JACF’s “China’s Capital Markets and Corporate Governance” issue (Summer 2014) presented articles on China’s financial policy since the death of Mao and the return to power of Deng Xiaoping. Below is our editor’s introduction.

Download the issue here: JACF_263

Editor’s Intro

Since the death of Mao and the return to power of Deng Xiaoping in the late 1970s, the Chinese government has succeeded in engineering what two contributors to this issue — Randall Morck and Bernard Yeung — describe as “the greatest economic feat in the history of the world—the lifting of hundreds of millions of people out of the abject poverty of a pre-industrial society.” “No other government,” Morck and Yeung go on to say, “has achieved anything remotely comparable.”

For the most part China’s National Champions remain state-controlled enterprises and act like them. Beijing plays every role from issuer, to underwriter, to regulator, to controlling investor and manager of the exchanges. The state in its many guises still owns nearly two-thirds of domestically listed company shares.

How was this feat accomplished? Was it the willingness of Deng and the Chinese Communist Party to adopt Western market capitalism? The answer offered by the collection of articles and CARE conference presentations in this issue is yes and no. (CARE, for those unfamiliar with it, is Notre Dame’s Center for Accounting Research and Education; and the presentations in this issue took place at a conference hosted in June by Hong Kong Polytechnic University and organized by CARE’s director Peter Easton of Notre Dame together with Joe Piotroski of Stanford and Gary Biddle of the University of Hong Kong.)

Let’s begin with a look at our lead article. Its author, Carl Walter, is a Stanford Ph.D. in Political Science who was among the first American graduate students to study in China after the collapse of Maoist revolution at the end of the 1970s. Fluent in Mandarin, Walter was able gather enough material during his first stay in Beijing—which ended with his acquiring a certificate in “advanced study” from Peking University—to complete his Ph.D. dissertation on China’s central bank back at Stanford in 1981. But instead of becoming an academic, Walter became a banker; and after several years in Tokyo and Taipei, he moved in 1992 to Beijing, where he lived and worked for the next 20 years. During that time, he played a leading role in China’s first IPO, Brilliance China Automotive, which was launched in October 1992. Then, after establishing Credit Suisse First Boston’s China office, he helped lead-manage in August 1994 the first listing of a state-owned enterprise, Shandong Huaneng Power, on the New York Stock Exchange. And after joining Morgan Stanley in 1999, Walter became a member of the Management Committee of China International Capital Corporation (CICC), China’s first and most successful joint venture investment bank. In that role, he not only supported debt and stock offerings by Chinese companies, but participated in numerous financial reforms over the years.

Economics surely has more to learn from China than China has ever learned from economics.

In 2010 Walter drew on these experiences to publish (with co-author Fraser Howie) a book called Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise. The main argument of the book — which was recognized by The Economist and Bloomberg as “A Best Book of the Year” — is that despite the intentions of its reformers, China has ended up adopting the forms, but not the substance, of Western capital markets. With considerable help from U.S. investment banks like Goldman Sachs and Morgan Stanley, the Chinese government succeeded in replicating the entire panoply of institutions that support public capital markets, from stock exchanges to regulators and auditors to listed companies large enough to justify the costs of raising public equity capital. But, as Walter makes clear, the profitability and values of most of China’s publicly traded companies—virtually all of them state-owned enterprises—are largely an illusion created and maintained by (1) government-granted monopolies and protection against foreign competitors and (2) a seemingly endless supply of cheap capital provided in large part by China’s state-owned banks (whose main mandate is to promote domestic growth, full employment, and the financial stability of the SOEs). And so, as Walter sums up the current state of affairs,

For the most part China’s National Champions remain state-controlled enterprises and act like them. Beijing plays every role from issuer, to underwriter, to regulator, to controlling investor and manager of the exchanges. The state in its many guises still owns nearly two-thirds of domestically listed company shares.

Thus it’s not surprising that the Chinese government’s conception of the role and rights of shareholders has turned out to be very different from that in most Western economies. Whereas the shareholders of companies in the West — and even some parts of Asia — play an important role in disciplining the managements of underperforming firms, the minority shareholders of Chinese SOEs are viewed in Beijing as a powerless and voiceless source of inexpensive capital. Most Chinese managers, as Walter reports, view equity as a form of bank loan with “optional” payments of interest called dividends.

That said, it’s also not hard to see why the interest of most Western institutional investors in Chinese companies — the recent case of Alibaba notwithstanding—has been falling steadily since the flurry of successful banking IPOs in the mid-2000s and the series of governance scandals in recent years. For as Walter points out, with the state still holding a clear majority of domestically listed shares, “Outsiders cannot help suspecting that state entities largely control the share price movements of even Hong Kong-listed Chinese companies.” And this means that for overseas investors looking at Chinese companies, there are two main sources of uncertainty that are likely to prevent their stock prices from reflecting fundamental values: (1) uncertainty about who’s buying the stock: are there large inflows of government capital ready to prop up the values when useful or expedient? and (2) uncertainty about the fundamentals themselves: will the government continue to protect the monopolies and favored access to public assets on which much of the value of such companies depends?

But if Walter is right and China’s leaders have retreated from their initial commitment to market capitalism, then how account for the country’s extraordinary growth? In the article that follows Walter’s, the above-mentioned Randall Morck, a chaired professor of finance at the University of Alberta, and Bernard Yeung, Dean of the National University of Singapore’s NUS Business School, begin with the provocative statement, “Economics surely has more to learn from China than China has ever learned from economics.”

The conventional wisdom of economists is that institutions like the rule of law, well-defined property rights, and well-functioning capital markets provide the most reliable—if not indeed the only—path for nations intent on achieving long-run growth and prosperity. But, as Morck and Yeung argue persuasively, China’s transformation into a modern industrial economy may well have been hastened by suppressing the development of such institutions.

After noting the aptness of the Communist Party’s official name for its approach—“market socialism with Chinese characteristics” — Morck and Yeung go on to show its affinity with the writings of Paul Rosenstein-Rodan, a mid-20th century development economist credited with designing the World Bank. In this economist’s view, the main challenge for most of today’s developing economies is finding a way to overcome “coordination failure”—that is, to create networks of suppliers and manufacturers necessary for large-scale production where there are none or few. The solution to this problem — and Rosenstein-Rodan’s main contribution to development economics — is what he calls the “Big Push,” a government-orchestrated effort to plan and carry out the simultaneous development of networks of companies across a range of industries. And the best illustration of the “Big Push” in action, according to Morck and Yeung, may well be China’s recent growth. What’s more, given the country’s desperate circumstances in the late ’70s, it may have been the only way of accomplishing the goal in such short order.

But after praising China’s leaders for pulling off this “greatest economic feat in history,” Morck and Yeung go on to express two major reservations about the theory and workings of the “Big Push.” First, such initiatives don’t have to be planned or carried out by governments. Indeed, research on Japan and Korea (much of it their own) provides compelling evidence that private-sector coordination—by networks of firms called zaibatsu in the case of Japan, and chaebol in Korea—has generally proved to be more effective than central planning in building an industrial economy and national wealth.

Second, and more important, although the “Big Push” has raised China to the middle ranks of the world’s economies, the odds are against its success in taking China to the next level. China’s per capita GDP, at about $6,000, is now about the same as Peru’s—as compared to $50,000 or more for the U.S., U.K., and other “high-income” countries. Recent economic history is full of rapid ascents by developing countries (like Brazil and Argentina) that, with almost predictable regularity, become mired in what economists now call “the middle income trap.” After discussing the main contributor to this trap—the tendency of well-entrenched “elites” to suppress competition — Morck and Yeung close by expressing strong doubt that China will continue its rise into the world’s economic upper ranks until it adopts the substance as well as the form of those “missing institutions” that are “the only well-marked path to high-income status.”

This prescription is reinforced by the CARE presentations that provide much of the material for the rest of this issue. In an especially memorable one, British-born David Webb, one of Hong Kong’s leading investor activists and authorities on Chinese corporate governance, urges the Chinese government to follow the example of the U.K. government under Margaret Thatcher and reduce its massive holdings of SOEs “to zero” while providing the greatest possible encouragement for foreign investors and banks to expand their participation in China’s capital markets.