinese Characteristics, by Yasheng Huang
Analysing Chinese Grey Income, by Wang Xiaolu (Credit Suisse report)
The Chinese Economy: Transitions and Growth, by Barry Naughton