Economic Reforms and Development in China : Volume 3 [1 ed.] 9789814332507, 9789814332460

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Selected Works of Cheng Siwei: Economic Reforms and Development in China Volume 3 This book, in three volumes, presents the thoughts and reflections of the highly-regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China, and from this perspective, studies such issues as the reforms of the Renminbi exchange rate regime and housing system, development of stock market and venture capital investment, and economic challenges and countermeasures in contemporary China. This book has been highly regarded by top-ranked Chinese politicians and distinguished scholars, and is essential reading for anyone wishing to understand the economic complexities of the development of China. • Authoritative commentary by a leading Chinese Statesman • Comprehensive coverage of economic and financial complexities facing China • Detailed examination of developmental issues facing China • Unique insight into China’s unparalleled growth and development

Author

He is now leading the Research Center on Fictitious Economy and Data Science at the Chinese Academy of Sciences. His research mainly covers complexity science, fictitious economy, and venture capital. Over the years, he has published 22 books and 200 articles. His proposal entitled “A Proposal on Speeding up the Development of Venture Capital in China” was ranked No.1 in the first meeting of the Ninth National Committee of the Chinese People’s Political Consultative Conference in 1998, and he has been dubbed the “Father of Venture Capital in China” by practitioners in the field for his groundbreaking work in this area. Chinese Economic Studies

Cheng Siwei

Cheng Siwei is the Chairman of International Finance Forum, and a former Vice Chairman of the Standing Committee of the National People’s Congress of the People’s Republic of China. He is the Dean of Institute of Management at the Graduate University of the Chinese Academy of Sciences, and Honorary Professor of the Faculty of Business Administration at the Chinese University of Hong Kong. He was an academic advisor to the World Bank Institute and Director at the Department of Management Sciences at the National Natural Science Foundation of China.

Economic Reforms and Development in China Volume 3

Interpreting China’s Economy through the Eyes of a Chinese Statesman

Selected Works of Cheng Siwei:

Economic Reforms and

Development

in China Volume 3

Cheng Siwei

Selected Works of Cheng Siwei This book, in three volumes, presents the thoughts and reflections of the highly regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China and from this perspective, studies such issues as venture capital, financial crises, capital and monetary markets, inflation and deflation, housing system reform, the social security system and enterprise management in contemporary China. The book has been highly regarded by top-ranked Chinese politicians and distinguished scholars and is essential reading for anyone wishing to understand the economic complexities of the development of China.

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660

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Rm 1108A, Culture Plaza, No. 59 Zhongguancun St., Haidian District, Beijing, China English edition © 2012 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2009 China Renmin University Press Translated by Yang Mifen and Zhou Kai All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage

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ISBN (Hardback)

978-981-4332-46-0



978-981-4332-51-4 (epub)

ISBN (ebook)

978-981-4332-50-7 (pdf)

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Enrich Professional Publishing is an independent globally minded publisher focusing on the

economic and financial developments that have revolutionized new China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate and engaging information on China.

Contents Preface

vii

Chapter 1 The Scientific Outlook on Development

1

Chapter 2 The Construction of an Innovation-oriented Country

25

Chapter 3 Institutional Innovation—The Core of Reform

53

Chapter 4 Theories and Methodologies of the Fictitious Economy

73

Chapter 5 China’s Venture Capital Investment

105

Chapter 6 China’s Economic Challenges and Countermeasures

131

Chapter 7 Toward a Healthy Development of China’s Stock Market

155

Chapter 8 Reform of the RMB Exchange Rate Regime

211

Chapter 9 Toward the Reform of China’s Housing System

247

Chapter 10 The Global Financial Crisis and China’s Countermeasures

281

Contents

References

319

Index

339

vi

Preface This book that is displayed before our readers is the study and thoughts on the issues of the reform and development of the economy of China by a Chinese scholar (Chairman of the China Soft Science Research Association, President of the Chinese Society for Management Modernization, Director of the Research Centre on Fictitious Economy and Data Science, Chinese Academy of Sciences, and concurrent Director of Management Science Department of the National Natural Science Foundation of China (1996–2004)), who is also a statesman (Vice-Chairman of the Standing Committee of the 9th and 10th National People’s Congresses), and a leader of a democratic party (Chairman of the Seventh and Eighth Central Committees of the China Democratic National Construction Association). Looking back on the trajectory of my life, I can see that there have been three turning points. The first one took place in 1951 when I returned to work in the Mainland from Hong Kong, which set my direction to serve my country. The second was in 1981 when I went to the U.S. to study business administration; this broadened the scope of my academic studies; and the third one took place in 1995 when I joined the China Democratic and National Construction Association and embarked on a political path. For decades, I have followed the principle of being “upright in behavior, conscientious in work, and industrious in research,” hoping that I could contribute in my own small way to the unification of my motherland and the revitalization of the nation. To me, serving the country is the goal of engaging in academic studies and entering politics, and engaging in academic studies is the foundation of entering politics. To this end, I have been working with my colleagues in Chinese management science circles and using complexity science to study issues relating to the development and reform of China, to make enormous efforts to explore and explain the characteristics and law of development of the fictitious economy, and to actively study and promote the development of venture capital in China. I want the results of all my research to be specific, timely and practical, and the proposals I make, technically feasible, economically justifiable, legally permissible, operationally workable, implementable within time constraints, and politically acceptable to all parties to reduce as much as possible resistance in their implementation. In my research methodology, I have strived to use a comprehensive and integrated approach that combines qualitative and quantitative methods so that my viewpoints are crystal clear and my arguments fully substantiated.

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Complexity science is a science that studies complexity and complex systems. It is a new phase in the development of systems science and is referred to by some scientists as “the science for the 21st century.” In recent years, I have been primarily drawing on the research findings of physical and biological complexity, taking mathematics, economics, and behavioral science as my foundation, and using and developing methods and instruments such as the quantification of qualitative variables, group decision-making, evolutionary computation, and mathematical logic, to explore complex social issues such as enterprise management and housing system reforms, establish the social protection system and reform public service units, transform the functions of the government, open up rural consumer market, foster Chinese multinational corporations, overhaul the rural-township enterprises, develop the western regions, boost the urbanization of rural villages, develop the knowledge economy, meet the challenges of economic globalization, oppose monopoly, adjust energy policy, reform the methodology of formulating plans, and promote the transformation of bonded zones into free trade zones. The fictitious economy is an economic activity that directly uses money to make money. At present, the scope of the fictitious economy in the world has increased rapidly and has far exceeded that of the real economy. In recent years, I have primarily used the principles of complexity science and financial engineering to elaborate on fictitious capital and the characteristics and laws of the fictitious economy, and have attempted to study, from the perspective of the fictitious economy, issues such as chaos and self-organization in the capital and money markets, financial crises, inflation and deflation, reform of commercial banks, rural finance, as well as futures and financial derivatives, Renminbi exchange rates, and real estate finance. Venture capital, which is specialized investment that is risky, portfolio, longterm, equity and professional, has the objective of “helping innovators start their own business and helping investors speculate.” In recent years, I have studied the strategy, legislation, policy, and selection of related projects in the development of venture capital in China, the organizational structure, methods of financing, and operation mechanism of venture capital companies, as well as practical matters such as the preparation of business plans, the selection of projects, management of venture enterprises, and channels for raising capital. I also proposed that the government follow the principle of “supporting enterprises but not controlling them through stock ownership, guiding them but not interfering with them” to encourage the development of venture capital business in the public sector. This book is based on a collection of selected research findings of several

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hundred researchers under my leadership regarding the three aspects mentioned above, which I further analyzed and deliberated on to complete the writing of 18 articles. I have also contributed another 12 articles based on my research, all of which are now published in three volumes. These articles were mainly published in the “Series of Contingency Research on the Issues of Reform and Development in China” sponsored by the National Natural Science Foundation of China and published in journals such as the Journal of Management Sciences in China and Economic Affairs , while some are first published here in this book. Despite the fact that the articles that I previously published cannot fully represent my current ideas, I did not make any revisions for this book so as to preserve their historical authenticity, to see how these ideas have stood the test of time, and to allow readers to follow the evolution and development of my academic train of thought. Whenever I discover something useful from my research and thinking, my principle is to “present my views strongly as I cannot possibly please everyone and to do my best to serve the people so that my conscience is clear.” Apart from writing books and articles, I also make suggestions and proposals to senior leaders of the Chinese Communist Party and put my ideas into practice in my work for the Standing Committee of the National People’s Congress and the Central Committee of the China Democratic National Construction Association. As a scholar, I believe my goals in academic research are not to make decisions on behalf of the government but to support the government’s decisions and promote the scientification and democratization of decision-making in four primary aspects of exploring theoretical foundations, reviewing overseas experiences, improving overall frameworks, and analyzing difficulties in policy implementation. As a statesman, I have to apply my academic research findings to the implementation of legislation and supervision of the National People’s Congress, steadily and thoroughly apply the scientific outlook on development, unremittingly push ahead reform and opening up. I need also to strictly observe the strategy of “ruling the country by law,” promote the development and stability of the country, and safeguard the fundamental interests of the people at large. As a leader of a democratic party, I need to combine my academic research findings with the functions of my participation and discussion of state affairs and democratic supervision, follow a policy of “considering the overall situation, upholding fundamental principles, and making my own contributions,” and play the role that a participating political party should have in Chinese political life. Despite the fact that I have for years been busy in public service and am now over 70 years old, I still have a singular passion for academic studies. I

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make myself read at least one hour every day, write at least one article every month, and publish at least one book every year; I find these activities always “enjoyable, satisfying and never tiring.” This is because I believe that a country like China, which has a long history, a largely rural-based population, and is economically underdeveloped, cannot mechanically copy the experience of Western countries. Only through the blending of theory and practice can China find its own path of development and realize the revitalization of the Chinese people in the 21st century. There’s a line in a poem by Lin Zexu: “I’ll do whatever is in the interests of my country even at the cost of my own life; I would never shrink back because of personal weal and woe.” I want to spend my remaining years working with my management science colleagues in China for the prosperity of the nation, the progress of society, and the well-being of the people. Cheng Siwei February 29, 2008

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Chapter

The Scientific Outlook on Development

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

China saw tremendous development over the past 30 years since the beginning of reform and opening up, with rapid economic growth and constantly improving living standards. In 2007, China’s GDP hit RMB24.6 trillion (equivalent to USD3.37 trillion), up 11.9% year on year; its external trade in products reached USD2.17 trillion, ranked 3rd in the world; and its foreign exchange reserves reached USD1.53 trillion. Despite all these remarkable achievements, China must face the severe challenges it is confronted with. It is still a developing country with an obvious regional economic disequilibrium and unbalanced development between rural and urban areas due to the dualeconomic structure. Since China is still in the middle of its industrialization, it is met with great pressures in terms of the environment and energy sources. Many problems will occur in a country with 1.3 billion people. Just as Premier Wen Jiabao once said, “For China, a problem, no matter how small it is, will become huge when multiplied by 1.3 billion; and financial resources, however profound they are, will become deficient when divided by 1.3 billion.” The people-oriented, comprehensively-coordinated and sustainable scientific outlook on development is a major philosophy that adapts to the requirement for further developing human society. Proposed by the CPCCC led by Secretary-General Hu Jintao on the basis of the work done by the previous three generations of CPC collective leaderships, the thought of scientific development has benefitted from the advanced achievements of human civilization. In his Report to the 17th National People’s Congress of the CPC , President Hu Jintao pointed out that “the scientific outlook on development has development as its essence, the people-oriented concept as its core, a comprehensive, balanced and sustainable development as its basic requirement, and an overall consideration as its fundamental approach.” At the Central Economic Work Conference held in December 2006, “fast and sound development” was reworded into “sound and fast development.” Putting “sound” in front of “fast” reflects the essence of the conference as well as a requirement of the scientific outlook on development. From the perspective of the economic development theory, prior to 1970, most Western countries followed Keynesianism, whose main development objective is to achieve economic equilibrium under the premise of guaranteeing full employment. Keynesianism may be regarded as the leading theory on economic development for the West since it was proposed during the 1930s. However, problems gradually occurred after 1970, in the form of sluggish economic growth, even stagnation. So they put forward a theory named “the Magic Quadrilateral.” It is composed of four indicators: sustainable economic growth, full employment, price stabilization and balance of payments, expanding the previous objective into four. Since the 1980s, issues such as

2

The Scientific Outlook on Development

sustainable development, income distribution have stirred widespread concern, thus the objectives of economic development were again increased to six. In the process of developing the local economy, Western countries gradually realized that to get better developed, they needed to maintain a balance of those six economic development objectives, which should also be taken as the main objective of the macro-economic regulation. This paper will discuss what a “sound” development refers to propose the quality indicators for development evaluation which fall into eight categories. Based on the scientific outlook on development, the author will also analyze issues that deserve special attention in the course of China’s tremendous economic progress.

Being People-Oriented and Benefit-Sharing Being people-oriented refers to protecting and improving the vital interests of the masses in accordance with the requirements of the important thought, “Three Represents” (san ge dai biao ). That means it is necessary to build a government “of the people, by the people, for the people.” Social wealth is created in physical economic activities by the masses through their physical and mental contributions. Contemporary patterns of economic activities include not only real economic activities but also fictitious economic activities, which are activities of “fictitious capital” operated on the financial platform. “Fictitious capital” is composed of credit capital, knowledge capital and social capital. They have to be matched with physical capital on the financial platform with securities as the carrier. A “fictitious economy” may improve—indirectly—the efficiency of real economic operations and create social wealth by way of optimizing the allocation of resources. For example, the stock market may play a role in supporting the superior and eliminating the inferior, in optimizing resource allocation so as to improve the operational efficiency of listed companies and indirectly create social wealth. However, listed companies are the true source of wealth; while the stock market serves to help superior listed companies get more capital supports and develop better. Deng Xiaoping once said, “Development is the absolute principle.” During the 5th Session of the 10th National People’s Congress, President Hu Jintao mentioned the issue of common construction and sharing resources with the statement that “the common construction is the foundation of sharing resources.” Only by making great efforts to create wealth could people constantly improve their income and living standards.

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

Macro-Distribution of Social Wealth—A Synchronous Growth of the Social Wealth and People’s Income Considering the macro-distribution of social wealth, social wealth created by the masses are partially collected by the country in the form of taxes to build the national wealth used for social development, public services, national security, etc., and in part converted into the private property or the common wealth to satisfy the public’s growing material and cultural needs. In China, national interests are fundamentally consistent with the interests of the people; a prosperous country prospers by making its people strong and powerful, and vice versa. One of the most important achievements in the “two conferences” (i.e. the National People’s Congress (NPC) and the Chinese People’s Political Consultative Conference (CPPCC)) in 2006 was the adoption of the Property Law of the People’s Republic of China . It took China 13 years to develop its own Property Law , which had been put under scrutiny seven times by the standing committee of the 9th & 10th NPC before being submitted to the 5th Session of the 10th NPC for a final vote. Many people did not quite understand, or even misunderstood, the meaning of this law during the rounds of scrutiny. So the scrutiny itself served to unify the differences, improve provisions of this law, and enable people to finally understand its essence. As an important part of China’s Civil Code, Property Law of the People’s Republic of China is a basic law which standardizes the relationships between different civil properties in a market economy, clarifies the proprietary rights and adjusts the relationship between property owners. With the development of the socialist market economy over the past three decades, China sees an increasing wealth accumulation both at the national and the individual level, an ever-complicating relationship among main market players, and widespread concern for the balance between efficiency and equity, all of which helped generate an objective demand for the Property Law. Some say that the Property Law protects only the properties of the rich. It is totally wrong. What the Property Law protects are the national, collective and private properties. With the development of China’s economy and the amelioration of its people’s living standards, private wealth has been increasing rapidly. The homeownership rate in China reached 72%. Only under a sound property protection system can China encourage its people to work more efficiently. Therefore, the prime criterion of a sound development is to maintain a synchronous growth of social wealth and income of the people. In 2007, China’s GDP grew 11.9%, and the per capita net income of rural residents and the per capita disposable income of urban residents grew

4

The Scientific Outlook on Development

9.5% and 12.2% in real terms, respectively. It can be found that the income of the people increases synchronously with economic growth. Unfortunately, the growth rate of the income of rural residents was slightly lower than that of urban residents, a result of the existing dual-economic structure, even if the two were increasing synchronously in a big picture. It should never happen again that the income of the people failed to increase even a little in a decade, just like what happened during the Cultural Revolution. During the Cultural Revolution, the monthly salary of a university graduate in Beijing was only RMB55 and Workman II (Civil Servant) was RMB38.61, and failed to increase for a decade. Therefore, to measure whether the scientific outlook on development has been thoroughly implemented, people should first see if the income of the people increases synchronously with social wealth.

Employment Is the Essence of People’s Livelihood The second important indicator is employment. As of the end of 2007, the number of employed Chinese reached 769.9 million, an increase of 5.9 million compared with the previous year. Of the total number of employed Chinese, 293.5 million had jobs in urban areas, a net increase of 10.4 million, newly increasing 12.04 million. The year-end registered urban unemployment rate in 2007 was 4%, a decline of 0.1% over the previous year. Despite the remarkable improvement in employment, many problems still exist. First, employment of newly-added urban labor force. Every year, nine to 10 million graduates from all types of schools all need jobs; second, reemployment of laid-off workers. Currently, there are about 6 million laid-off workers in China and the number is being enlarged all the time; third, a rational and orderly transfer of rural labor forces. Each year, China needs to transfer as many as 9 million surplus rural laborers to cities. Although China once solved the employment of about 12 million people within one year, the employment problem today still exerts a great pressure on China. One of the symbols of industrialization is urbanization, or the migration of rural workers to urban areas so they are no longer grain-growers but net grainconsumers. Only by doing this could it be possible to facilitate the process of urbanization and improve the labor productivity of agriculture. Otherwise, there would be massive idling of the rural labor force. And labor productivity and farmers’ income will not see a substantial increase, given arable land per capital is small. Therefore, transferring rural labor force in a rational and orderly manner is something China must accomplish in order to achieve modernization. In the industrialization process of many countries around the world, it was

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

a must for rural labor force to migrate to urban areas. According to the author’s preliminary studies, it took UK more than 200 years to reduce the proportion of its rural population from 70% to 30% in 1850 by depriving farmers of their land and forcing them to work in urban areas. The same process took the U.S. about 100 years, from 1820 to 1920, through land acquisitions, that is, lands of disadvantaged farmers were merged and acquired by farmers possessed with advanced technology, thus forcing farmers who lost their land to migrate to urban areas to work in factories or start businesses. By the end of 2007, urban population accounted for 44.9% of China’s total population, and a 25.1 more percentage points was still needed to reach 70% that UK had achieved. In recent years, urban population has been increasing by 1% annually through rural-urban migration, meaning that it would take China more than 20 years to achieve urbanization. So it is clear that the migration of rural labor force is very important. However, the government must take the social security system, education of children, housing and other issues brought by the migration into serious consideration. China should avoid problems that are happening in cities such as Mexico City and Rio de Janeiro, where a large number of slums existed due to massive rural migrations. Under the socialist market economy, it is necessary to keep unemployment rate at a certain level so as to stimulate the labor market and achieve the rational flow and optimized configuration of human resources. Based on China’s current situation, the author believes China should maintain its unemployment rate at 3% or lower.

Price Stabilization The third indicator of being people-oriented is to stabilize prices. If the rate of inflation grows in line with the people’s income, it will not result the deterioration of the people’s living standards, and that is why commodity prices need to be stabilized. Based on the principles of the fictitious economy, inflation is a general trend and the overall level of commodity prices will climb, but China still must make the efforts to stabilize the overall level of commodity prices within a certain range in the event of any obvious inflation. The consensus is that a below 5%that inflation rate is affordable and moderate. The overall situation in China was generally better several years ago. In 2006, the overall consumer price increased 1.5% year on year, of which service price grew 1.7%, retail price up 0.1%, industrial product price up 3%, the purchase price of raw materials, fuels and energy up 6%, fixed-asset investment price up 1.5%, the price of agricultural products up 1.2% and the index of real estate sales in 70 large and medium-sized cities up 5.5%.

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The Scientific Outlook on Development

The public may have different views toward the statistics. Some may feel that the overall consumer price index in 2006 went up more than 1.5%. That’s because the consumer price index was the weighted mean of the prices of selected commodities. Although home prices rose by 5.5%, they were not included in the price index, people may notice hidden danger in the 2006 statistics: The price of raw materials, fuels and energy increased by 6%. If the trend continued and enterprises had a limited processing capacity, prices of industrial goods and subsequently will rise, as will the overall level of market prices. In fact, since the second half of 2007, commodity prices have been. The consumer price index (CPI) grew 4.8% year on year, of which the farm products grew 18.5%, food price index 12.3%, retail price index 3.8%, fixedasset investment prices index 3.9%, the price index of raw material, fuel and energy price index 4.4%, industrial products price index 3.1%, and the price index of real estate sales in 70 large and medium-sized cities grew 7.6%. Since commodity prices are closely related to the living standard, China needs to make great efforts to stabilize commodity prices so as to avoid runaway inflation and increase people’s income and living standard. It is not accurate that some people regard inflation as simply the rise of prices of all commodities. Currencies can be used to exchange for various commodities. From the infancy of the use of currencies, circa 1821, when Britain implemented the gold standard system, gold has been playing a role in ensuring the widely- issued paper currencies, and the gold standard system gradually became popular in Europe and the U.S., before finally becoming the foundation of world currencies in 1870. After WWI, the gold standard system gradually degenerated into gold exchange standard system. And when the U.S. set the minimum U.S. dollar price for foreign central banks to purchase or sell gold, major European countries stipulated that, in 1958, currencies of Europe may be converted freely into gold or U.S. dollar in international payments. However, in 1971, the U.S. stopped converting U.S. dollar into gold at the fixed price (USD35 an ounce), since U.S. dollar and other currencies became the international base currencies, the gold standard system in international currency exchange activities terminated with currencies “decoupled” from gold and not freely convertible into gold at a fixed price. After the decoupling, currencies have become fictitious to some extent and were issued solely based on the overall credit of a country, thus became inconvertible paper money (“fiat money,” also known as legal tender). As such, the value of a currency can be measured only by its purchasing power, that is, commodities of the entire society plus the total amount of labor services divided by the monetary aggregate of the entire society. The stronger the purchasing

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ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

power of the currency is, the larger the number will be, meaning that people could use less money to buy more commodities and labor services. In the event that the currency aggregates increase faster than commodities and total labor services, the purchasing power of the currency will keep dropping to the level of inflation; or deflation if the purchasing power of the currency keeps growing. Since the purchasing power of a currency is always changing, it is in flux as well. There will always be inflation or deflation. If a currency is under inflation for 10 months within a year, that is short-term inflation. Inflation that lasts between one and three years is called medium term; anything longer is regarded as long-term inflation.

Narrowing the Wealth Gap The fourth indicator of being people-oriented is narrowing the wealth gap. The Gini coefficient is the internationally accepted benchmark that measures the wealth gap. The coefficient refers to the ratio of the amount of residents’ income used for uneven distribution against the total. According to the provisions of relevant United Nations (UN) organizations, a Gini coefficient below 0.2 suggests a high level of equality in income distribution, 0.2–0.3 indicates modest equality, 0.3–0.4 indicates a relatively rational income gap, 0.4–0.5 points to a large income gap, and 0.6 or above indicates a substantial income gap. Based on The World Bank statistics The, the Gini coefficient of the income of Chinese residents has grown from 0.16 prior to the reform and opening up to currently 0.47, which has surpassed not only the international warning line of 0.40, but also the level of all developed countries in the world. In the meanwhile, China’s Gini coefficient does have its unique characteristics and reflect the country’s unbalanced development. First, it shows the unbalanced development in urban and rural areas, in which an urban resident’s average income is more than three times higher than that of rural residents; second, it points to the gap between the eastern and western of the country. There is a huge gap between the development of the East coast and that of the western hinterland, leading to a substantial income gap. If the Gini coefficient in the rural area and urban area is calculated separately, the result will be below 0.4. Therefore, to narrow wealth gap, China needs to first make efforts to close the gap between urban and rural, and to subsequently bridge the gap between regions. There is a very important coefficient that measures people’s living standards—the Engel coefficient, which it is the ratio of food expenditure in the total household expenditure. Only after they have consumed enough food will people make other forms of consumptions. Based on 2007 statistics, the

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The Scientific Outlook on Development

Engel coefficients of rural residents and urban residents were 43.1% and 36.3%, respectively, indicating that it still is a developing country. The Engel coefficient is normally below 20% in developed countries, or as low as 10% in some underdeveloped areas. Assuming the absolute poverty standard in rural areas in China is regarded as below RMB785 per year, the rural population below the poverty line was be 14.79 million at the end of 2007; if the standard for identifying low-income population is between RMB786 and RMB1,067 per year, the low-income population in rural areas in China was 28.41 million at the end of 2007. It made for a total of 43.2 million people, only 3.3% of the total population. The standard used by The World Bank to measure the population below the poverty line is less than 1 dollar in daily income, equivalent to an annual income of roughly RMB1,300 based on purchasing power parity (PPP) calculations. Under this standard, China still has about 80 million people living in relative poverty. Therefore, narrowing the wealth gap, in particular, addressing the issue of poverty (mainly in the rural area) is an urgent task.

Distributions of the Social Wealth Narrowing the wealth gap will inevitably involve the distribution of social wealth. In his Report to the 17th National People’s Congress , President Hu pointed out that “equitable income distribution is an important indication of social equity. We will adhere to the system in which the wealth distribution is in line with the work. We will improve the distribution system to allow factors of production such as labor, capital, technology and managerial expertise to have a rational share according to their respective contribution. A proper balance will be struck between efficiency and equity in both the primary distribution and the redistribution, with particular emphasis on the equity in the redistribution process.” Primary distribution system needs to be efficient and enable innovative and diligent people to get more returns and become rich first. In primary distribution, the principle of taking “distribution according to work” as the priority must be adhered to, based on which the distribution should be carried out in line with the quantity, quality and supply-demand relationship and all production factors. Otherwise, if “equal treatment” were adopted in primary distribution, it would undermine the entire primary distribution system. While the government should never directly interfere with the internal distribution of enterprises, it may adjust such distribution by setting the minimum wage standard and improving the system of labor force employment through legislation.

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Redistribution has to be fair. That is, the government must wield the tax tool and other means to help the disadvantaged and establish a social security system that is comprehensive, systematic, appropriate, fair and effective. “Comprehensive” means that the system should cover both urban and rural areas. Being “systematic” means the system should have a three-dimensional structure composed of the following four aspects, namely the endowment insurance, the unemployment insurance, the medical insurance and the insurance for work injuries and accidents. It needs to have four layers, namely, social assistance, social welfare, social insurance and commercial insurance. And it should have four main foundations, namely, units, individuals, governments and the society as a whole. Only such a three-dimensional social security system could be viewed as being systematic. Within this social security system, different layers and aspects must be supported by different strengths. For example, social assistance, or the minimum living allowance, must be the responsibility of the government; social welfare should be the common responsibility of both the government and the society, while social insurance should be borne mainly by units and individuals with a certain amount of government subsidies. The same applies to China. Social insurance in China combines pooling of individual accounts, that is, the social pooling is borne by enterprise units. The individual accounts should be compulsorily borne by both units and individuals in accordance with general rules. Although such individual accounts are being established and gradually improved in China, the percentage of such accounts is relatively small and mainly depends on individual contributions. Such a social security system is called a dual-layered social security system in China. Commercial insurance in China is mainly borne by the individuals. Under exceptional circumstances, the unit will undertake part of it. It is commercialized and operated in accordance with the risk principle of insurance. The social security system in China has to be “appropriate,” too. It could only adapt to the degree in line with China’s social and economic development, instead of adopting a high level as in developed countries, such as Northern Europe. It is impossible for China to reach that high level of social security. A “fair” social security system is defined by two aspects of fairness: intragenerational fairness and inter-generational. “Intra-generational” fairness means that people of the same generation should enjoy roughly the same level of social security. However, retirees from government organs and those from enterprises currently do not enjoy the same degree of social security, leading to the phenomenon of “intra-generational unfairness.” For example, why did two

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The Scientific Outlook on Development

men get different amounts of old-age pension after retirement just because one retired from a government organ and the other retired from an enterprise, even if they used to be classmates? During the NPC and CPPCC, some delegates pointed out the same problem and gave such an example where in a family, the husband graduated from a university and used to work as the general engineer of an enterprise, while his wife never received college education and used to work in a government body. Yet, after the couple retired, the wife received a higher pension than her husband. It is this kind of “intra-generational unfairness” to which China should pay special attention. Of course, it may be some kind of legacy problem that cannot be resolved overnight. The current salary adjustment has appropriately improved the security of enterprise retirees. However, generally speaking, the gap hasn’t been completely bridged. Inter-generational fairness refers to the fact that the social security fund contributions by the current generation are for the use of the last generation. When people of the current generation reach retirement age, it can be difficult for them to enjoy the same level of social security due to the fact that the population is aging and the “one-child policy” becomes more popular, the employment rate of the next generation might decline while the number of old people increases. Therefore, China must begin to establish a social security fund so as to ensure the security of the current generation when they retire and hence inter-generational fairness. The last characteristic is “effective.” There was a problem in establishing the social security system during China’s transition from planned economy to socialist market economy. Previously, the wages of some senior workers did not contain the social security, because the state had borne it all. Then it’s only a few years left before they would retire, so it is for sure that they had only paid the social security funds for the years left while their individual accounts had a limited amount of accumulations. It was hard to guarantee effective social security. Some places adopted the so-called onerous termination of the labor contract, or the “buy-out offer.” However, since it was not legally standardized, the problem had yet to be solved completely. For example, some places simply eased workers out with merely RMB20,000, which proved to be far from being securable. The moment he ran out of the money, he would still sort to government for help. In some monopoly enterprises, a considerable sum of money was offered in order to terminate the labor contracts though, it still could not satisfy the senior workers’ appetite. They believed they deserved a greater sum of compensation, because they could earn more if on the position. Therefore, even RMB100,000 would not be enough. All in all, how to effectively

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solve the so-called reform costs or institutional transition costs is very important. Such costs shall never be borne by laborers themselves, but by governments and enterprises, rationally. There’s another problem. Both the social pooling and the individual account are for the purpose of getting added value. However, currently, of all social security funds collected in China, little has been functioned as value-added but being embezzled. Therefore, to make the social security system effective, China has to make the social security funds sound and safe as the priority. Only by doing this could China give social security system full play to its guaranteeing function in the future. Therefore, China has to establish a comprehensive, systematic, appropriate, fair and effective social security system. Now, the Chinese government is dedicating on this objective. Besides primary distribution and redistribution, China needs to focus on the third distribution, which highlights social responsibilities and encourages the rich to donate part of their wealth into improving the poor’s living standard, education and medical care. Such practice exists in all countries. In China, it is usually called philanthropy or social welfare. As philanthropy is growing fast in China, it needs a whole host of policy supports. China added another article into the newly revised Income Tax Law of the People’s Republic of China on Enterprise . To wit, “in relation to the expenses from charitable donations incurred by enterprises, the portion within 12% of the total annual profit may be deducted from the taxable income.” Before that, it stood at 10%. The NPC delegates, however, held that the level should be increased to 12% as an incentive. The author agrees that personal tax-deductible charitable donations encourage more voluntary donations

An All-Round Development and a Synchronous Growth The so-called all-round development aims at achieving the economic, social, political and cultural development. Economic development is an essential foundation, with GDP an important measurement of economic development. And in recent years, the government has indeed showered more dedication on social and cultural development and spent substantially more on education, science and technology, etc. Between 2003 and 2007, the cumulative national fiscal expenditures in education, medical care, social security and culture and sports reached RMB2.43 trillion, RMB629.4 billion, RMB1.95 trillion and RMB310.4 billion, respectively, representing a jump of 1.26 times, 1.27 times, 1.41 times and 1.3 times, respectively.

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The Scientific Outlook on Development

The planned GDP growth rate of China in both 2006 and 2007 was 8%, which was a flexible target. Fortunately, the actual percentage reached 11.6% and 11.9%, respectively. On the one hand, that the economy had maintained a double-digit growth rate was no small feat. On the other hand, those figures implied that China had failed to allocate sufficient resources to improve science and technology, education, social undertakings, public services, energy conservation, environmental protection, etc. Therefore, when deliberating on the target GDP growth rate for 2008, the NPC still set it at 8%. That is to say, China’s economy is pursuing a moderate yet all-round growth pattern so as to enable a synchronous economic, social, political and cultural development. The wealth gap between developing and developed countries mainly originates from the knowledge gap. Developed countries are making money by producing and exporting knowledge, such as patents and classified technologies, brands and standards. When hi-tech products are imported, patent fees account for the lion’s share of the total costs. Of most hi-tech projects being introduced to China, the software costs will exceed the hardware costs, demonstrating that developed countries accumulate their wealth via patents and classified technologies. For example, though China manufactures most computers, it still must rely on Intel for chips from and Microsoft for software. Thus, for each computer produced, China has had to pay Intel and Microsoft for their proprietary products. In other words, the Chinese enterprises making computers actually work for Intel and Microsoft and profit merely through selling accessories and peripheral devices. Brands are even more profitable. Shengzhou, in Zhejiang Province, is renowned for its tie-making industry, with a great number of international brands establishing their overseas factories there. The production cost of each tie is not high. The average unit price of a domestic brand tie usually is below RMB588, yet that of a general foreign brand tie ranges from RMB588 to RMB888, and that of a top foreign brand hovers around RMB888 to RMB1,288. In fact, there is no significant internal cost difference between these ties. It is the brand effect, built on reputation that differentiates one tie from the other. However, some reports have exposed certain quality problems of some wellknown foreign brands after their entries into China. This is where China must step up its monitoring efforts. Anyway, the wealth effect of a brand is also a reflection of the knowledge effect. Importing product standards profits most. China’s first-generation analog mobile phones, second-generation GSM (1G) mobile phones and 2.5-generation (2.5G) CDMA mobile phones all have adopted foreign standards, for which the

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country has paid hundreds of billions of RMB. Whoever controls the standards controls top technologies. Prior to the 2008 Summer Olympics, China promised to launch the third-generation (3G) mobile phones. Currently, 3G mobile phones have three standards: WCDMA, CDMA 2000 and China’s TD-SCDMA. China has spared no efforts in supporting its domestic TD-SCDMA standards so that it won’t lose out in a potentially huge market. The Ministry of Industry and Information Technology has sped up research and development (R&D) of the TD-SCDMA standard. There are still problems that call for more efforts and studies. Therefore, the 3G license plate had been delayed for a long time before it was finally issued. The above example demonstrates that the wealth gap between China and developed countries is mainly brought by the knowledge gap. Developed countries produce and export knowledge. Developing countries import and use these knowledge. Some people say that countries producing and exporting knowledge are brain countries, while those introducing and using knowledge are brawn countries. China has to have both the “brawn” and the “brain.” Therefore, it needs to vigorously develop its technical and educational courses so as to narrow the knowledge gap with developed countries. The author believes that while the economy may guarantee a temporary growth, science and technology will guarantee more sustainable development, and education will ultimately outfit all these developments with an eternal engine. Behind the competition of economic strengths among different countries, it is the competition of technical strength, the core of which is the competition of the strength of talents, the key to which is the competition of the scientific and technological strength. This is the basic reason for the central government to propose building an innovation-based country. Education aims at improving people’s scientific and technological, cultural, moral qualities on the one hand and, on the other hand, cultivating creative talents so as to guarantee China’s day after tomorrow. Though in recent years China has invested have been made in technologies and education by, it still is not enough to build an innovation-based country. In 2006, R&D expenditures reached RMB366.4 billion, up 22% year on year, accounting for 1.49% of the GDP, far lower than the international level; in 2005, expenditures in education China was RMB63.48 billion, accounting for 3% of the GDP in current year. In 2007, the figure increased slightly, yet it was still far lower than the minimum requirement of 4%. To guarantee its future China should appropriately cut back on its expenditures in other areas and strive to increase its investment in technology and education.

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The Scientific Outlook on Development

Developing in a Coordinated Way and Improving the Efficiency In the Decision of the CPCCC on Some Issues concerning the Improvement of the Socialist Social market economy adopted by the 3rd plenary session of the 16th CPCCC on October 14, 2003, Beijing, for the first time, proposed the strategic development guideline of “Five Balances,” balancing, namely, urban and rural development, development among regions, economic and social development, development of humans and nature, and domestic development and opening up to the outside world. At the Central Economic Work Conference in 2006, the Central Committee proposed the “Three Coordinates,” coordinating, namely, speed, efficiency and quality; investment, consumption and exportation; and population, resources and the environment. Both the “Five Balances” and the “Three Coordinates” were important measures for thoroughly implementing the scientific thought of development. China needs to make efforts so as to achieve a coordinated development and improve the overall efficiency.

Three Indexes for Measuring Investment Efficiency To begin with, China needs to improve its investment efficiency. Since 2003, GDP growth rate in China has surpassed 10%, sporting 10%, 10.1%, 10.4%, 11.6% and 11.9%, in 2003, 2004, 2005, 2006 and 2007 successively. Some people argue that the economy has become overheated. The author would not agree with this characterization. Looking at economic development of countries around the world, we can see there were times in history when some countries sported a GDP growth rate of about 10%. The real problem in China is overheated investment. That is, GDP growth in China is mainly pulled by a great deal of investments, thus reducing investment efficiency. The author here recommends that the following three indexes be used as measures of investment efficiency. The first index is the elasticity coefficient of investment. Based on neoclassical economic theories, economic growth comes from three sources: the growth led by the growth of investment, the growth led by the labor force increase, and the growth led by integrated factors in science and technology, education and management. China’s elasticity coefficient of investment from 1995 to 2006 saw a dip due to rapid investment expansion. Currently, every 1% increase of total investment in fixed assets can only bring a 0.3% to 0.4% increase of the GDP in China. Assuming integrated factors had contributed 30% to China’s economic growth, even if setting aside the contribution of an

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expanded labor force, it could still bring at least a 0.7% GDP growth. Therefore, the current investment effectiveness in China is far from being satisfied and isn’t yet up to the requirement of achieving a “sound and fast” economic development. The second index refers to the annual conversion rate of investment. Simply put, it means the percentage of a RMB1 investment converting into to the final GDP growth. Due to the construction process, investment cannot be totally converted into GDP. However, the degree of conversion, to some extent, demonstrates the investment efficiency. Judging from China’s conversion rate in recent years, it has decreased somewhat, ranging from about 0.5% at its highest to an average rate of 0.2%. Last but not least is the percentage of investment in GDP, an extremely important index for presenting the relationship between investment and consumption. During 1960s and 1970s, the portion was maintained at around 0.28; in 1980s and 1990s, the reform and opening up slightly drove the portion to one third; however, in recent years, it has been growing quickly, hitting 0.56 in 2007. If investment takes up a large proportion of GDP, it will suppress consumption and cause proportional disequilibrium between investment and consumption. Therefore, according to the above three indexes, China should improve its investment effectiveness in order to achieve a sound and fast economic development.

Main Causes for China’s Low Investment Effectiveness First, China is in the middle of industrialization, features an accelerating expansion of its heavy-chemical industry, which is capital-intensive with an obvious scale effect and a lengthy construction cycle, thus leading to low investment effectiveness. Second, treasury bond (or T-bill) investment mainly focuses on infrastructure and other project constructions which have a lengthy payoff cycle. For example, China has invested heavily in the highway construction, especially in the west, where some well-paved highways are for the use of only a few vehicles, such a low utilization rate affects the investment payoff. However, with gradual economic development in out west China, its benefits will surface sooner or later. Third, impulsive investments and vanity projects reduce the effectiveness. To drive regional GDP growth, some government decision-makers will inevitably increase the volume of investment and make certain wrong investment decisions.

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The Scientific Outlook on Development

Fourth, repeated low-level constructions result in low effectiveness. Chinese banks have been saddled with excessive liquidity for two reasons: China has a high savings rate with current bank deposits exceeding RMB40 trillion. Since banks make profits via interest rate spread, Chinese banks have to lend out the money, thus causing a great amount of capital awaiting for being lent; The other reason is, by the end of 2007, foreign exchange reserves in China hit USD1.53 trillion, for each dollar flowing in, the People’s Bank of China has to provide the corresponding amount of RMB based on the real-time exchange rate. So, by the end of 2007, China’s funds outstanding for foreign exchange reached RMB11.52 trillion. The above two reasons combined lead to a low capital cost, hence stimulating the increase in construction loans. Consequently, some repeated low-level constructions are built, thereby reducing their effectiveness. Considering the repeated constructions, we should adopt a dialectic approach. Strong objection will lead to technological stagnation, because there is no place for a new enterprise if the original production capacity becomes saturated. What we emphasize here is to avoid repeated low-level constructions. In this context, a new enterprise equipped with more advanced technologies should be allowed to join in the competition. That’s why people should not categorically oppose any repeated construction. Otherwise, it will neither conform to the rules of the market economy nor drive the technological advancement. Finally, corruption and policy malfunction also caused losses, which manifest themselves in a manner of investment ineffectiveness. Nevertheless, China needs to further improve its investment effectiveness, which is essential to achieving a sound and fast economic growth.

Improving the International Balance of Payments Another important issue is to improve international balance of payments. The growth of China’s foreign trade is ranked ranking no. 3 worldwide. As trade surplus keeps swelling, trade frictions grow apace, while foreign direct investment (FDI) is basically stable. In 2007, the number of newly-approved enterprises set up with FDI in the non-financial sector reached 37,871, down 8.7% year on year. Paid-in FDI in 2007 amounted to USD74.8 billion, up 13.6% year on year. However, China’s foreign exchange reserves grew substantially, amounting to USD1.528 trillion at the end of 2007, an increase of USD461.9 billion. That year the USD/RMB exchange rate was 7.3, up 6.9% year on year. In recent years, China’s foreign trade has been growing at a double-digit clip, often higher than 20%. Trade surplus has been swelling from 2004 to 2007,

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standing at USD32.1, USD102, USD177.4 and USD262.2 in successive years. In this aspect, China needs to adjust its foreign trade structure. Substantial trade surplus is not always a good thing, for it leads to ever-escalating trade conflicts and brings difficulties upon China. Increased trade surplus will definitely lead to a significant increase in foreign exchange reserves, subsequently creating more excessive liquidity and gradually putting more pressure on RMB to appreciate. As China’s foreign trade surplus continues to grow unchecked, its trade partners will urge China to allow RMB to appreciate so as to bring international trade equilibrium back to normal. Furthermore, the anticipation of RMB appreciation is more terrifying than the appreciation itself. Here is an analysis: In recent years, China’s foreign exchange reserves have reported an annual increase of USD200 billion; the year 2007, however, saw a sharp uptick to nearly USD500 billion, of which only USD350 billion were trade surplus and FDI, while the other USD150 billion, except for a small amount of income from the appreciation of Euro reserves and export of labor services, was mainly contributed by the influx of “hot money,” accounting for approximately USD100 billion. All these “hot money” from foreign countries speculated on RMB appreciation. Therefore, this hot money “invaded,” mainly in the form of investment in real estate market and the stock market. For example, in some cities, houses were not bought by local residents but by speculators. Also, excessive liquidity stimulated investment in building factories whose products could not be completely absorbed by domestic market. Thus enterprises would compete to transfer excessive products into overseas market with deep discounts, which cheapened China’s labor force, energy and resources and further exacerbated the foreign trade disequilibrium. Improving the international balance of payments is an urgent task in China, requiring China’s import and export structural adjustment, the rational use of foreign investment and a sound administration of the large amounts of foreign exchange reserves. Domestic and foreign scholars have different views on the amount of foreign exchange reserves China should keep. According to the author ’s study, approximately USD650 billion is sufficient, of which USD400 billion should be put in strategic foreign exchange reserves and USD250 billion in tactic foreign reserves. However, China’s current foreign exchange reserves exceed tens of hundreds of billions dollars. They should be well utilized in the following three ways: First, to increase imports, though this may not be viable because the U.S. and Europe have imposed many trade restrictions and refused to sell certain hi-tech products and technologies to China. Second, to make foreign investments. And third, to liberalize controls of the foreign exchange

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utilized by enterprises and individuals. These measures should be adopted to reduce our excessive foreign exchange reserves.

Achieving the Sustainable Development and Pursuing the Harmony Between Humans and Nature The UN defines sustainable development as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs.” To achieve sustainable development, the most important thing is to properly handle the relationship between humans and nature. Society is an existing system with a multi-tier structure and functional structures, in which humans play the essential role to understand, utilize and remodel the nature. Of course, there are some conflicts in the development between humans, society and nature.

Evolution of the Relationship between Humans and Nature Evolution of the relationship between humans and nature shows that in primitive society, people were in awe of the nature. So they worshipped the sun, the moon, the fire and other natural beings. In the agricultural society, people worked in accordance with the natural rules and relied on nature for subsistence; whereas in the industrial society, people tried to conquer the nature using science and technology which further intensified the conflict between humans and nature. As early as in 1886, Friedrich Engels said, “Let us not, however, flatter ourselves overmuch on account of our human victories over nature. For each such victory nature takes its revenge on us. Each victory, it is true, in the first place brings about the results we expected, but in the second and third places it has quite different, unforeseen effects which only too often cancel the first.” Not many of his contemporaries heeded Engels’ warning. It was not until the second half of the 20th century, when developed countries began to enter the post-industrial era, that people gradually realized the importance of environmental protection and that of the harmonious relationship between humans and nature. In the early 1960s, Rachel Carson wrote about the ecological damages caused by pesticides in her book The Silent Spring . It was not until the 1980s that people gradually recognized the concept of sustainable development; the UN defined “sustainable development” and put forward the issue of environmental and ecological protection; only then did people begin to realize the importance of harmonious co-existence with nature.

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From the perspective of social and economic development, there are three types of societies: the agricultural society, the industrial society and the knowledge society. Each requires a civilization of its own. In the advent of the knowledge-oriented era, a new civilization is much more needed. The author believes that the new civilization will be an eco-friendly, energysaving civilization under which humans and nature co-exist in harmony, and a thorough implementation of the scientific outlook on development will contribute to the construction of this new civilization.

Resource-Saving and Environmental Protection As a developing country, China shoulders heavy responsibilities for the environment and sustainable development. In particular, China is now in the midst of industrialization in which heavy industries dominate the scene, making it more difficult to conserve resources and protect the environmental. In 2006, China failed to meet the annual pollutant reduction targets of set

in the 11th Five-year Plan. SO 2 and emissions of Chemical Oxygen Demand (COD) increased 1.8% and 1.2%, respectively. Meanwhile, China’s GDP growth rate exceeded the 8% target and soared to 11.6%, proof positive that China allocated more resources to economic growth than to environmental protection. The situation improved in 2007. China needs to make greater efforts to save resources and reduce pollution. China should also take global environmental issues into serious consideration, such as climate change, ozone depletion and desertification. Since the end of the 20th century, global warming has been attracting attention worldwide. On June 4, 1992, the UN Conference on Environment and Development aka Earth Summit, was held in Rio de Janeiro, Brazil. The UN Framework Convention on Climate Change —the first ever international convention aiming at comprehensively controlling the emission of CO 2 and other greenhouse gases—was adopted. In its 4th assessment report published in 2007, the Inter-governmental Panel on Climate Change (IPCC) pointed out that “in the past 100 years (1906–2005), the average surface temperature worldwide

had increased 0.74℃; the global atmospheric concentration of CO2 was 379 ppm in 2005, the highest level in the past 650,000 years. Most of these unprecedented increases were, in all likelihood, caused by human activities; comparing with 1980–1999 period, the global average surface temperature might increase 1.1℃–6.4℃ in the 21st century; high temperature, hot waves and heavy rainfall frequency might increase, and tropical cyclones (typhoons and hurricanes) might become more intense.”

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In 2005, China emitted more CO 2 than any other country except the U.S., accounting for 18% of the global total volume. China’s emission intensity of

CO2 in was 2.7kg/GDP (based on the constant price of USD in 2000), 3.5 times higher than the world average and 6 times higher than the average level of the Organisation for Economic Co-operation and Development (OECD) countries. The per capita CO2 emission in China, however, was low. In 2005, the volume was 3.9 tons, 0.3 tons lower than the world average and 7.1 tons less than OECD’s average volume of. But with industrial development, urbanization, improvement in living standard and population growth, energy consumption

of and with it CO 2 emission will continue to grow into the future, making it more difficult for China to combat climate change. To this end, President Hu proclaimed in 2008 that China must be highly responsible for the long-term development of the nation and the humankind, recognizing the importance and urgency to fight climate change, insisting on sustainable development, adopting more powerful policies and measures which enhance the nation’s capability in dealing with climate change and contributing to the sustainable development of China and the world as a whole. Existing in the atmosphere, the ozone layer could partly resist the ultraviolet B (UVB) radiation. However, due to the substantial emission of Freon and other chemicals produced by the human beings, the ozone layer at the Polar Regions is thinning, increasing the UVB radiation to the surface of the earth (it is usually thought that every 1% decrease of the ozone concentration would increase the UVB radiation by 1.5–2%). The UVB radiation is able to destroy the DNA and other bio-molecules, thus increasing the odds of getting skin cancer, cataracts and immune system disorders, damaging the marine eco-systems, reducing the agricultural output, shortening the life span of some construction materials, and exacerbating the greenhouse effect. The ozone depletion has been drawing global attention since the 1970s. In March 1985, Vienna Convention for the Protection of the Ozone Layer , an international convention on protecting the ozone layer, was adopted at Vienna, capital of Austria. Later at the Montreal Conference on September 16, 1987, the Montreal Protocol on Substances that Deplete the Ozone Layer was signed. With the efforts of different countries, the growth rate of major chemicals that deplete the ozone has been reduced significantly and the global ozone content has begun to gradually restore since 2000. It is estimated that the ozone hole above the South Pole will disappear in the middle of the 21st century. Desertification refers to land degradation that happens in arid, semi-arid and dry sub-humid areas. Currently, one-fifth of the world’s population and one-third of the world’s land are affected by desertification. And at the UN

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World Environment and Development Conference in June 1992, the prevention and control of desertification was one of the top development priorities. On June 17, 1994, the UN Convention to Combat Desertification was adopted. China is one of the countries that suffer the severest desertification. Desertified land mass spans cover 2.6 million square kilometers (hereinafter shortened as “km2”), about 27.4% of the country’s territory. More than two-thirds of the desertified land was the result of wind erosion, the main culprit of China’s desertification. Statistics show since the 1970s land desertification has been accelerating at the speed of 24.6 million km 2 per year. The direct economic losses from desertification have reached RMB54.1 billion. Recent years saw some success in controlling and preventing land desertification so much so that the size of desertified land mass has shrunk by 12.8 million km2. However, there remains an urgent need to convert more than 500,000 km 2 of desertified land into farmland. Greater efforts also should be made to protect the potentially desertified lands covering an area of 320,000 km2. Moreover, desertified lands in some areas keep expanding; these factors combined make the task of land governance and protection even heavier. To better protect the environment, China needs to strengthen its legislation and regulate the relationship between humankind and nature. The NPC, as China’s legislature of, had established a legal system in 2010. Up to now, effective laws on environmental protection and sustainable development include the Environment Protection Law of the People’s Republic of China , the Environmental Impact Assessment Law of People’s Republic of China , Water Law of the People’s Republic of China , Forest Law of the People’s Republic of China and Grassland Law of the People’s Republic of China . The NPC’s Standing Committee should make more efforts in stepping up law enforcement in order to ensure effective enforcement of all these laws. To strengthen corporate social responsibilities, enterprises should not only undertake the responsibility for environmental protection and social development of their communities but also contribute to solving global environmental issues. More enterprises should be encouraged to get the ISO14000 certification and take part in such activities as “global protocol” and “responsible care.” The NPC’s Standing Committee has approved China’s entry into the Convention Concerning Occupational Safety and Health and the Working Environment which will help further improve the working conditions of enterprise employees. To achieve a sound and fast development, China must change its concepts of development, create new development pattern, and improve quality of its development. Practices in recent years have proved that under the guidance of

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the scientific outlook on development, China has seen a significant increase in its economic strength, paid more attention to improving the livelihood of its people, carried out social constructions and protected social justice and fairness. But note that thoroughly implementing the scientific outlook on development is an arduous long-term task, and China must fight behaviors that sacrifice global interests for local interests, pursue a synchronous development of technologies, education, environment as well as economy. The development relying on technology and management, pay more attention to energy conservation and environmental protection, and gradually narrow the gap between urban and rural areas. In the long run, China should make more efforts to build an innovation-oriented country, develop hi-tech industries, finance, information, consultation and other service industries, gradually transfer from exporting raw materials and products to exporting capital and knowledge, combine the construction of an innovation-oriented country at the macro-level to that of a learning-oriented organization at the micro-level, and improve the scientific, cultural and moral standards of the entire nation and cultivate creative talent by developing education. Completed on June 30, 2008

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Chapter

The Construction of an Innovation-oriented Country

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

Since the CPC and the State Council set the grand objective of building an innovation-oriented country at the Science and Technology Conference held in early 2006, the definition of innovation and the construction of an innovationoriented country have become hot topics. The author will discuss major issues regarding the construction of an innovation-oriented country based on his years of experience in scientific researches and technological management.

Building the Innovation-Oriented Country The theory of innovation was initially put forward in 1912 by J. A. Schumpeter, an Austrian economist, in his book The Theory of Economic Development . Schumpeter believed that “innovation” referred to the “new combination of production factors by entrepreneurs” and it should include the development of new products, the adoption of new methods, the opening of new markets, the acquisition or control of a new source of supply of raw materials or semifinished products, as well as the implementation of a new institutional pattern. With the development in the past century, people now better understand to the innovation. Innovations may be viewed as some new measures adopted by the people in order to adapt to the changes of the objective environment. Different from inventions, innovations are not necessarily originated from inventions. Only original innovations can be originated from inventions. In addition, innovations are different from inventions in that innovations may lead to practical changes, while the proposal of a new invention may not necessarily be put into practice. An innovation-oriented country is a country that makes innovations the main driving force of development. The author believes that an innovation-oriented country may not be an S&T country measured by its scale, but by its proficiency. People may confuse an S&T country with an innovation-oriented one. In terms of the number of researchers, academic papers published and S&T achievements made, China can only be counted as a large-scale S&T country. To measure whether a country is innovation-oriented, we should not merely refer to the number of researchers, academic papers published or S&T achievements made. The more important indicator is whether or not innovations play a leading role in the country’s overall development. Currently, 30 countries, including Sweden, Denmark, Finland, Germany, Israel, Japan, Switzerland, UK, the U.S., France, South Korea and the Singapore, are recognized as being innovation-oriented. However, there hasn’t been a unified assessment system to standardize the innovation-based countries. In the past five decades, abundant studies have been focusing on national

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innovation capability assessment system, ranging from the single-indicator assessment, the multi-indicator assessment to the establishment of assessment systems such as the OECD Scientific and Technological Indicators, EIS, the U.S. Technological Indicators and the FP&S assessment approach, etc. Among them, the EIS, after five revisions of its indicator system since its 2001 official launch, has been widely regarded as a comprehensive assessment system measuring national innovation capability. EIS 2007 , released in February 2008, included altogether 25 innovation indicators which are classified into five categories. Innovation Drivers . The innovation drivers include five indicators: Science & Engineering (S&E) graduates (percentage of population aged 20–29), the population with tertiary education of population aged 25–64), broadband penetration rate (number of broadband lines per 100 population), participation in life-long learning percentage of population aged 25–64), youth education attainment level percentage of population aged 20–24 having completed at least upper secondary education). Knowledge Creation . The knowledge creation includes four indicators: public R&D expenditures (percentage of GDP), business R&D expenditures percentage of GDP), share of medium-high-tech and high-tech R&D (percentage of manufacturing R&D expenditures) and share of enterprises receiving public funding for innovation). Innovation & Entrepreneurship Measures . The innovation & entrepreneurship measures includes six indicators: small and medium–sized enterprises (SMEs) innovating in-house (percentage of SMEs), innovative SMEs co-operating with others (percentage of SMEs), innovation expenditures (percentage of turnover), early-stage venture capital (percentage of GDP), information and communication technology expenditures (percentage of GDP) and SMEs using non-technological change (percentage of SMEs), Applications . The applications include five indicators: employment in hightech services (percentage of total workforce), high-tech exports as a share of total exports, sales of new-to-market products (percentage of turnover), sales of newto-firm not new-to-market products (percentage of turnover) and employment in medium-high and high-tech manufacturing (percentage of total workforce). Intellectual Property . The intellectual property includes five indicators: (new) European Patent Office (EPO) patents per million people, (new) United States Patent and Trademark Office (USPTO) patents per million people, (new) Triadic patent families per million population, the number of (new) domestic community trademarks per million people and the number of (new) domestic community industrial designs per million people).

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The first three dimensions belong to input dimensions and the latter two dimensions belong to output dimensions. The EIS 2007 includes innovation indicators and trend analyses for the 27 EU member states as well as for Croatia, Turkey, Iceland, Norway, Switzerland, Japan, the U.S., Australia, Canada and Israel. Based on their innovation performance, the countries included in the EIS 2007 fall into the following groups: (1) innovation leaders , including Denmark, Finland, Germany, Israel, Japan, Sweden, Switzerland, UK and the U.S.; (2) innovation followers , including Austria, Belgium, Canada, France, Iceland, Ireland, Luxembourg and the Netherlands; (3) moderate innovators , including Australia, Cyprus, Czech Republic, Estonia, Italy, Norway, Slovenia and Spain; and (4) catchingup countries , including Bulgaria, Croatia, Greece, Hungary, Latvia, Lithuania, Malta, Poland, Portugal, Romania and Slovakia. Turkey currently performs worse than other countries. Based on EIS, the EU has also launched the GIS. The EIS 2006 cited the results included in the 2006 GIS Report which was released on December 4, 2006. The report contains a comparative analysis of the innovation performance of 48 countries and regions, including the 27 EU member states. This analysis was based on a more limited set of 12 indicators classified into five dimensions, namely innovation drivers (including 3 indicators, namely new S&E college graduates, labor force with completed tertiary education and researchers per million population), knowledge creation (including 3 indicators, namely, public R&D expenditures, business R&D expenditures and scientific articles per million people), diffusion (including only one indicator, information and communication technology expenditures), applications (including two indicators, exports of hi-tech products and share of medium-hi/hi-tech activities in manufacturing value added products) and intellectual property (including three indicators, namely EPO patents per million population, USPTO patents per million people and third-party patents per million people). Then the following steps should be adopted in order to arrive at the Global Summary Innovation Indicator (GSII): 1) Choose the reference year (e.g. 2003) and the reference time period (e.g. 1999–2002) of a country; finding the value for each indicator in the reference year, as well as the lowest or minimum value and the greatest or maximum value for each indicator during the reference time period. 2) The numerator takes the difference between the square root of the reference value and the square root of the lowest or minimum value found for that indicator for all countries. The denominator takes the difference between the square root of the largest or maximum value found for that indicator for

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all countries and the lowest or minimum value found for that indicator for all countries. Then we’ll get the regular value of the indicator. 3) Calculate the GSII as the average of the re-scaled indicator values, using equal weights for all indicators except for the business R&D indicator, which receives double weighting. Based on the ranking of their GSII scores, the above 48 countries (regions) fall into the following four groups: 1) Finland (0.76), Sweden, Switzerland, Japan, Singapore, Israel and the U.S. (0.67) are “global innovation leaders”; 2) Germany (0.63), Denmark, Netherlands, Canada, UK, South Korea, France, Iceland, Norway, Belgium, Australia, Austria, Ireland, Luxembourg and New Zealand (0.47) are “next-best performers”; 3) Hong Kong (0.39), Russia, Slovenia, Italy, Spain, Czech Republic, Croatia, Estonia, Hungary and Malta (0.32) are “follower countries”; and 4) Lithuania, Greece, China (0.27), Slovakia, South Africa, Portugal, Bulgaria, Turkey, Brazil, Latvia, Mexico, Poland, Argentina, India (0.17), Cyprus and Romania (0.11) are “lagging countries”. The report also saves a cluster analysis of the performance of various indicators of each country. Assessment results of national innovation capacity using other approaches have demonstrated that China is still far from being an innovation-oriented country. Just as EIS 2006 pointed out: Neither Argentina, Brazil nor India and China are comparable to any of the better performing EU countries in either absolute or relative performance levels. It would seem that in these countries a substantial improvement in their innovation systems is still necessary to catch-up with the best performing countries. In the Guidelines for the Medium- and Long-term National Science and Technology Development Program (2006–2020) , China used four indicators to set certain targets for 2020. For example, the document called for more than 2.5% of GDP to be invested in R&D; the contribution of S&T progress to economic growth to be at least 60%; and the foreign technology dependency to be reduced below 30%. It also set the goal for China to rank in the world top five in terms of invention patents and international paper citations. Let us herein make an analysis of the above four major indicators.

The Proportion of GDP Invested in R&D A high R&D investment intensity is an important condition of a country’s innovation capabilities. From the perspective of R&D input, the R&D/GDP growth in China was slow in 1990s, yet it began to increase rapidly since 1999. In 2007, China’s R&D investment intensity was 1.49%, showing a significant gap with that of developed countries, though topping developing countries. In 2005,

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the R&D investment intensity in most of the developed countries was above 2% and that in Israel even exceeded 4%. According to the author’s estimate, the average annual growth rate of social investments in R&D activities should be maintained at 12% prior to 2020 so as to ensure that at least 2.5% of GDP will be earmarked for R&D investment in 2020.

The Contribution Rate of S&T Progress to Economic Growth The definition and measurement of the contribution rate of S&T progress to economic growth has been a controversial issue. In 1957, Robert Solow, an American economist, introduced S&T progress into the economic growth model. This neo-classical economics development formula is usually expressed as: Y=A+αK+βL Of which, Y represents the growth rate of the total output (added value); K represents the growth rate of capital investment; L represents the growth rate of labor investment; α is the elasticity coefficient of capital input-output; β is the elasticity coefficient of labor input-output; α+β=1; and A represents the economic growth rate stimulated by the total factor productivity (TFP). In fact, it divides economic growth into three parts: economic growth led by capital investment, by labor force investment and by the TFP. The economic growth rate led by TFP has something to do with “soft” factors like science and technology, education, management, etc., and can be viewed as the contribution rate of S&T progress to economic growth in a broader sense. For years, the computed results of China’s TFP have been emerging in an endless stream along with various interpretations. There were also views completely denying the TFP. The author believes that TFP has some limitations, though it is appropriate to use it to measure the contribution rate of S&T progress to economic growth before the invention of a better theoretical framework. The World Bank, OECD and other international organizations are currently using TFP as well. In recent years some research findings have shown that since the late 1990s, China’s TFP has been maintained at a low level. Calculations by Hu An’gang and Zheng Jinghai show that China’s TFP declined significantly between 1995 and 2001, from 0.3% to 2.3% (based on the different weightings of capital and labor force). Using the Solow Residual approach, the latent variable approach and the potential output approach, Guo Qingwang and Jia Junxue estimated the growth rate of China’s TFP from 1979 to 2004. Results showed that since 1993 it had not seen any signal of recovering until 2000, yet hovering at a low

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level between 0–3% (results may vary depending on the method used). Cao Jiyun took the proportion of labor force input in the tertiary industry as the substitute of the technical capability and run statistical regression to directly estimate the aggregate production function and measure the contribution rate of S&T progress to economic growth in China since the reform and opening up. The results showed that the 1995–2005 contribution rate was 21.57%, which accounts for about 1.8% of the TFP. Also, some researchers (Ren Baoping, Chao Xiaojing, Xu Jiajie et al.) got relatively high estimated TFP values. For example, the TFP has been very close to the set target 60%, thus rendering the indicator meaningless. In light of these research findings, the author believes given one of the objectives of building an innovation-oriented country, it is reasonable to set China’s current contribution rate of S&T progress to economic growth at around 25%.

Foreign Technology Dependency Foreign technology dependency is difficult to measure. On September 28, 2004, then Minister of Science and Technology Xu Guanhua pointed out at the 3rd China Scientists Forum held in Beijing in 2004 that the China’s foreign technology dependency was as high as 50%. Ma Huzhao et al. claimed that the most common algorithm was: Foreign Technology Dependency = Expenditures on technology introduction/ (Expenditures on technology introduction + R&D funding) Based on this formula, China’s foreign technology dependency declined from 75.74% in 1995 to 36.84% in 2004. Ma Huzhao et al. held that this algorithm had the following disadvantages: first, it adopted a single-indicator measurement and from the angle of expenses, which was insufficient to cover the scope of the technology dependency; second, it failed to reflect the structural problem of foreign technology dependency; third, the data were not accurate enough and caused errors in the final results; fourth, due to the repeated technique imports and the industrial structure, foreign technology dependency may face drastic fluctuation. Ma Huzhao et al. selected four representative indicators to measure the China’s foreign technology dependency, namely, technological expenditure dependency, invention patent dependency, hi-tech industry import dependency and dependency on foreign investment in hi-tech industries. By employing the factor and SPSS statistical analyses, Ma Huzhao et al. found that the China’s foreign technology dependency increasing from 27% to 66% between 1995 and 2004, contrary to the abovementioned result.

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The author thinks it is understandable that since the reform and opening up, in particular after joining the WTO, China saw an increase in its dependence on foreign technologies, because that is consistent with the country’s current development. Creating innovations by adopting and integrating imported technologies is an important strategic measure which developing countries use to catch up with the innovation-oriented countries. As Wu Xiaobo et al. pointed out, “foreign technology dependency itself is affected by the degree of internationalization, the stage of economic development and other factors. Experience shows that absorbing foreign advanced technologies reflect the characteristic of the rapid-growth period and an important strategic path that is usually taken in technological catch-up. Therefore, a relatively low level of foreign technology dependency should not be set as the only objective in the near future. People cannot ignore the essence of independent innovation capability while indulging in a low dependency on the foreign technology; otherwise, it will restrain our technology introductions and learning process.” However, it should be recognized that key technologies are hard to buy. Therefore, to build an innovation-oriented country, we need to strengthen our independent innovation capability, strive to master “the state-of-the-art technologies” in some aspects, and gradually reduce our foreign technology dependency. With our joint efforts, it is possible to reduce the dependency from the current 60% to 30% by 2020.

The Annual Amount of Domestic Invention Patents and International Paper Citations This indicator is easy to calculate. Based on World Intellectual Property Organization (WIPO) statistics, the number of China’s authorized domestic invention patents in 2005 reached 21,519, about 3.5% of the world’s total for the year. That put China in the No. 6 spot, after Japan, the U.S., South Korea, Germany and France. It seems possible for China to climb one spot—to the world’s top five—by 2020. However, if calculated on a per capital basis, the number of patents approved in China accounts for only 0.7% of the world’s average and 0.14% of that in developed countries. Studies conducted by the task force responsible for the “statistical monitoring and researches on the progress of innovation-oriented countries,” the amount of papers on scientific discoveries (limited to papers collected by the Science Citation Index (SCI) in China shows a relatively small gap with that in the technologically-advanced countries. However, the major problem is the low citation frequency of papers written by Chinese scholars (In 2005, the scientific papers of innovation-oriented countries

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were each cited for 8 times on the average, while the number in China was only 3.8 times). Given the above analysis and the perspective of international standards and the objectives set forth by China, constructing an innovation-oriented country is an arduous task.

Major Types of Innovations Many people view innovation only from its technological nature, which is far from comprehensive. Innovations come in three types: technological innovation, management innovation and institutional innovation. Technological innovation refers to the process of introducing new products, artisanship or services to the market so as to capture commercial value; management innovation refers to the introduction of new concepts, methods or institutional patterns into enterprises or national administration and obtain positive results; while institutional innovation refers to the process of introducing new relationships, systems or mechanisms into the social and economic activities so as to push forward the social and economic development.

Technological Innovation Technological innovation refers to the process of introducing new products, artisanship or services to the market so as to realize its commercial value. The technological innovation capability of an enterprise is its ability to acquire competitive advantages by introducing or developing new technologies, products and services to meet or create market demand. It relies mainly on an enterprise’s R&D capability, as well as the sensibility of the enterprise to market demands. R&D refers to the entire process from proposing related scientific concepts to achieving artisanship or manufacturing products in a competent industrial scale. It includes basic researches, application researches and development. R&D activities in enterprises mainly include process improvement, e.g. the settlement of unexpected problems in production, the removal of weak links, operational fee reduction, product quality improvement, amelioration of operational conditions and the elimination of environmental pollution, etc.; process development, e.g. creating a new artisanship over an existing product, developing a new production process for a new product, or utilizing the byproducts of an existing artisanship, product development (aiming at meeting the customers’ demands for a certain function, technically and economically),

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background study (aka application foundation research, aiming at deepening the understanding of the basic characteristics or technical principles of the products), as well as providing technical supports for the sales department, etc. In general, technological innovation can be classified into three types: first, follow-up innovation, referring to innovating on the basis of the existing works. The typical pattern is “introduction–digestion–absorption–re-innovation.” It is also an important strategy adopted by developing countries in order to catch up with developed countries. Both Japan in the 1960s and South Korea in the 1980s followed this pattern and made significant achievements. China should also pay due attention to this innovation type, especially since its foreign technology dependency currently hovering at 60%. “Introduction–learning–re-innovation,” as the process implies, includes four stages. The first stage involves technology import, purchase of patents, proprietary technologies, or even complete sets of equipments or assembly lines. The importance lies in the selection of advanced and applicable technologies based on various investigations and studies. The second stage is the integration of the introduced technologies. To achieve this, first, it is necessary to keep the installations stable and operational for a long run and meet product quality standards and various technical and economic indicators; second, domestic workers must be able to independently operate and maintain the imported sets of equipment or assembly lines and the manufacturing of parts; and third, components must be localized. The third stage involves the absorption of the introduced technologies. Efforts must be made to manufacture, install and operate the introduced installations in compliance with the import contract terms. The fourth stage is re-innovation, which is the process of creating independent patents or proprietary technologies in the manner of improving the imported hi-tech products. Besides, the follow-up innovation also includes peripheral innovation, made in the periphery of core technologies introduced. For example, in 1996 when GSM network occupied the leading position in the field of wireless communications, South Korea chose CDMA after detailed analyses and comparisons and established the world’s first officially commercialized CDMA network, while most South Korean mobile phone manufacturers in adopted the wireless transmission technology of Qualcomm in the U.S. However, in recent years, the South Koreans have made a great number of innovations in the peripheral technologies of CDMA mobile phones (e.g. network technologies and mobile phone technologies, etc.) and obtained a number of patents for their peripheral technologies. Although South Korea still has to pay patent fees to the U.S. for some core technologies (the amount of patent fees for CDMA

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technology has soared to USD2.63 billion during the past decade), its patented peripheral technology has contributed to pave the way for the development of its CDMA mobile phones. Currently, South Korea has been able to export CDMA technologies independently, enjoying greater advantages in the 3G wireless competition. Fairly great efforts must be made by China if it is determined to surpass the international level of IC chip development. This is because the most important parameter of chips, the feature line width, is calculated in microns, developing from 0.5 at the beginning to 0.35, 0.25, 0.18, 0.13, 0.08, 0.05 and 0.035. And China is currently decades behind the most advanced level, meaning that it would be very difficult for China to independently develop IC chips. China may consider first importing chip manufacturing technologies and equipment, and then finishing the design work domestically and processing IC chips using foreign chips as raw materials. The simulation innovation is also a form of follow-up innovation. That is, to manufacture similar, even better products through analyzing existing products and making proper changes to bypass intellectual property barriers. It is commonly applied to technically simple products. After WWII, many Japanese enterprises manufactured motorcycles, refrigerators and washing machines through stimulating innovations. The second type of technological innovation is integrated innovation referring to the process of integrating existing technologies to create new products or artisanship. For example, prior to the emergence of copier, all single technologies were already mature. But to integrate all the single technologies into a copier was an innovation. Attention should be paid in choosing proper single technologies, which may be transferred from other domestic industries or from abroad, and ensuring that the technologies are complete and systematic. The third type of the technological innovation is original innovation, which is based on inventions to create a new product or technique through R&D activities. Original innovations usually lead to major technical reforms and bring long-term competitive edges to the enterprises. For example, the invention of transistors has fundamentally transformed the electronics industry contributed to massive emerging enterprises and great achievements. Therefore, an enterprise must develop its own R&D capability and invest capital and labor force in making original innovations. Among overseas enterprises, R&D expenditures vary across industries, usually accounting for 3%–10% of the sales amount. Especially in high-tech industries, such as information technology, biotechnology and pharmacy, R&D expenditures of an enterprise may account for as much as 10% of its sales. Some enterprises have competent R&D teams, first-

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class talent and equipments, enabling them to make original innovations in certain fields. Making original innovations requires substantial investment and massive time devotion, which it is very difficult, Follow-up innovations and integrated innovations are relatively more common. However, China should devote more resources to original innovations, most of which are currently conducted by S&T institutions, colleges and universities relying on national supports. Due to insufficient R&D investment, lack of talents and high-quality equipment, China will have to gradually create new conditions for original innovations. China needs to be focused and selective when pushing forward original innovations and provide sustainable supports to the approved projects. For example, China possesses the know-how in bio-technologies, especially in developing medicines and technologies for treating incurable diseases. If it can make some breakthroughs in this field, it will bring significant influence to the world.

Management Innovation Management innovation refers to the process of introducing new concepts, methods or institutional patterns into enterprises or national administration to obtain positive effects. The general management innovation capability of an enterprise includes its capabilities in managing its production, finance, personnel, marketing, R&D activities and information, etc., as well as the ability to reform its organization. These innovations may be originated from scientific and technological changes or changes of the business environment of the enterprise. The S&T development, in particular the information technology, has vigorously pushed forward the management innovation. Thanks to the application of information technologies, which helps realize the information sharing (via the network and various databases), the sharing of rules (via a variety of databases of norms and rules, the sharing of methods, e.g. Computeraided design (CAD) and decision support system), the sharing of experience, e.g. the expert system, and the improvement of the automated operation and the intelligent control, people thus may now be able to conduct the same task simultaneously in different places, a few people or even a single individual can accomplish complicated tasks used to require by several people, greatly reducing organizational layers. Business environment, in particular the changes of regulations and standards will also facilitate enterprises creating management innovations. For example, the formulation and implementation of ISO-9000 and ISO-14000 have set

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higher standards on the quality of products and environmental protection, stimulating innovations in such two aspects. Seen from its development process, management experiences three stages, or models, which are, experience management, scientific management and cultural management. Prior to 19th century, management conduction was mainly based on the experience of the manager. It was the stage of experience management. At the turn of the 19th and the 20th century, scientific management began to emerge. Proposed by Taylor, scientific management refers to the management conducted using scientific approaches. With the development of the science and technology, theories and methods on scientific management kept emerging. In the 1960s, someone drew a conclusion and proposed 11 schools of management theory. Coupled with the development of computers, the level of scientific management was improved. The organization of an enterprise must constantly adapt to environmental changes, making the reform of enterprise organization an important management innovation. Initially put forward by Adam Smith, the division of labor enables workers to be more professional and better use machinery and equipments. In the early 20th century, Henry Ford gave full play to the role of the labor division by dividing the manufacturing of a car into 8,772 working procedures. However, this form of enterprise organization was challenged. Through the Internet, people are able, on the basis of the division of work, to realize the sharing of information, methods and experience, and the improvement of automated operation and intelligence control, or complete one task together at different places. Therefore, with the development of the science and technology, such meticulous labor division caused the following three problems. First, meticulous division of scientific management would consume workers’ initiative to innovate. Simple daily operation makes workers complacent in their specific role, regardless of the improvement of the overall production procedures. Second, meticulous labor division adds redundant organizational layers, while one more layer added would, in all likelihood, cause information transmission distortion. Third, meticulous labor division is supported by plenty of sub-departments, which will cause frequent inter-departmental frictions. Some departments might neglect the important decision made by other departments, thus reducing the efficiency of the entire organization. For example, a customer called certain department of a telephone company, asking for telephone maintenance; the customer officer then called the maintenance department, which may respond

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with “manpower is not enough, you may have to wait till tomorrow.” This will eventually lead to low working efficiency. To address the situation, starting from the 1980s, two American professors proposed to reorganize business procedures, change the overly meticulous labor division, enable everyone to enjoy a relatively independent management responsibility, give full play to their initiative, simplify organizational structure, improve organizational efficiency, reduce information transmission distortions, and reduce inter-departmental disputes and frictions. It was an innovation of organizational management. Another management innovation is the emergence of cultural management, or the third development stage of management. Along with the development of enterprise informationalization and the reorganization of enterprise business procedures since 1980s, a question arose: how to stimulate the enthusiasm of employees? It could not simply rely on the supervision through scientific approaches, but on encouraging corporate culture. Therefore, corporate culture has been adopted as a management tool. Corporate culture may be manifested as visual materials, role models, ceremonies, etc. For example, albums and documentaries about the enterprise belong to visual materials, allowing the staff and workers to create a “corporate identity”; commemorative activities held by the enterprise during its anniversaries. All of these external manifestations, by nature, are the shared values of the enterprise capable of uniting employees striving toward same management objectives. Manifestations of cultural management are necessary, though they aim at enhancing the internal shared values. We may take quality management as an example to explain differences among the above three management modes. In experience management, the manager (the boss in most cases) supervises the workers, and deducts wages of the person at fault, or even fires him or her. For scientific management, total quality control (TQC) and total quality management (TQM) were introduced and comprehensive management of all staff and working procedures with the assistance of computers is carried out. However, quality accidents are still inevitable. To minimize accidents, employees must reach a consensus, which is, it is shameful to cause any quality accident because the quality was the life of the enterprise.

Institutional Innovation Institutional innovation refers to the process of introducing new relationships, systems or mechanisms into the social and economic activities so as to drive the social and economic development. The word “institution” has been frequently used recently. However, different people have different understandings over the nature

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of institution. It is generally believed that institution refers to a set of rules and norms that provide certain procedures for employees to follow. The academic circles believe that institutions are political, economic and cultural systems formed under certain historical conditions. The school of institutional economics emerged in the U.S. in the early 20th century focused on studying institutions and analyzed the role of institutional factors in social and economic development. To them, the organization and control of economic systems were more important than resource allocation, the level of income, income distribution, yield and consumer price. Therefore, they highlighted the enormous role of social, historical, political, psychological, and cultural factors in the social and economic life, and proposed to adopt the approaches of institutional analysis and structural analysis. The author once used complexity science to analyze institutions, believing that an institution should include two aspects—system and mechanism. System refers to the state and structure of the institution at a specific time, while mechanism refers to the process of and driving force for the evolution of the institution. System and mechanism are mutually dependent. System is the starting point and the final result, while mechanism is the evolutionary process. The interaction among institutional agents and that between the institution and the external environment will produce a self-organization function inside the institution, form the layer and functional structure of the institution, and push the institution forward to a certain direction. Since institutions are dynamic and in constant evolution, it is insufficient to study it relying simply on static structural analyses, such as power analysis, interest group analysis, normative analysis. Just as the famous institutional economist D.C. North once straightly pointed out, the world we live is dynamic, theories we proposed are static. Deng Xiaoping once pointed out that institutional issue was “fundamental, comprehensive, stable and well-established.” One word to explain the role of institutional innovation, which is, the person possessing the right of distribution cannot enjoy the right of choice. In the event both rights are controlled by one individual, it will potentially cause corruption or abuse of power. System and mechanism are mutually complementary. However, people tend to focus on the system construction while ignoring the mechanism construction. For example, when the Standing Committee of the NPC was discussing the Company Law of the People’s Republic of China , some members proposed that independent directors and the board of supervisors were overlapping, thus increasing the cost of supervision. Therefore, independent directors were not necessary. However, the author argued that independent directors and the board of supervisors play different roles. Members of the board of supervisors

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are usually representatives of major shareholders or workers, while the aim of establishing independent directors is to protect the interests of the general investors. Since the interests of the general investors would be sacrificed if the interests of major shareholders and those of workers are consistent, there must be independent directors in order to protect the interests of the general investors. But why would there be constant violations of the general investors’ interests even though China has set up the independent directors? It is because it copied foreign independent director system but failed to fundamentally solve the following institutional problems. First, the qualifications of independent directors; if the bar is set too high so that few people are qualified, it will cause that one person serves as an independent director for a number of companies and actually does not serve his function. If the bar is set too low that even people do not understand management can get the job, it will be difficult for the independent director to play his or her role as a supervisor. Second, the payment for independent directors; if the payment is low, the independent director will lack enthusiasm; yet if it is too high, it seems that the independent directors is bribed by management and become its pawn. In China, there are several cases when independent directors fail to protect the interests of public investors. Third, independent directors have to be given corresponding authority in order to protect public investors. Currently, transactions with an affiliate require the signature of an independent director. However, if the independent director cannot supervise the company’s related documents and accounts, how can he judge whether it is an affiliate transaction or not? That’s why independent directors should be given certain authority. For example, in a foreign enterprise, the independent director should be in charge of the audit committee and the income and wages committee. The independent director should closely follow the company’s internal auditing and determination of both the salaries of the top management; otherwise, the company will encounter internal auditing problems or unbalanced income distribution. Finally, there should be corresponding provisions on the duties and resigning procedures of an independent director. Currently, it is frequently seen that an independent director resigns right after a listed company meets serious operational problems. In this case, it is suggested the independent director properly clarify the responsibilities of, thus precluding the possibility of responsibility evasion. There is another case: The independent director intends to resign, for some operational problems caused by the company’s board, yet withdraw the resignation after a board’s re-shuffling. Therefore, it is insufficient

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to merely build an independent director system. We have to fix the mechanism deficiency first before building a sound institution. People who oppose the establishment of the independent director claim that independent directors do not function. That is a wrong idea. It is of great importance to perfect the mechanism, thus empowering the independent director to protect the interests of the public investors. An enterprise’s institutional innovation capability includes its ability to encourage and discipline staff, regulate the internal horizontal relationships within its employees and coordinate the innovation capability between employees in terms of objectives and actions. It is an important factor capable of determining whether an enterprise can survive and develop as an organization. Therefore, the internal innovation capability is also important to an enterprise. Complexity science regards innovation as an emergent phenomenon caused by the interaction and recombination of the existing knowledge and the individuals. It reflects the fundamental transformation of the ways of doing things in the field of science, management and business. Under such circumstances, enterprises must give top priority to developing knowledge and intelligence. Complexity scientists study the sources of producing innovation, creativity and intelligence within an enterprise through the interaction between its employees. They have found that innovations depend mainly on organizations and incentives, as well as the creation of conditions that will enable employees to communicate, integrate their group wisdom and closely follow the development trend of the enterprise. Innovations are different from inventions, which may depend on the thinking of others. Innovations are the results of collective communication and studies. Innovation is a reaction of the system to adapt to the changes of the objective environment which calls for new measures. Fresh ideas and innovations bring changes. Therefore, the institutional innovation is the core of an enterprise’s innovation capability. Only by stimulating the initiative of its staff through institutional innovations can an enterprise better achieve technological innovation and management innovation.

Innovation Capacity is the Core Innovation is the core of national development and an important factor for the survival and growth of an enterprise. Therefore, it is safe to say that the innovation capability is the core capability of a country and its enterprises. Currently, possessing this capability to make independent innovations is essential for adapting to the rapid changes of the objective environment. The first important change is the emergence of the knowledge economy

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and the knowledge-based society. The OECD once published a book entitled The Knowledge-based Economy , in which it proposed an idea of “knowledge economy,” which was defined as an economy based on knowledge and was different from the capital-based industrial economy. The author holds that the knowledge economy has the following four characteristics: First, knowledge-based industries take up a dominant proportion in the industrial structure. Second, knowledge plays a leading role in the economic growth. Third, knowledge has a crucial influence in the composition of productive forces. And fourth, knowledge-related expenses account for a significant proportion of total costs. From the viewpoints of the fictitious economy, knowledge capital belongs to fictitious capital, which, though invisible with an uncertain value, is becoming more and more important. Knowledge capital includes patents, proprietary technologies, brands and standards, etc. From the development process of many countries, it has four levels in general: exporting agricultural products, ore products and other primary products; exporting finished products; exporting capital; and exporting knowledge. The evolutionary trend may be seen in the development history of economic globalization. It is well-known that costs could be divided into labor costs, capital costs and the costs of materials (including raw materials, fuels, etc.) or into variable costs and constant costs. However, the economic onward marching shows the importance of intellectual properties. The share of knowledge-related costs, such as brand royalty, patent fees, fees for using technologies and technical services fees, has been increasing. Of the technologies currently introduced, such costs may account for 20% to 40%. For certain high-tech projects, the cost for introducing the software even exceeds that of the hardware. For example, considering microelectronic technologies, the raw materials cost much less than the precision processing techniques. Exporting knowledge may create more job opportunities and bring more revenues than exporting commodities. Since the marginal cost of the repetitive application of knowledge is low, the higher the technical contents in the export products, the greater the actual profits. Mobile phones are developing fast in China. It is reported that by the first half of 2008, the mobile phone users in China exceeded 600 million. In the era dominated by digital and analog mobile communication, China developed more than six million mobile phone users and cause at least RMB250 billion flowing to foreign manufacturers. For the second development stage of the mobile communication, domestic manufacturers took up a modest share of 5% in China’s enormous GSM equipment market, and nearly RMB500 billion flew overseas through operators. With development of the mobile communication, who controls the standards

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gets an upper hand. 3G (the 3rd generation) mobile phones are the development direction in the future. Currently, there are three standards: WCDMA, CDMA 2000 and China’s TD-SCDMA. Despite the insufficient development of China’s TDSCDMA standards, the author believes that they may be adopted globally in the future, or at least play a role in China’s domestic market. It is safe to say that in the future, there will be two types of countries in the knowledge society: the brain countries that produce and export knowledge and the body countries that import and use knowledge. Currently, competition between nations is superficially determined by economic strengths, which are backed up by the technological strength, whereas the core of technological strength lies in the innovation capability of talents. If China lacks talents competent of leading technological, management and institutional innovations, China will definitely lag behind the world. The author has repeatedly proposed to cultivate professional managers, instead of excellent scientists and engineers, to get ready for the future international competition. An excellent professional manager should be equipped with professional horizons, broad subject territories and a philosophical foundation, and strategic visions. Only those people with for-dimensional knowledge structure are able to undertake the important task of bringing independent innovations. China is now facing severe tests in terms of the innovation capability. For example, it lacks experience in the operation of fictitious economy; by the first half of 2008, the foreign exchange reserves in China had exceeded USD1.8 trillion, a large part of which was used for purchasing foreign bonds. Actually, China was lending money to foreign investors who only needed to pay meager bond interest to China after making profits. Therefore, the author wonders that of all foreign capital invested in China, part of which might originate from our country. However, China dared not to operate these money due to the lack of experience in operating the fictitious economy. Therefore, the capital then flowed to purchasing foreign bonds, which cause losses in a vicious circle. Considering the trade with foreign countries, most China’s exports are lowend products, while quite a lot of its imports are high-end products. The price difference between the two is enormous. For example, China has to trade 800 million shirts for an Airbus. The author once heard a U.S. congressman crying foul that all ships from China to the U.S. were fully loaded, whereas those from the U.S. to China were almost empty. How severe was the trade imbalance between China and the U.S.! Later when I was delivering a speech in the U.S., I told them it was no surprise, because China sold shoes, shirts, toys, etc. to the U.S., which required ocean shipping; while the U.S. sold chips, software etc. to China, which required air transportation.

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China is the world’s factory in computer production. However, it uses the chips from Intel and AMD and most software from Microsoft. For each computer produced, China has to pay related fees for importing chips and software. So in a certain sense, those Chinese enterprises engaged in the computer production are overseas factories of those leading manufacturers. China is also the world’s powerhouse in the manufacturing and exporting DVD players; however, Chinese enterprises do not possess core patented technologies in video, audio, etc.; and that is why 4C Association, 6C Association, Thompson and Moving Pictures Experts Group successively claim patent fees. It is reported that from 2002 to 2006, institutions and agencies which collected patent fees from Chinese DVD manufacturers increased from RMB1 to RMB37 and the fee had also increased from the original USD5 per set to USD20, accounting for about half of the selling price. Moreover, the patent fee was collected based on the export standards, which might consequently cause China’s DVD enterprises gradually losing their brand awareness. We should admit that China’s currently high dependency on foreign technologies which would linger in a longer run. In recent years, China’s foreign trade turnover accounted for more than 60% of its GDP, indicating a high dependency on foreign trade. China’s GDP in 2008 reached USD3.37 trillion, of which USD2.17 trillion was contributed by foreign trade; and its foreign exchange reserves accounted for nearly 50% of its GDP. However, problems occurred behind the scene. The Chinese worker ’s average hourly wage is only USD0.5, yet his/her U.S. and Mexican counterparts were making USD16 and USD4 per hour, respectively, so foreign companies are willing to invest in China due to a much cheaper labor force and a greater profits. China’s low commodity price cannot be misinterpreted as a low living standard. With the economic development in China, wages of Chinese workers will keep increasing. Moreover, Chinese manufactures products for export by consuming a large amount of raw materials and fuels. China’s GDP accounts for only 5% of the world’s total, yet China consumes 7% of the world’s petroleum, 20% of the world’s iron and steel and nearly 40% of the world’s cement, which is inevitable at the present stage. However, China should gradually improve its industrial structure through independent innovations in order to achieve a new type of industrialization.

Creating an Innovation-Friendly Environment To construct an innovation-oriented country, China must create an innovationfriendly environment. The author comes up with five measures.

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First, develop education. Since the competition basically relies on the innovation capability of talent, thus a sound educational system is absolutely necessary. In an interview with Central Education TV in 1999, the author said that the economy guarantees a short-term growth; science and technology promotes medium-term expansion, but education determines the long-term prosperity. Education improves the ideological, cultural, moral and scientific qualities of the general public on the one hand while cultivating talent with innovation capabilities on the other. Second, push forward venture capital investment and achieve a combination of financial capital and knowledge capital. Without the support of financial capital, it will be impossible to truly convert innovations into technologies, products and productivity to make profits. Venture capital investment is the combination of knowledge capital and financial capital, or a new investment mechanism. The investment capital should be separately put into a number of projects so as to hedge against losses. The author believes that venture capital investment can grow only when 1) it is located near capable S&T institutions, colleges and universities, sources of knowledge all; 2) there are enterprises with a better industrial foundations and the desire to innovate; and 3) it receives government supports. Third, create a legal and policy environment favorable to innovations. Studies have to be conducted in legislation and policy-making. The legislative process serves to guarantee the laws to be systematic, fair, scientific and progressive. A great number of laws have to be revised based on specific situations. For example, after implementing the Law of the People’s Republic of China on Science and Technology Progress for 15 years, China revised it based on the need to build an innovation-oriented country. The author also advocates formulating Law of the People’s Republic of China on the Promotion of Venture Capital Investment . When developing policies, more attention should be paid to the fact that no policy is flawless, and all policies are the results after weighing the pros and cons; a policy can be adopted as long as merits overweigh demerits; the policy-making process is in line with certain political and social requirements, which is subject to further revision. Fourth, cultivate an innovative culture. The priority should be given to cultivating values that encourage exploration. Most people often do not recognize or even object to a new concept when it is initially proposed. The author used to meet with such cases when serving as the director of the Department of Management Sciences, National Natural Science Foundation of China. For some projects, two experts voted yes, three voted no. If following the original practice, such projects would have failed to be approved. Some

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of them, however, were truly innovative. Therefore, the author decided to set up a special category named “non-consensus projects,” which would be submitted independently for examination. It later turned out that the number of the approved projects doubled. An innovation at its birth cannot be easily recognized by all people, so we have to cultivate values that encourage people to explore. We have to support those explorations, tolerate failures and never judge anything by its short-term performance. In addition, we should cultivate entrepreneurship and integrity and establish an environment for brainstorming. Finally, create an innovation support system. Such systems include the information system, aiming at enhancing the exchange of information through holding forums, publishing books and journals, establishing websites and setting up associations; and the training system, which requires the establishment of relevant disciplines, postgraduate and PhD programs, as well as the launch of various types of training courses.

Empowering Enterprises to Become the Mainstay of Innovation To construct an innovation-oriented country, China must empower its enterprises to become the mainstay of innovation. At the National S&T Conference in 2006, China highlighted this point. The newly-revised Law of the People’s Republic of China on Science and Technology Progress authorized the establishment of a technological innovation system taking enterprises as the mainstay, the market as the development direction, and the combination of production, education and research as the basis. However, empowering enterprises to truly become the mainstay of innovation faces enormous obstacles. Currently, only 0.3‰ of the Chinese enterprises own independent intellectual property rights and most Chinese enterprises cannot be regarded as the mainstay of innovation. It is mainly because the planned economy for years dominated China, under which production activities of the enterprises were pre-scheduled by the planning department, thus eliminating the innovation capabilities of enterprises. As for the enterprises leaders, they care first about maximizing their achievements during their tenures instead of pursuing long-term development. Therefore it requires enterprise operators and managers to be insightful and have strategic visions. To allow enterprises to become the mainstay of innovation, China should first carry out institutional reform and innovation, which requires it to change

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the existing R&D model. Under the planned economy in the past several decades, the R&D model in China basically took after that in the former Soviet Union, namely the so-called “science-driven model.” That is, innovations relied on achievements and researchers from research institutes, colleges and universities before seeking enterprises for application. Those enterprises were then responsible for the production and marketing. Somewhat effective, though this model faced many uncertainties. For example, whether the enterprise is willing to try the innovation, whether the market is willing to accept the product, and so on. So we should rely on a demand-driven model to empower the enterprises as the mainstay of innovation. The demand-driven model requires enterprises to study the market and determine the R&D direction based on market demands before inviting research institutes, colleges and universities to carry out R&D activities. R&D achievements in this model can soon be converted into products and productivity and produce practical effects. Only with this model can enterprises lead the innovation. Meanwhile, we should also give full play to the educational institutions and research institutes. The key to making enterprises the mainstay of innovation is to guarantee innovations are originated neither from foreign literature nor from ideas of researchers, but from market demands. An enterprise’s sensitivity to market demands is mainly reflected in its ability to upgrade old products and develop new products in line with the actual needs. For example, the nylon developed by DuPont was initially used for producing parachutes and silk stockings. It was later used as warp in 1945, tire cord fabric in 1948, swollen cotton yarn in 1955 and carpet yarn in 1959. All these changes enabled DuPont to have a long-lasting market, extended its lifecycle and generated continuing profits. Take another example, the production of mobile phones catered to the increase in business connections and the development of multinationals. An enterprise’s sensitivity to market demands is also reflected in its ability to see the prospects of a new technology or product, grasp commercial opportunities as soon as it emerges and dominate the market. For example, IBM saw the prospects of chip technology early in the 1960s. Later, it resolutely invested USD5 billion to develop the second generation “360” series computer products using chips to replace transistors, aiming at improving the computational speed and reducing the cost. Its efforts paid off four years later. Since then, it had maintained a leading position in the market for nearly 20 years. Yet, the company lost a golden business opportunity by refusing to purchase the patent of “914” copier produced by Xerox in the late 1950s. It miscalculated that copiers could only replace the market of copy paper and

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stencil paper, failing to realize that the birth of copiers would create substantial market demands. Improving the technological innovation capability can enable an enterprise to create its own intellectual property rights, produce products that are hard to duplicate, and help enhance its market competitiveness and gradually strengthen its core competence so as to achieve innovation-based intensive development. Core competence is a concept put forward by C. K. Prahalad and G. Hamel in 1990. They found that due to rapid market changes and the increasingly fierce competitions, an enterprise couldn’t maintain sustainable development with only an average technological innovation capability, so it had to propel and integrate technological innovation, technological cooperation and technology introduction in order to foster its core competence. Like a big tree, the core products of a multi-layered enterprise would function as the trunks, while business departments the branches, all terminal products the leaves and its core competence the root, of the tree responsible for absorbing nutrients and buttressing the tree. Therefore, the enterprise leadership must have the ability to identify, cultivate and manipulate its core competence to seek for greater growth, and must be able to integrate all technical sources of the enterprise into the ability to liven all enterprise businesses adapting to the ever-changing opportunities. To allow enterprises to become the mainstay of innovation, we have to give enterprises a leading role in R&D programs, in capital investment, in benefitsharing and risk-taking, all of which need policy supports from all aspects. According to statistics, of the approximately 30,000 provincial and ministeriallevel technological achievements each year in China, only 15% to20% can be converted into products and less than 5% can finally foster an industry, which behooves China to closely investigate the market demands and empower the enterprises to set their R&D direction. Capital investment in the enterprisefriendly R&D projects is the manifestation of enterprises as the mainstay of innovation. Of course, national supports are also needed in this course. After becoming the mainstay of investment, enterprises should also play an important role in benefit-sharing and risk-assuming, thus requiring China to introduce institutional and management innovations to help the Chinese enterprises to gradually become innovation makers. However, it requires great efforts and in particular government supports. For example, R&D expenditures of an enterprise will be included in the production cost, so are the expenditures of joint R&D activities carried out by the enterprise, educational institutions of higher learning and research institutes. All these costs should enjoy preferential

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policies. Currently, the ratio of R&D expenditures of a Chinese enterprise in its total sales volume is much lower than that in developed countries, which is a main obstacle that restraining enterprises from making innovations. Of course, enterprises shall make innovations in line with their capability. After all, there are capital restrictions, R&D capability limitations, etc. If making innovations costs too high, it may need a great amount of investment that is beyond the affordability of the enterprise. Therefore, enterprises have to set targets in line with their capability yet make great efforts to achieve the targets once they are set.

Learning Organizations are the Basis of Innovation-Oriented Country Learning is a process of people constantly understanding the objective world and adapting their behaviors to it. However, some people narrowly define it as a process of acquiring knowledge and absorbing information. Since the objective world is in constant change, people have to take learning as the process of understanding this ever-changing world and adapt to it in reality. The author once pointed out at an S&T conference that an innovationoriented country at the macro-level must be based on various learning organizations at the micro-level. The concept of the “learning organization” was put forward by Peter Senge of Massachusetts Institute of Technology. In his book The Fifth Discipline , Senge proposed five disciplines necessary for creating a learning organization: 1) Systems Thinking —people have to first observe the problem, understand the inter-relationships between different parts and find the determinant factor; 2) Personal Mastery —fosters the personal motivation to continually learn how our actions affect our world; 3) Metal Models —focus on the openness needed to unearth shortcomings in our present ways of seeing the world; 4) Building Shared Visions —fosters a commitment to the long term; and 5) Team Learning —develops the skills of groups of people to look for the larger picture beyond individual perspectives. The concept of learning organization is very important, too. Since an organization is a complicated dynamic system, people are required to analyze it. A learning organization is an organization that keeps learning and innovating. The key lies in the driving force for innovations and constant personal mastery. In a learning organization, everyone has to treat learning as a lifelong commitment in order to pursue a self-development in the coming

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knowledge society. The learning involves three levels: The first level is individual learning. In a learning organization, each member must learn knowledge consciously. The motivation of learning comes from ambitions, the sense of responsibility and the thirst for knowledge. Ambitions and personal mastery will urge people to work hard and never rest on current situation. The sense of responsibility requires people to learn workrelated knowledge in order to have a better performance. With the thirst for knowledge, people would like to learn new things and absorb new knowledge. The second level is group learning, the core of which is the intercommunication and mutual inspiration between group members. These are very important for creating innovations. As the complexity science go, innovations do not rely on the intelligence or wisdom of individuals, but some new ideas and practices produced by organization members as a whole through communication and discussions. To this end, an environment capable of enabling idea exchange and discussion should be created. Only through conducting a sound and efficient individual and group learning process so that the third level—organizational learning—can be smoothly promoted. In the course of constructing a learning organization, some problems will occur: First, addressing problems on an ad hoc basis. It refers to some people who never reflect on the reasons for a problem, but take the stop-gap measure without considering its side effects. Second, complaining about the objective environment. It refers to shifting the blame to objective environment with no self-introspection. Third, be subjective and arbitrary. Fourth, pay too much attention to details. Detail is important, but it will produce adverse effects when paying too much attention to it. For example, when an individual used to be engaged in S&T activities becomes the leader, he or she should not pay too much attention to the details of the issues relating to his or her own profession, but widen the vision on company’s overall strategies. Fifth, reluctant to make progress. It refers to individuals who are obsessed with past achievements and insensitive to the changes of the objective environment. It is a major obstacle to sustainable innovation of many organizations. Sixth, rely too much on experience will wear off people’s willingness to learn new knowledge. Seventh, internal power struggles will often affect the construction of a learning organization.

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Eighth, conceal contradictions will exacerbate the problem. “By others’ faults, wise men correct their own.” Some principles put forward in The Fifth Discipline may serve as our reference when we construct learning organizations. The author hopes that people can push forward the learning organizations so as to lay a solid foundation for China to achieve its grand objective of building a new-type innovation-oriented country. Completed on July 31, 2008

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Chapter

Institutional Innovation—The Core of Reform

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

President Hu Jintao pointed out in his report to the 17th NPC that “the

orientation and path of reform and opening up are entirely correct, and their merits and achievements can never be negated. To stop or reverse reform and opening up would only lead to a blind alley.”

During the 10 years of turmoil during the Cultural Revolution, the Chinese

economy was on the verge of collapse; per capita income stagnated for 10

years. It was at the 3rd Plenary Session of the 11th NPC that launched the

reform and opening up and made an important decision vital to the destiny of contemporary China.

The word “institution” has been widely used in recent years, despite of

different understandings toward the nature of “institution.” It is generally

believed that institution refers to a set of rules and norms that provide certain

working procedures for people to follow. The academic circles believe that institutions are political, economic and cultural systems formed under certain

historical conditions. The school of institutional economics emerging in the United States in the early 20th century focused on studying institutions and

analyzing the role of institutional factors in social and economic development. This school advocated that the organization and control of economic systems

were more important than resource allocation, income distribution, income level and commodity prices. Therefore, it highlighted the enormous role of social, historical, political, psychological and cultural factors in the social and

economic life, as well as proposed to adopt institutional analysis and structural analysis.

The author used to employ the complexity science to analyze institutions,

believing that an institution should include two aspects—system and

mechanism. System refers to the state and structure of the institution at a specific time, while mechanism refers to the process and driving force of the evolution of the institution. System and mechanism are mutually dependent. System is the starting point and the result of evolution, while mechanism is the path. The interaction among institutional agents and that between the

institution and the external environment will produce a self-organization effect

inside the institution, form the institutional layer and functional structure, and push the institution forward in a certain direction. Since institutions

are dynamic, it is far from being enough to study it simply relying on static structural analyses, such as power analysis, interest group analysis, normative analysis. As the famous institutional economist D.C. North once pointed out: “The world we live is dynamic; the theories we proposed are static.”

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Four Characteristics of China’s Reform First, it is a top-down approach. China’s reform in the past more than three

decades is the institutional innovation led by the CPC. For example, at the initial stage of reform and opening up, China implemented the household contract responsibility system which greatly liberated productive forces in rural areas and promoted agricultural development, established the capital market, which

later served as the platform for investment and financing, pushing forward the growth of the non-public sectors of the economy. And by formulating

polices on the active introduction of foreign investment, the country not only

replenished the shortage of construction funds but also improved its technical and management skills. The CPCCC put forward the scientific outlook to

achieve balanced, coordinated and sustainable development at the beginning of the 21st century. With a substantial growth of China’s economic strength, the

CPCCC stressed on guaranteeing the social equity and improving the living standard of rural residents and the disadvantaged urban residents. The Chinese government is pushing forward the institutional innovation of public services,

intensifying educational, scientific and technological reforms, and strengthening the institutional construction of the social security and management, etc. All of these important institutional innovations further propel China’s reform.

Second, it is a modest development. China’s reform is not as radical as that

in the former Soviet Union or East European countries but is based on China’s

national conditions, the public affordability and the stage of economic and social development. It is carried out in phases. Therefore, China is capable of maintaining rapid economic and social development and basic social stability during the reform.

Third, China’s reform is progressive. At the initial stage of reform, China

had no experience and had to “probe its road ahead just like crossing the river by reaching for the stones.” To be sure, after making some achievements and

getting some experience, China may find better ways. After a slew of reforms during the past three decades, the relationship between the government and the market has been changing gradually since the implementation of the rural

household contract responsibility system. It carried out the initial reform of

its planned economic system, taking the planned economy as the mainstay

and market regulation as the supplement during 1978–1983, committed to establishing a planned economic system capable of applying the law of value

consciously and to developing socialist commodity economy during 1984–1988;

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further deepened the reform of the planned economic system, substantially

reduced mandatory planning and made guidance planning the main form of planning during 1989–1993; and succeeded in transiting to the social market economy since 1993. Fourth, China’s reform features path dependency, akin to a chess game. Each step taken will influence the following several steps. With one inappropriate step, the several steps that followed will be tough. For example, in October 2001, the Chinese Government at the time launched a policy of underweighting stateowned shares at the market price so as to enrich the social security funds. Despite being a good will gesture, the policy was questioned by the general public. Stateowned shares were non-negotiable at the time while the price of circulating shares was high due to investors’ speculations. To reduce the holdings of state-owned shares at the market price would absolutely cause significant rebound. The policy was later abandoned, though it became the fuse to keep the market expanding for the next consecutive years. The case indicated that the reform process is indeed complicated and path-dependent. Each measure taken will impose great impacts on the following reforms. Therefore, we have to carefully ponder any move or measure before its adoption and obtain experience by launching pilot programs. Currently, the reform in China has reached an advanced stage, where a lot of contradictions call for prudent solutions. The author believes that China has to carefully handle the relationship between the rule of law and the rule of man, between equity and efficiency, between the government and the market and between power centralization and decentralization.

Relationship Between the Rule of Law and the Rule of Man The rule of law and the rule of man are two diametrically opposed concepts. Simply speaking, the rule of law is the governance of a country by the ruler in accordance with the law. It requires a legal system (legislation) and the compliance of all social members, including the leader. While the rule of man is the governance of a country by the ruler on his own will. It needs a ruler whose authority is acquired through some approach (e.g. “divine right of kings”) and the obedience of all of the ruled. In the Chinese feudal society that lasted more than 2,000 years, the emperor of each dynasty had supreme authority and the concept of “the rule of man” was deeply-rooted. Although China made great efforts in constructing its legal system since the founding of People’s Republic in 1949, “the rule of man” has still

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been playing a decisive role in China’s political life due to the influence of the traditional feudal ideology, thus finally leading to a 10-year catastrophic Cultural Revolution. After the reform and opening up, Deng Xiaoping once expressed in clear-cut terms: “Feudalism dominated our country for thousands of years while socialist democracy and socialist legality are still lacking. We are now working earnestly to cultivate socialist democracy and socialist legality. Only in this way can we solve the problem.” The Chinese academicians launched into a hot debate on the issue of the rule of law and the rule of man in early 1980s, focusing on the definitions of the rule of law and the rule of man, their respective advantages and disadvantages as well as the conditions of achieving the rule of law in China. Although the rule of law was to be preferred to the rule of man, some scholars still believe that the rule of man developed in China in history formed its own characteristics, so they advocated the combination of the rule of law and the rule of man. The author here holds that “the combination of the rule of law and the rule of man” seems plausible. However, a sound rule of law relies mainly on a complete and mature law system, whereas a sound rule of man relies mainly on a wise ruler. It is obvious that chances of having the former condition are more than those of the latter. What’s more, even a wise ruler would make serious mistakes. Besides, legislation is the process of converging collective wisdom and coordinating the interests of all parties concerned, while law enforcement has to be in compliance with laws, which is fundamentally different from the rule of man. Moreover, in reality, the rule of man and the rule of law partially overlap. As Carl Kohen pointed out, the most fundamental difference that distinguish between the rule of law and the rule of man is whether the authority of the law would prevail over man’s will when the two were in conflict. The strategy of ruling the country by law was put forward at the 15th NPC held in September 1997. “Ruling the country by law means that the broad masses of the people, under the leadership of the Party and in accordance with the constitution and other laws, participate in one way or another and through all possible channels in managing state affairs, economic and cultural undertakings and social affairs, and see to it that all work by the state proceeds in keeping with law, and that socialist democracy is gradually institutionalized and codified so that such institutions and laws will not change with changes in the leadership or changes in the views or focus of attention of any leader.” In the Amendment to the Constitution of the People’s Republic of China adopted at the 2nd Plenary Session of the 9th NPC in March 1999, it was provided in clear-cut terms that “the People’s Republic of China governs the country according to law and makes it a socialist country ruled by law.”

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Ruling the country by law requires the country to manage all of its political, economic and social activities in compliance with the law instead of allowing the interference of any man’s will. Then-president Jiang Zemin pointed out in the report to the 15th NPC that “ruling the country by law is the basic strategy employed by the Party in leading the people in running the country. It is also the objective demand of a socialist social market economy, an important hallmark of social and cultural progress, and a vital guarantee for the lasting political stability of the country.” The reform and opening up has contributed to China’s transition from the rule of man to the rule of law. The strategy of ruling the country by law might answer the question of “whether the Party or the law prevails.” That is, the Party’s will can be made the national will only in the form of law through statutory procedures which then must be obeyed by all of the other parties and all individuals. However, in actual implementation, contradictions frequently appeared between the rule of law and the rule of man. Therefore, China has to continue pushing forward the rule of law so as to eliminate the feudal remnants of the rule of man. The constitution, which is the fundamental law and the basis of a constitutional government, is the cornerstone of ruling the country by law. The constitutionalism embodies the following meanings: 1) the government has to be constrained by the constitution and must perform its governance in accordance with the terms of the constitution; 2) the government under the ruling of the constitutionalism is essentially the minimum government in a free country according to the social compact theory, which stated the people’s willingness to establish the government is to ensure their interests of life, health, freedom, properties and other rights; 3) constitutionalism possesses a superior value that its rights comes prior to the constitution, the society and the government; and people enjoy the natural rights without being endowed by any other individual; 4) constitutionalism is a set of institutional designs for constructing a limited government. It means that the power of the government is empowered by its people, thus should in turn serve its people; 5) some technical requirements in realizing the constitutionalism are basically depicted by the theory of the rule of law. For example, the constitutionalism also requires the judicial authorities to exercise the judicial power independently so as to prevent the government from deviating from the provisions of the constitution and the rights of the people; and 6) constitutionalism and the rule of law have almost the same pursuit of values, namely the achievement of democracy, freedom, order, etc. In recent years, China has revised its constitution for many times to make

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it more complete. In the most recent revision, China included the protection of private properties and human rights into its constitution. However, it is an extremely serious problem that people fail to recognize the fundamental role of the constitution in its implementation. Breaching of the constitution is the worst violation of law, yet China hasn’t established the authority of the constitution. With regards to this, China should further examine the laws, regulations and policies formulated by departments or governments, ensure them to be in accordance with the constitution and revoke those unconstitutional ones. For the implementation of rule by law, priority should be given to the administrative aspects, guaranteeing the administration is conducted by law, or in other words, the administration of government officials is conducted by law. Because rights of government officials are superior to those of ordinary people, whether or not government officials can conduct administrations in accordance with law is extremely important. The CPCCC has repeatedly stressed that the administration by law is exactly the administration of government officials by law. Only through conducting a transparent and sound administration of government officials in accordance with law can China truly implement its strategy of ruling the country by law. Laws are constraints that regulate not only the behavior of the people but also that of government officials. It is crucial to ensure that the laws are observed and strictly enforced and lawbreakers will be prosecuted. In particular, the country has to crack down on and eradicate corruption, the collusion between government officials with businessmen, the practice of trading power for money and other malpractices so as to build an honest and diligent government. Some phenomena are worth pondering. For example, some foreign businessmen and figures engaged in non-public economic sector expressed their problems to the author and repetitively told the author not to “inform” the local government, but simply pinning their hopes on formulating relevant laws. The reason for these “gag orders” was that if the author “informed” local government officials of the problems, they would wipe out those enterprises relentlessly. There is another example. An entrepreneur once saved an enterprise from the verge of collapse and made a remarkable turnaround. However, local government interfered with coercive measures to dismiss the entrepreneur and returned to him merely his original investment capital. When the author worked in the NPC, similar problems occurred almost every day, indicating that the rule of law was yet to be improved in China and government officials were arbitrary in the discretion of a great number of issues. As pointed out by Deng Xiaoping, “the centralized leadership often turns into the reign of some individuals, which is a problem existing in local governments at all levels in China.”

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It is well known that corruption is a problem severely hindering China’s development. On the one hand, corruption is a huge waste of social resources that turns public properties into personal belongings; on the other, corruption will tarnish the government’s image and weaken the authority of the rule of law. Although the CPCCC has taken measures to tackle the problem and punish corrupt individuals, it must rely on the rule of law if it wants to root out corruption. Rousseau believed that power led to corruption and absolute power led to absolute corruption; corruption is in nature the abuse of power due to personal will. Locke believed: “…it may be too great temptation to human frailty, apt to grasp at power, for the same persons who have the power of making laws to have also in their hands the power to execute them, whereby they may exempt themselves from obedience to the laws they make, and suit the law, both in its making and execution, to their own private advantage, and thereby come to have a distinct interest from the rest of the community, contrary to the end of society and government.” Despite the fact that China has already established the people’s congress system, clearly defined as the supreme authority with the legislative power and the power of supervision for the Chinese people to exercise their rights and playing an ever-important role in China’s political life, some legal provisions are still vaguely established, or even with clear indication as “subject to the specific measures of the State Council.” Moreover, government departments and local governments possess the power to formulate their own regulations and policies as “official documents,” thus centralizing the power of legislation and execution and making it possible for them to pursue private benefits, which in all likelihood will develop into corruption. Therefore, in the course of legislation, the NPC should pay attention to their enforceability and the balance between power, responsibilities and obligations. That is to say, when granting power to law executors, we have to clarify the corresponding responsibilities they should assume; while setting the obligations of the legal counterparts, we have to empower them with the rights they should enjoy and require government officials to act by law and downplay the right of discretion. Regulations and policies formulated by government departments and local governments, as well as the written and oral instructions from higher authorities, should all be based on the law; any inconsistency with the law must be corrected. The guarantee for ruling the country by law is the maintenance of the CPC’s leadership. The Party and its people collectively formulated the constitution and other laws to confine and restrict their activities. Ruling the country by law

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ensures, both institutionally and legally, that the Party’s policies and development direction are carried out smoothly and that the Party serves as the core of the leadership at all times. The prime responsibility of the CPC is to put forward major instructive suggestions on China’s development and to select Party members to hold important government positions. Since most of the members of the NPC at all levels and their standing committees are Party members, the rest are composed of politically-unaffiliated figures and members of the parties participating in the administration of state affairs. As long as it is a collective decision made by the ruling Party, its proposals would be turned smoothly into the will of the country through legal procedures and made into specifications with which all parties and the Chinese people must comply. Any candidate recommended by the Party would be appointed government official through legal procedures and be taken under supervision. In doing so, China can effectively combine its leadership of the Party, the mastery of the country by its people and the rule of the country by law. Ruling the country by law requires the strength and awareness of the entire Chinese people. It is far from being enough to simply rely on the supervision of relevant departments. It needs the supervision by the masses and democratic supervision, including the supervision by the CPPCC, the democratic parties and the masses in the forms of writing letters, paying visits, and the public media. The author has paid special attention to the role of the media as an effective supervisor. At a Greater China conference, he pointed out that the role of the media should be “enlightening, innovative, pragmatic and realistic.” The author also holds that for various reasons, there is a gap between the status quo of the Chinese media and the above expectations. However, the supervisory role of the media is extremely important. Cases like dispatching the police force to Beijing to catch journalists who wrote articles critical of local governments must be stopped resolutely.

Relationship Between Efficiency and Equity A sound relationship between efficiency and equity can help ease many problems China currently encounters and secure a sound economic development and social harmony for the future. Opinions vary in terms of the relationship between efficiency and equity. According to Fu Yao, there are six representative opinions in the Chinese academic circles. 1) Giving priority to efficiency with due consideration to equity. Giving

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priority to efficiency is the basis of giving due consideration to equity. 2) Efficiency and equity should be dialectically unified. Efficiency is the premise of equity, while equity is the guarantee of efficiency. The improvement of efficiency helps the realization of equity. Social equity helps improve the efficiency. 3) Equal attention should be given to efficiency and equity. The scientific outlook of development requires more attention to be paid to equity in the pursuit of efficiency and development. 4) Market controls efficiency, while the government controls equity. The government should give full play to the efficiency of the market in resource allocation while strengthening the macro-economic control in order to narrow the income gap and to achieve relative equity. 5) Giving priority to equity with due consideration to efficiency. The government has to stimulate the initiative of the people and improve the efficiency with due consideration to efficiency. 6) Giving priority to efficiency while promoting equity. Giving priority to efficiency is an inherent requirement of the socialist market economy. Deng Xiaoping’s proposal of the socialist market economy has the guided China to handle the relationship between efficiency and equity at the present stage. That is to say, on the one hand, China has to utilize the socialist market economy to pursue rapid and efficient economic development, and combine useful experience and practice, advanced modes of business operations and management techniques of capitalist nations with its own national conditions. That has given birth to venture capital investment, joint-stock companies, capital markets, futures, etc. Yet, on the other hand, China has to adhere to and improve its socialist system to secure social equity, in particular the legal rights and interests of the disadvantaged groups. Efficiency and equity are contradictory yet complementary. Focusing more on efficiency than equity will widen the gap between the rich and the poor and undermine social stability, which in turn will lower the overall efficiency; however, if overemphasizing equity will reduce rather than develop social productivity, and fail to meet people’s growing material and cultural demands. Therefore, it is necessary to strike a balance between the two. Since the reform and opening up, the guiding principles of handling the relationship between equity and efficiency in the economic sector have generally experienced three phases. Phase 1: Giving equal attention to efficiency and fairness. Aiming at egalitarian treatment in terms of income distribution existing in the planned economic era, the report to the 13th NPC in 1987 pointed out that income

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distribution policies “have to be conducive to allowing well-managed enterprises and honest workers to get rich first, thus rationally enlarging the income gap, yet preventing the polarization of the rich and the poor, ultimately pursuing the common good, and demonstrating social equity under the premise of promoting the efficiency.” In the report to the 14th NPC, it reads, “the distribution system should take distribution according to work as the mainstay and other modes of distribution as the supplements, and should give due consideration to efficiency and fairness.” Phase 2: Giving priority to efficiency with due consideration to fairness. Considering that productivity in China was low and that China urgently needed to improve the efficiency of economic development, the 3rd Plenary Session of the 14th NPC held in November 1993 adopted Decision of the Central Committee of the Communist Party of China on Several Issues Concerning the Establishment of the Socialist Social Market Economy, in which it put forward, “personal income distribution shall take distribution according to work as the mainstay, allow the co-existence of multiple modes of distribution, and reflect the principle of giving priority to efficiency with due consideration to equity. A competitive mechanism should be introduced into individual remuneration of laborers so as to break egalitarianism, implement ‘more pay for more work,’ rationally enlarge the income gap, and allow personal capital and other personal production factors to get involved in income distribution.” Phase 3: Proper handling the relationship between efficiency and equity. In September 2004, the 4th Plenary Session of the 16th NPC deliberated and adopted the Decision of the Central Committee of the Communist Party of China on Enhancing the Competence of the Party as the Core of Leadership , in which it proposed to “correctly handle the relationship between the distribution according to work and a variety of distribution methods, encourage some areas and people to get rich first, pay attention to social equity, rationally adjust the distribution pattern of national income, take effective measures to solve income gap which may be too large among different areas and some social members, and gradually achieve common prosperity for all people.” In October 2007, President Hu Jintao proposed to “combine efficiency with social equity,” “a proper balance will be struck between efficiency and equity in both primary distribution and redistribution, with particular emphasis on equity in redistribution” and “increase the share of work remuneration in primary distribution.” The author holds that when dealing with the relationship between efficiency and equity, we must strike a balance between the two and avoid using one inclination to replace the other. At present, China should pay special attention

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to correctly understanding the meaning of equity and the relationship between efficiency and equity. Equity involves two aspects—justice and equality, which are mutually connected, yet different. Justice means that the legal rights and interests of social members should not be violated or damaged, while equality means that all social members should have the same opportunities for self-development and should enjoy their due share of income. Justice should guarantee the equality of everyone in compliance with the law, while equality is conducive to the construction of social equity that is to the satisfaction of most people. Under the premise that “in light of the basic reality that China is still in the primary stage of socialism and will remain so for a long time to come has not changed, nor has Chinese society’s principal contradiction—the one between the ever-growing material and cultural needs of the people and the low level of social production,” primary distribution has to be efficient and enable those creative and diligent individuals to become rich first by adhering to the principle of “distribution according to work,” in which distribution should be carried out in accordance with the quantity, the quality and the supplydemand relationship of labor and all production factors should also be taken into account according to their respective contributions. Besides, China has to curb the inclination of egalitarianism in primary distribution. Should equal treatment be adopted in primary distribution, it would undermine the role of primary distribution in encouraging people to make innovations and start new businesses. Unduly emphasizing equity in enterprises and unrealistically increasing the wages without corresponding improvement in labor productivity would eventually cause losses, even bankruptcy. The primary distribution therefore should be market-driven. The government should never directly interfere with the internal distribution of enterprises, but adjust such distribution, when needed, by setting the minimum wage standard and improving the system of labor force employment through legislation. Some people hold that China’s widening income gap is the result of overemphasizing efficiency in the primary distribution. The author disagrees. At the present stage, the income gap caused by the distribution system in which takes distribution according to law as the mainstay and allows the co-existence of various distribution methods is necessary and basically rational. The improvement of efficiency will accelerate the improvement of the system and the increment of the share of work remuneration in the primary distribution. The irrationally high income caused by corruption, rent seeking and smuggling should be eradicated; while equity also is not the reason for us to support lowincome indolent dwellers.

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Inborn deficiency, environmental differences and uneven opportunity

distribution would produce some low-income earners, even some

disadvantaged groups. It is when government-led secondary distribution (redistribution) to guarantee social equity by differentiating taxes, transferring

payments and improving the social security system. For example, most China’s rural residents receive less education or fewer business opportunities due

to backward production mode and low labor productivity, resulting in rural

residents earning only about a third of what city dwellers do. Therefore, the Chinese Government should make efforts to gradually change the situation

following the principle of “granting more, requiring less and loosening control” (namely “increasing investments in agriculture and rural areas, accelerating

the infrastructure construction in the rural area to directly increase the income

of rural residents, reducing the financial burden of rural residents, pushing

forward tax and fee reforms in rural areas to enable rural residents to recuperate

and rebuild themselves and deepening rural reforms, carefully carrying out policies of the Party in rural areas to give full play to the initiative of rural residents”).

The author believes that to properly handle the relationship between

efficiency and equity in income distribution, we need to 1) carry out scientific analyses and correct a variety of biases resolutely 2) leverage our strength

before taking actions, pay attention to being “appropriate,” and prevent harsh and unwarranted requirements, 3) highlight efficiency in primary distribution

to curb the rise of equalitarianism and 4) stress equity in the redistribution

process and maintain the synchronous growth of the per capita income and the overall national economy. Certain attention should be given to the third distribution based on the primary distribution and redistribution.

Based on the primary distribution and redistribution, China has to pay

attention to the third distribution, which highlights social responsibilities and

encourages the rich to voluntarily contribute some of their wealth to improving

the living standard, education and medical conditions of the poor. Philanthropy and social welfare industries develop fast in advanced countries, so do in China, which still needs a series of policy supports. When revising The Law of

the People’s Republic of China on Enterprise Income Tax, China added another article, “In relation to the expenses from charitable donations incurred by Enterprises, the portion within 12% of the total annual profit may be deducted from the taxable income.” The author thinks that the same article should be applied to personal charitable donations as an incentive.

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Relationship Between the Government and the Market In the socialist market economy, the market, responsible for resource allocation and economic regulation, requires all enterprises to employ the most economical method to rationalize commodity production based on market demands. Enterprises are the cells of the market. They are both producers and purchasers. Millions of enterprises capable of independent business operations and decision-making activate the market and push forward economic development via self-organization. Therefore, as management science implies, without the free enterprise system, there will be no socialist market economy. However, such freedom comes with conditions, because the decision made by an enterprise is determined, more or less, by other enterprises and external environment. The disordered operations of millions of enterprises at the micro-level could rationalize the economic development direction at the macro-level, and that is the result of self-organization. From the viewpoint of system engineering, in certain cases, changing the external environment would artificially accelerate or postpone changes and development of systems. This process is called Herter organization. The role of the government in the market is one of the Herter organizations in the market system; it influences the development of the market system by changing external conditions. The government has to appropriately regulate and control its national economy at the macro-level in order 1) to overcome the possible “market malfunction,” 2) to meet the minimum demands for the sustenance of low-income groups, 3) to prevent people from seeking personal gains at the expense of common good, 4) to protect the economic safety of the nation and 5) to ease the influences of international economic environment changes to the development of its national economy. In his book Economics , Paul A. Samuelso, concluded the role of the government in the economy as improving the efficiency, protecting equity and maintaining stability. Meanwhile, he pointed out that due attention should be given to avoiding “government malfunction,” or in other words, the reduction of efficiency due to improper government interference. Therefore, we should recognize the important role of the market, the “invisible hand,” in guiding business operations and promoting economic development on the one hand; on the other, we should admit that the government, the “visible hand,” also plays an indispensable role in macroeconomic regulation. Efforts should be made to appropriately maintain the

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balance between these two “hands.” The government and the market should cooperate closely rather than compete. The author believes that macro-economic regulation must follow three basic principles.

Respecting the Basic Rules of the Market Economy Market economy features commodity exchange (in accordance with the law of value), the balance between supply and demand (in accordance with the law of demand and supply) and competitive development (based on the competition law). Macro-economic regulations must take the above three basic laws as the premise and admit the leading role of market regulation, “the invisible hand,” instead of interfering with economic development based on subjective will under the planned economic system. First, to comply with the law of value. For example, the government is able to stabilize the prices of important commodities by means of price ceilings or subsidies, though, in the long run, the market should be empowered to influence consumers’ demands and the enthusiasm of producers by price changes, in order to reach an ultimate balance. Price ceilings and subsidies are expedient measures. And price ceilings might even weaken the productivity, leading to a distorted relationship between market supply and demand, while granting subsidies might create room for speculation. For example, subsidies for petroleum products have recently caused this problem. Lots of vehicles from Hong Kong get filled up in Shenzhen, not only the tank, but also the oil drum; flights of foreign airlines would get filled up in China before taking off; and the smuggling of petroleum products to outside China becomes more and more serious. Second, to comply with the law of supply and demand. Supply and demand have always been very important factors in the market. However, under the planned economy, China resorted to mandatory measures while failing to keep a close eye on the market situation. Therefore, planners should trust market signals instead of using their subjective judgment. For example, China once made the same mistake in power supply. There was a period when the Chinese Government assumed it had paid too much attention to power construction and thus stopped its development. The consequences: Factories in some areas operated for four days a week, air-conditioners became inoperable due to the lack of electricity, and the public had to escape the heat in civil air-defense constructions. Third, to comply with the competition law. China used to bar new comers from the market in the name of “preventing repetitive construction.” However,

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without new comers or new competitors to the market, technical progress would be extremely slow. The proposal was later rationalized into “preventing low-level repetitive construction.” There is always a resistance among market competitors against new comers. Therefore, the government should never limit but instead encourage competition so as to prevent some enterprises from seeking private gains by monopolizing. Only through competitions can we achieve technical progress and bring to the consumers larger benefits.

Empowering Business Operators with Micro Decision-Making Rights I n t h e m a r k e t e c o n o m y, e n t e r p r i s e s a re e c o n o m i c e n t i t i e s o p e r a t e d independently and assuming full responsibilities for their own profits and losses. They survive and develop by themselves through market competitions. Business operators shall be empowered with full decision-making rights over the internal business operations (including aspects as planning, organization, finance, personnel, sale, production and techniques) of the enterprise at the micro-level. Macro-economic regulation shall be carried out by the government under the premise of not violating the decision-making rights of business operators at the micro-level. The government may influence the decisions made by business operators through power restriction (e.g. denying or increasing the possibility of selecting a certain course of action, changing objectives and conditions of certain decisions), but should never make any decision for the enterprises.

Promoting the Establishment of Market Economy China is now in the transition from the planned economy to the market economy, a long, arduous and sometimes painful process. Measures for macroeconomic regulations should be subject to change in order to cater to such a transition. For example, in foreign exchange management, with the realization of free convertibility under current items, China should gradually lower the threshold of personal foreign exchange settlement, raise the settlement volume, implement limited convertibility under capital items when it is appropriate, thus gradually achieving the free convertibility of the RMB. The government may supervise and control the market and market entities by law so as to correct market malfunctions and improve the economic efficiency. However, due to higher costs and the possible adverse effect towards the market, government regulations should be based on a practical and realistic principle and never assume the regulation objectives as the actual results of the regulations.

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Relationship Between Power Centralization and Decentralization China has launched some reforms in power centralization and decentralization and has basically guaranteed a sound performance in the decentralized environment without risking social and economic chaos. However, when it comes to power distribution (the power structure) and restrictions (procedures for exercising the power), many problems are needed to be studied in depth. The decision-making power can usually be divided into the selection power and the restriction power. The former, as a part of the decision-making power, refers to the power to select the best one from various action plans; and the latter refers to the power to deny or add a new action plan and change the decision-making objectives or conditions. The author pointed out in 1990 that main problems existing in China’s decision-making structure were the inappropriate distribution of the selection power and the inadequate application of the restriction power. For years, China’s selection power in economic decision-making has been distributed among national planning departments, local planning departments and the planning sections and bureaus of all departments of the State Council. However, China failed to establish a rational distribution pattern to solve the contradictions between national departments and their local counterparts. In recent years, for the reasons that the central finance and local finance were separated and local governments were required to make matching investment, etc., the selection power of local governments has grown. In some provinces, the selection power is even allocated to prefectures or cities (counties), focusing on local processing of raw materials and establishing local-specific systems. It is said that in some cities, a real estate company registered in one district has to register another one if engaging in the real estate industry in another district so as to increase the tax revenue of the new district. The abovementioned problems have led to a sharp increase in policy errors due to temporary decentralized decisions, while other obviously unreasonable decisions are the compromise between the central government and local governments on the power distribution. Proper power centralization is conducive to solving the separated, short-term and compromising features in the decision-making; it cannot solve its subjective and mechanical decision-making. Since planners often make selections based on their understanding and analysis of the objective situation and their personal knowledge and experience, decisions are thus inclined to be subjective. And

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planners of China’s central government are so passionate about implementing a “unified” pattern that they allow no flexibility in its implementation. They also seldom take into consideration the real local conditions and difficulties; thus decisions made this way will certainly be very mechanical. The author holds that power centralization and decentralization are contradictory yet complementary. The key is to realistically maintain the balance between the two. Currently, special attention should be paid to the following three problems: 1) Properly handling the power distribution between the central government and local governments. On the one hand, the central government should enjoy certain power and authority; on the other hand, local governments should have corresponding duties and responsibilities. A great number of problems are caused by the behavior of local governments induced by the balance between power centralization and decentralization. Local governments pursue the GDP for political feats and fiscal revenues. When dealing with the relationship between power centralization and decentralization, we should take into consideration that centralizing power would centralize conflicts and that centralizing financial resources would centralize financial burdens, too. It takes tactics to solve the issue. 2) Giving rational play to the role of integrated departments. The primary function of the leadership is to make plans map out the future, set goals and find appropriate approaches. However, leaders are busy with public affairs and do not have sufficient time and energy to study possible problems of related planning or understand and the tactics of making plans. It is usually very difficult for them to turn quantitative analyses into specific planning targets and measures. To help leaders gather information, analyze problems and make plans, establishing the authoritative planning department is necessary. When China was implementing the planned economy, the power of the planning department was significant, since it was responsible for many related decision-makings. With the advance of China’s socialist market economy, the function of the planning department has been experiencing constant changes. Its decision-making power was weakened and it was renamed from China National Planning Commission to National Development Planning Commission, then to National Development and Reform Commission. However, its fundamental planning function and decision-making function have never been separated. On the one hand, this causes the planning department to focus too much on the current concrete issues and fail to take the long-term macro-problems into full consideration; on the other, it enables planners to get familiar with the microproject management techniques such as examining feasibility study reports,

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examining and approving projects, appropriating funds, and checking the schedule, while they fail to fully understand the systematic engineering and key techniques of prediction, evaluation and optimization in the process of drafting development blueprint, and hence making it hard for the planning department to play an effective role in making an overall planning for China’s development and reform. In March 2008, the 1st Plenary Session of the 11th NPC adopted the Plan on Reform of State Council Organs , pointing out, in clear-cut terms, that the functions of the National Development and Reform Commission will experience further transformation; efforts would be made to improve macro-economic control and the overall balance of the national economy, to comprehensively guide the economic system reform, to solve major problems in economic operation, to strengthen early warning system and offer necessary information, and to promote the coordinated regional development. Meanwhile, the micromanagement services and specific examination and approval procedures would be deducted. 3) Strengthening the use of the restriction power. On the one hand, China has to strengthen the rule of law and require governments at all levels to comply with the law. On the other hand, it requires China to establish sound systems and procedures for democratic decision-making and to give full play to the NPC and CPPCC at all levels. Expert reviews, technical consultation and decision evaluation should be delicately carried out in professional and highly technical affairs. Public summons and hearings are needed in terms of major issues closely related to the interests of the public. Powerful measures should be taken to improve the qualities of planners, increase their sense of responsibility and dedication and help them master the basic methods on economic analyses and scientific decision-making. For the small number of people who abuse their power to seek personal gains, accept bribes, embezzle public properties, or cause great losses and wastes due to malpractice, they must be detected and punished by law. In addition, China should also intensify the information management, improve the mechanism and channels for collecting, transmitting, processing, storing, searching and analyzing economic data so as to timely provide sufficient and reliable information to personnel who are related to decision-making. In the report to the 17th NPC, President Hu Jintao pointed out that “as a great new revolution, reform and opening up are not to be plain sailing or be accomplished overnight.” Reform and opening up requires not only institutional innovations to change various irrational structures, but also mechanism innovations to promote various structures to develop in a rational direction.

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Thus it is an arduous and complicated systematic project. In the process of reform and opening up, it is inevitable that some problems and errors will appear. A careful study of the expectations of the general public on education, medical care and housing, etc. needs to be carried out. And the demands of the general public have to be satisfied gradually. However, we have to resolutely fight against the act of denying the overall direction of the reform and opening up with local problems and temporary shortage as the excuses in the name of “retrospection. All experts and scholars with a good conscience should promote the reform and opening up by studying theoretical bases, commenting foreign experience, improving policy framework and analyzing possible difficulties instead of simply criticizing and blaming the government and the society. In the three decades since the reform and opening up, Chinese experts and scholars have made great contributions. The author hopes that China’s experts and scholars should make greater contributions to further deepening the reform and widening the opening up of China with a realistic attitude and innovative spirit. Completed on August 21, 2008

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Chapter

Theories and Methodologies of the Fictitious Economy

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As an emerging concept, fictitious economy has varied definitions and can be broadly classified into three categories: transactions of capital such as securities, futures, and options, called the fictitious economy; the economic activities conducted with the tools of information technology, called the virtual economy or the digital or information economy; and, the visual economic activities simulated by computers, called the visual economy. Here I will limit my discussion to the first category. In the Western academia, the fictitious economy is known as the “virtual economy.” However, opinions vary on both its connotations and denotations of the above three categories, as well as the economic activities conducted in the online-game market. According to Wikipedia , “a virtual economy (or sometimes synthetic economy) is an emergent economy existing in a virtual world, usually exchanging virtual goods in the context of an Internet game. People enter these virtual economies for recreation and entertainment rather than necessity. However, some people do interact with virtual economies for ‘real’ economic benefit.” But according to the Virtual Economy Research Network , “virtual goods, also known as virtual assets and virtual property, are artificially scarce resources that exist in online spaces. Examples of virtual goods include powerful characters in massively-multiplayer online games (MMOG) and virtual items and gifts in social networking services (SNS). Virtual goods and currencies are frequently bought and sold for real money.” This type of “virtual economy” has seen a rapid expansion in China, too. Some Chinese scholars advocate the use of “virtual economy,” but the author insists on the phrase “fictitious economy,” which is not only more rigid in an academic sense but also consistent with the concept of “fictitious capital” put forward by Marx. The study of fictitious economy currently comes three schools or three general views. The first view holds that fictitious economy is literally a fictitious value system, which reflects a traditional economic stance. In traditional economics, economy itself is a value system, so it is easy to conclude the fictitious economy that is a fictitious value system. The second view advocates that fictitious economy is finance. Most people holding this view are from financial sectors; their knowledge on the fictitious economy is mainly derived from their surroundings, thus mixing the economy with finance. The third view, which is proposed by the author, claims that the fictitious economy is another pattern of economic activities mirroring the real economy in terms of both its structure and its evolutionary paths. And the fictitious economy is the software in the economy.

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The author has studied the fictitious economy in recent years based on theories of complex science and finance, attempting in a fictitious economic perspective, to solve problems in terms of chaos and self-organizing in such fields as the securities market, the currency market, the foreign exchange market, the futures and options market, the property rights trading market, the financial crisis, inflation and deflation, commercial banks reform, rural finance and the real estate finance, etc. Besides, the research has touched on theories and methodologies of fictitious economy.

PROPOSAL AND DEVELOPMENT OF THE FICTITIOUS CAPITAL THEORY Marx’s Fictitious Capital Theory In the third volume of Das Kapital , Marx put forward the concept of fictitious economy. According to Marx, the phrase “fictitious capital” had been used as early as in 1840 by W. Leatham (banker of Yorkshire) in his Letters on the Currency, in which it mainly referred to accommodation paper (bill). In brief, his theory of fictitious capital includes two major points. First, Marx held that fictitious capital emerged from credit capital (interestbearing capital) and the credit system of banks. Through capitalized production, currency was thus converted into capital, which had an intrinsic value capable of self-proliferation. Therefore, the value in use of the currency lied in its convertibility into capital and profit-making capability. In this sense, currency may be viewed as a special commodity lent by its owner to those who needed it under certain legal terms and conditions and repaid to the owner with both the principal and the interests after an agreed-upon period. Currency then served as a kind of interest-bearing capital with credit as the requisite of lending. However, when currency was lent in the form of interest-bearing capital, its owner could not gain any equivalents as a reward, which was usually obtained from commodity exchange, but merely some form of guarantee for the future repayment of the capital and the interests. Such guarantee, usually in writing, was fictitious capital. Banks then gathered most of the idle capital from society and converted them into interest-bearing capital. With the development of the credit system, banks lent out not only cash but also various credits, thus gradually increasing the types of fictitious capital. At the time, Marx held that fictitious capital consisted of credit capital (such as banknotes), capitalized values (such as securities) and mortgages of immovable properties, etc.

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Second, Marx claimed that fictitious capital per se did not present any intrinsic value, but it could generate profits, or a kind of surplus value, through circulation. According to Marx’s theory of labor value, the magnitude of a value in use refers to the socially necessary labor time needed for creating such value. Since fictitious capital in itself did not involve any labor, it did not contain any value. In Das Kapital , Marx believed that surplus value could only be created through real economic activities: Capitalists used currency as capital and exchanged them for production factors, including hiring workers, purchasing raw materials, building factories or machines, etc.; products were produced through production process and then became commodities in the circulation process; and commodities would become currency again through exchange. In this loop, profits were generated because of the existence of surplus value. Marx also shed light on the capability of fictitious capital to create some form of surplus value through circulation. However, in fact, such surplus value is not created directly by fictitious capital itself, but is paid, in the form of interest, by entrepreneurial capitalists (industrial capitalists or commercial capitalists) to the owner of fictitious capital from the profits obtained (surplus capital) as agreed. Marx said capital must have two characteristics: It has to have a value and it must be able to generate surplus value. Since fictitious capital was equipped with the latter characteristic, implying that it could be regarded as capital. However, it lacked the former thus could not be used directly to purchase production factors through exchange, so it was fictitious.

What Is Fictitious Capital? Fictitious capital is a kind of resource built on the basis of mutual trust. Although with no material basis and not belonging to any form of currency with certain value, fictitious capital can produce profits. Fictitious capital can be used to obtain the rights of use of actual capital, yet on the condition of certain amount of reward (usually in the form of interest payment), or profit-andloss sharing. The former situation can be seen in the securities market, while the latter is usually seen in the stock market. Above all, the emerging of the ownership certificates reflected the dual nature of capital ownership and at the same time realized the separation of the capital’s ownership and usufruct, thus giving birth to fictitious capital. In real economy, the exchange process refers to the exchange of the currency’s ownership and usufruct with the commodity to be purchased. The ownership of

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the currency usually binds together with its usufruct. After someone purchases a commodity with a certain amount of currency, both ownership and usufruct of the currency transfer. However, the ownership and usufruct of capital can be separated. For example, someone purchases an enterprise’s bonds with currency and delivers the usufruct of his purchasing to the enterprise and in turn receives an ownership certificate denoting his ownership over that amount of money. Therefore, the creditor owns the rights to require the enterprise to repay him the principal and the interest as agreed upon. Stocks serve as a proof that the owner enjoys the rights and undertakes the obligations of a shareholder. A mortgage of immovable property demonstrates that the ownership of the designated immovable property has been transferred to the financial agency or individual that accepts the mortgage, and the individual who obtains the mortgage enjoys the usufruct of the immovable property in an agreed period. In case of default on the due date, he will lose the usufruct. Therefore, it can be seen from above that the separation of the ownership and the usufruct gives birth to the fictitious capital.

Main Types of Fictitious Capital Two important factors contribute to the emergence of fictitious capital: the evaluation and measurement of real capital as a widely-recognized symbol of value; and the capitalization of technology, education, management and other related “soft” factors to evaluate various “soft” factors by observing capital in the traditional stance and generalizing them into fictitious capital. Such a pattern creates an economic match-up between various kinds of fictitious capital and the real capital (that has been evaluated as a symbol of value), through which people can observe the operational mechanism and efficiency of the fictitious economic system. That makes it the core among profound fictitious economic relations. Putting those soft factors into perspective, fictitious capital comes in three major types. Credit capital, the cornerstone of the current financial sector. For example, both bank deposits and the issue of enterprises bonds and securities rely on their credit ratings; while borrowers also rely on their credit scores to attract loans from banks. Currently, most Chinese banks require borrowers to provide guarantees or collateral, which make them akin to money shops or pawn shops. Banks grant loans based on borrowers’ credit ratings. Therefore, credit capital refers to the credit rating-based usufruct of the real capital obtained by financiers.

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Knowledge capital, which is the usufruct of capital obtained by financiers

through knowledge, such as techniques, trademarks, and even standards. A typical example of this is the venture capital investment. Venture capital investment refers to the capital invested by venture capitalists in the high-

potential innovations based on a profit-and-loss sharing mechanism. Therefore, venture capital investment manifests as a combination of real capital and fictitious capital.

Social capital, which is a concept initially put forward by socialists. It is a

theory developed in 1970s on the basis of social network studies. It mainly refers

to the connections within the same social network and between different social networks. In the past 30 years, social capital has been growing and expanding. However, sociologists are still debating the definition and functions of social

capital. Despite some recognitions of social capital in economic development, the concept of social capital has not been widely publicized in the economics

field. The author transplants the concept of social capital into fictitious capital

and defines it as “the cooperative connections and systems forged among social

members through interactions.” Simply speaking, social capital is “connections.” Through communication, social members gain mutual trust and establish cooperative connections. If institutionalized, this connection will become social capital. Social capital is part and parcel of economic development. Private

equity fund has boomed in recent years, whose capital is raised by the general

partners through limited partners in a private manner. Only when the limited partners trust the capability and morality of the general partners will they be willing to allow the general partner to handle the money to create benefits.

In general, these three types of capital have no real value, though they can

obtain the usufruct of the real capital by issuing an ownership certificate to

guarantee the future returns based on a profit-and-loss sharing mechanism. Their value will not be calculated until when combined with real capital.

When combined with the real capital, corresponding rights and interests

of the above three types of fictitious capital have to be clarified in the

ownership certificates (commitment), such as setting the proportion of shares or acknowledging that owners shall be entitled to all profits (excluding the

interest). Since the ownership certificate does not possess any intrinsic value

and serves simply as the carrier of fictitious capital, it may be called secondary fictitious capital. Credit capital, knowledge capital and social capital can be collectively called original fictitious capital. Most fictitious capital hereinafter refers to secondary fictitious capital based on the ownership certificate.

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DEFINITION AND CHARACTERISTICS OF THE FICTITIOUS ECONOMY Compared with the real economy, fictitious economy is another economic pattern in the economic system. It refers to all circulation-related activities of

fictitious capital based on the financial system and all relations thus generate.

In real economic activities, capital produces profits through a loop of exchange–

production–circulation–exchange. However, in fictitious economic activities, capital may generate profits through other channels.

Development History of Fictitious Economy The development of fictitious economy can be roughly divided into the following five stages:

Capitalization of idle money . In other words, idle money becomes interestbearing capital. The origin of the fictitious economy can be traced to commercial borrowing and lending among individuals. For example, A is in urgent need of a material of commodity but lack of enough money, while B has some extra money in hand. Therefore, A borrowed money from B , promising to repay the principal and interest within a certain period. Through this exchange, A obtained the right to use it as means of payment to generate profits via actual business activities, while B enjoyed its ownership over the money and was entitled to the principal and the interest from A . At this stage, this debit note was the incipient form of fictitious capital, which might proliferate through the borrowing-lending cycle. B did not practically involve in real economic activities, but still made money through fictitious economic activities. Socialization of interest-bearing capital . At this stage, banks served as intermediary agencies to loan out individuals’ idle money for profits. In addition, enterprises might issue securities and stocks to raise money by guaranteeing to return the principal and interest in due time, or share profit and loss with investors. Therefore, people could also gain profits by using their idle money to buy stocks or securities. The socialization of interest-bearing capital created banks, as well as various forms of fictitious capitals, such as securities and stocks. The socialization of interest-bearing capital could channel social capital from people not engaged in production, circulation, exchange and other real economic activities into the hands of those who are capable of using these social capital into potentially profitable economic activities so as to optimize the investment structure and produce a more efficient use of capital.

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Marketization of negotiable securities . The biggest problem of fictitious capital at its early stage was the liquidity deficiency. That is, when the owners of fictitious capital were in urgent need for money, they could hardly transfer and cash it, thus a halting the conversion from idle money to interest-bearing capital. Securities may be freely traded based on their expected returns after being marketized, from which the fictitious capital trading markets gradually emerged (such as the stock market, the bond market and the currency market, etc.). The socialization of negotiable securities could not only cash the securities held by individuals and enhance the liquidity of fictitious capital but also direct the capital to promising industries and enterprises so as to further the efficient use of capital. However, the process created loopholes for illegal speculations by exploiting the price fluctuations of the securities market. Internationalization of the financial market . Fictitious capital could be traded in the international market. The process could be traced to the fixedrate bonds issued by debtor governments and railways companies in the financial markets in United Kingdom, France and Germany in the mid-1800s. However, large-scaled international securities investments did not appeared till the 1920s, yet it quickly slowed to a crawl due to the Great Depression in the United States in the 1930s and the subsequent World War II. It was not until 1944 that an international financial market was gradually taking shape under the Bretton Woods Agreement and the General Agreement on Tariffs and Trade (GATT) . Internationalization of the financial market serves to channel the capital to profitable industries, greatly improving the efficiency of capital use and breeding a new financial market—the foreign exchange market. Futures trading became increasingly fictitious, indicating that the purchase of futures was taken as a means of speculation. Since 1960, futures trading had seen in the transactions of stocks, futures, foreign exchanges and other financial commodities successively. In 1973, option trading appeared. Integration of international finance , which is manifested in a closer tie between the financial markets of individual countries and the international financial market. Since 1980s, world economies have become increasingly dependent on each other and the degree of financial liberalization has experienced a gradual increase thank to the ongoing globalization. Besides, due to the formation of the floating exchange rate system caused by the decoupling of the U.S. dollar from the gold standard, as well as the strengthening of financial innovations, fictitious economy has expanded. Moreover, with the development of information technologies, fictitious capital has been flowing at an increasingly faster clip. The above three factors have collectively facilitated

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the gradual integration of the financial markets in all countries, enabling them to be closely linked to the international financial market and to strengthen their mutual influence. During the East Asia financial crisis of 1997, we can see that a liquidity crisis in Thailand created the domino effects on the region and the world as a whole.

Rules of Movement of Fictitious Capital Exchange–re-exchange is the primary movement process of fictitious capital The buying of bonds or stocks is actually the transfer of the usufruct of real capital for an ownership certificate and the re-exchange of the ownership certificate after a certain period for the usufruct of real capital and gaining profits. Such fictitious economic movements enable capital to make profits without any real economic activities. The movement of fictitious capital is actually comprised of two links, namely, exchange and re-exchange. The process of exchange includes not only the exchange of real capital with the ownership certificate (virtualization of real capital) but also the exchange of the original fictitious capital with the ownership certificate (generating the secondary fictitious capital) Re-exchange is the process in which fictitious capital becomes cash, including selling or privately transferring fictitious capital in the financial market.

Price uncertainty breeds speculation attempts Neo-classic economic theory assumes that all people engaged in economic activities are “economic men” pursuing the maximization of their personal profits with totally rational behavior. According to the theory, the stock prices reflect investors’ rational expectation of the future values of real economic variables. That is to say, a rational stock price should equal the present value of its future profits. However, as Herbert Simon, a Nobel Prize laureate in Economics, pointed out, people engaged in economic activities are rational yet limited. Confined by available information and knowledge, they find it hard to understand and predict all possible results. Instead, they could only make decisions simply relying on their subjective judgment. Moreover, they are not able to take into consideration all possible action plans. In addition, other people’s values and actions are also factors that may prevent them from making the right decisions. Tradings in the stock market take place based on different expectations towards the rational price of the same stock. Some investors may sell the stock,

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for it has exceeded its rational price, while others may buy the same stock, believing that the present price of the same stock is lower than the rational price. Therefore, if all investors are rational, there will not be any transactions in the stock market. The stock market is not only for investment but also for speculation. Generally speaking, “investment” means the behavior of making long-term stock investment, with the expectation of receiving higher dividends and an increased business value, while “speculation” refers to the behavior of making short-term stock investment, with the expectation of a quick sell-off under favorable conditions for profit. Modest speculations do not harm the securities market but instead contribute to its smooth operation. First, it is conducive to activating stock trading, enhancing market liquidity and shortening the turnover period of funds. Second, since speculators dare to bear the risks of initial public offerings (IPO), they facilitate the issuance of new stocks. Third, the “buy low, sell high” speculations can regulate the supply-demand relationship in the market and help stabilize stock price. The author holds that a fully-functional stock market is a market with modest speculations, capable of maintaining a dynamic balance between investment and speculation, conducting stable operations in face of the market fluctuations caused by the external environment and bringing desirable returns to most investors while playing its role in promoting economic development. As a matter of fact, many investors in the stock market are motivated to invest and speculate, yet the specific amount varies between people and depends on specific circumstances in the stock market. However, if most investors are significantly speculative, it will foster a market too full of speculations, in which investors ignore and spurn blue chips (profitable and reliable stocks) in favor of stocks with speculative potentials, and hence significantly weakening the role of the stock market in allocating resources. Over-speculations will also instigate short-term market behavior and create conditions for dealers to illegally manipulate the market. Therefore, overspeculation brings hidden danger that may risk market chaos and ultimately harm the economy and the society.

Undue expansion of the fictitious capital brings potential risks Fictitious capital emerges based on the investors’ optimism on financiers and the profit prospect of an investment project. The ownership certificate given by the financiers to the investors has nothing to do with the financiers’ own

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physical and currency assets. However, optimism bias (overly optimistic toward the investment projects) will lead to excessive investing or financing, causing the expansion of fictitious capital. Should such optimistic estimate burst due to subjective or objective reasons, it would bring immense risks. With the development of science and technology and the advance of financial innovations, various financial derivatives emerge. The original purposes of promoting financial derivatives are to meet investors’ different preferences in terms of safety, profitability and liquidity and minimize risks through hedging. However, financial derivatives, at the same time, provide a variety of speculative tools, consequently expanding the fictitious capital. The expansion of fictitious capital may manifest itself in the following forms. Overvaluation . When investors overestimate the value of a certain ownership certificate, it will lead to the inflation of fictitious capital. For example, in the stock market, if investors are unduly optimistic about the prospects of a certain listed company, they will buy its stocks at a relatively higher price, which is particularly true in a bull market. Either to follow suit or to play the “greater fool” (as the name implies, it refers to someone assuming that others would pay a higher price for the stock), many investors chase the same stock, only to increase the risk of bubble burst. Over-indebtedness . On the ground that the returns on its assets are expected to be higher than the rate on loans, financiers borrow money and risk their debts to be dozens of or even hundreds of times larger than their holding assets. When investors require repayment of the loans or refuse to grant new loans due to unfavorable outlook, financiers will, in all likelihood, face bankruptcy. “Guaranteeing the large with small.” It refers to the behavior of using a small amount of money to guarantee a large-scaled trade. For example, in the commodity futures market, buying a futures contract usually requires a guarantee deposit merely 5% of the total amount. Multiplier effect . Due to the currency’s multiplier effect, the initial amount of currency issued by the central bank will be largely multiplied, ultimately forming the social currency. Similarly, fictitious capital may also multiply in the same way. For example, the bond holder may cash in his or her bond in the bank and use the cash to buy futures and financial derivatives. Thus, the initial amount of money used to buy the bond is diverted into the outstanding bond and open futures contracts (the amount of which can be 20 times higher than the guarantee deposit) and open financial derivatives contracts. Although the carrying amount is multiplied by a dozen times, the risk grows correspondingly due to the transformation from low-risk bond to high-risk financial derivatives.

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Movement of fictitious capital cannot directly create social wealth Since the movement of fictitious capital (fictitious economic activities) is not a material production activity, it does not create social wealth. The role of the fictitious economy is to redistribute of the wealth created by the real economy. For example, the stock market only redistributes the wealth under its reign, while the sources of such wealth are from listed companies. Stock investment may increase the wealth of some people, yet the fact is: Winners make money off of losers (after the deduction of the stamp duty, the commission charge of securities companies and the management fee for the stock exchange), so it is only a redistribution of wealth. In the bull market, where stock prices rise rapidly and the capital influx seems endless, everybody wins. However, should any sudden dip destroy this cozy relationship, people who enter the stock market at the very last moment are most likely to become losers. Stock dividends are the profit a listed company shares with its stockholders as a reward for using their capitals. However, the fictitious economy may create wealth indirectly by optimizing the real economy. For example, the stock market plays a role in supporting the superior, eliminating the inferior and optimizing the allocation of resources. It is capable of both helping those promising enterprises which meet capital shortage to acquire lower-cost financing and marginalizing enterprises with poor performance in the stock market.

Characteristics of the Fictitious Economy Fictitious economic system features complexity, metastability, high risks, parasitism and periodicity.

Complexity A complex system commonly features a large scale and a high degree of coupling and low transparency. It is dynamic and open. Yet, fundamentally its components are intelligent, as manifested in the capability of understanding the surroundings, predicting potential changes and taking actions. This is also the inherent cause of biological evolution, technical innovation, economic development and social progress. The stock market is a complex system composed of natural persons and legal persons (buyers, sellers and intermediaries), all of whom are engaged in stock trading following certain rules. Each person has the freedom to make decisions independently based on his understanding of the environment, the development outlook and the anticipated objectives; yet individuals practically

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will be influenced by others’ decisions and the external environment. The nonlinear interaction among different components may produce chaos, though the self-organizing of the system enables it to present a certain order and stability at the macro-level and in the long run. When trading securities, investors usually lack sufficient information on the present and future market conditions and price changes, so they exhibit uneven investment strengths and risk tolerance, as well as diverse understanding and estimates toward the investment value, purposes and the length of expected return. There are also a great number of investors who do not know the analytical methods of the technical tendency, even the fundamental knowledge of stock investment, thus they are unable to distinguish and pick up the useful ones from the sea of information. Therefore, these investors often follow suit, even rely simply on their intuitions to make impulsive decisions. This explains why there are a great number of chaotic phenomena in the stock market. That is due to the interpersonal influence and the external environment that guide the stock market to present certain general trends at the macro-level and in the long run. Those trends are the so-called bull market and bear market.

Metastability The so-called system refers to the system that deviates from the balanced state, yet is capable of maintaining a relative balance by exchanging materials and energies with the outside world. In systems science, it is also known as “system with a dissipative structure.” Although the system may become stable through self-organizing, its stability is vulnerable to external disturbances. After its stability is damaged, the system may present a stable state and moving state alternately. At the macro-level, the system is thought to be stable within a certain range, meaning it has a regional stability. However, the system may face sharp changes, even a crash, when sometimes it loses its stability. After that, the system will restore its stability through in-depth structural adjustments; otherwise, it will be ultimately eradicated. Generally speaking, the greater the system inertia, the smaller the possibility of system crash. As a metastable system, the stock market has to maintain a relative balance by exchanging capital with the outside world. Reasons are manifold for the metastability of the stock market, but the most fundamental one is the inherent instability of fictitious capital. The inherent instability of fictitious capital originates from its own fictitiousness. For example, stocks per se do not have any value and merely represent the rights to get benefits. Thus, they are a kind of ownership

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certificate that secures the holder ’s legal rights to require his or her part of surplus value when investing capital in securities. Stock prices are determined not by the objective law of value, but by people’s subjective estimates of their future prices and the concurrent demand-supply relationship, leading to the derivation of their prices from the performance of practical economic activities. When stock prices go beyond rational expectations, they would cause “bubbles” and need the outside world to keep injecting capital so as to maintain price stability. However, it is a fictitious stability easy to disrupt. In case of insufficient capital injection, stock prices will drop, if not substantially. The instability of the system of fictitious economy also comes from currency virtualization. Although currency has maintained the value in use as a means of payment since its decoupling from the gold standard system and the gold exchange standard system, it has actually lost its real value. Consequently, its value can only be measured by its purchasing power, which is influenced by such factors as money supply, interest rates, exchange rates, people’s consumer behaviors, etc. To conclude, currency virtualization would make fictitious economy more unstable. Positive feedback effects of fictitious economy will also aggravate the system instability. For example, the more the purchasers there are of a certain stock, the higher the number of people who will follow suit. Such interaction is the positive feedback effect, which will be amplified and cause violent fluctuations of stock prices.

High risks The so-called risk in economic activities refers to the difference between expected benefits and real income. It is contributed by the uncertainty of the objective world, the limitations of people’s cognition towards the objective world and the subjective wrong estimates of the expected benefits. However, in stock market, high risks bring potentially great benefits. The high-risk nature of the fictitious economy also originates from its complexity and metastabililty. First, the inherent instability of fictitious capital leads to constant and irregular price changes, while the expansion of the trading scale and trading varieties make the system of fictitious economy more complicated. Second, people’s insufficient knowledge in market predictions and the absence of better techniques to estimate expected benefits might cause decision errors. Third, many people are vulnerable to risk-assuming and even amplify the level of risks due to the positive feedback effects. Fourth, to pursue high benefits, many people are willing to take risks, leading to the emergence

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of high-risk, high-return financial innovations, such as a variety of futures, options, forwards and swaps. In addition, some illegal behaviors will contribute to a high-risk financial market. For example, disclosure of false information misleading investor; internal trading undermining the interests of small and medium-sized investors and malicious market manipulation which brings dealers with quick and dramatic profits. Study results have shown that people would overestimate their riskassuming capabilities. For example, for a number of projects, each with an investment of RMB1 million, a risk rate of 80% and expected profits of RMB5 million. Because their risks and returns are symmetrical, people often misinterpret that as long as they invest RMB5 million in five projects, one successful project will sufficiently hedge the potential risk. However, according to the “adventurer insolvency laws,” with an investment of RMB5 million, the percentage of succeeding in one project would be 67%. To secure at least 95% success rate, people have to invest RMB14 million in 14 projects. Therefore, RMB5 million is far from being enough to avoid the risk.

Parasitism There are close links between the fictitious economy and the real economy. The former is generated by and dependent on the latter. Fictitious economy is closely related to real economy. Risks produced in the real economy, such as overstocking inventory, enterprise bankruptcy, etc., will all undermine the stability of the fictitious economy. Also, risks in the fictitious economy, such as stock market and real estate market fluctuations, surge of bad debts, currency devaluation, etc., will greatly influence the real economy. These are actions and reactions of between real economy and fictitious economy. With the domination of financial sector in the entire economy, real economy cannot survive without fictitious economy. Therefore, if the system of real economy is regarded as the “hardware” of the economic system, fictitious economy may be viewed as the “software” of the economic system. The two bodies mutually interact, yet software has to rely on hardware in order to work. Stock is a form of corporate equity certificate issued by the limited liability company. It represents its holders’ (e.g. shareholders) ownership of the issuing corporation. Since stock is a type of securities without any repayment period, investors cannot withdraw after subscribing to a certain stock in the primary market, but they are able to sell the stocks in the secondary market. Theoretically, the value of a stock should depend mainly on the future

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performance of a listed company, i.e., the cash value of its future benefits, regardless of whether it is in the primary market or the secondary market.

Stock prices show irregular fluctuations, though stocks parasitize on the listed companies, while the stock market parasitizes on the real economy. Therefore, the listed companies are the building blocks of the stock market.

Since investors estimate the price of a certain stock based on their prediction

of its future performance, stock “parasitism” is manifested mainly by the fact that stock price is usually influenced by the information of its issuing company. Such information includes information proactively disclosed by the

corporation, information due to changes of the external environment, and the information spread in society.

At the same time, reaction of the stock market to real economy cannot be

ignored, either. Rise in the stock market will enhance people’s confidence over the economic prospects and create more wealth as indicated by the “wealth

effect,” thus driving economic development. Contrarily, in case of stock market bubble burst, people will slash their consumption, and causing panic-selling of financial products and ultimately resulting in the economic decay, even economic crises.

Periodicity The evolution of the system of fictitious economy is periodical, going through

various periods: accelerated growth of the real economy, the formation of economic bubbles, gradual inflation of money and credit, gradual rise of prices of various assets, extreme optimism in the market, rising stock prices and real

estate prices, economic bubble burst due to external disturbances, sharp drop of various financial indexes, panic-selling of physical and financial assets,

stagnation or even negative growth of the real economy, etc. However, such periodicity does not simply progress in cycle, but develops in a spiral manner.

The operation of the stock market is also periodic. Bull market and bear

market alternate. Since the stock market is established upon investors’ optimistic expectation of the future benefits (or concisely, their optimistic

expectation of economic development), at the macro-level there will be bubbles

in the stock market, its swelling and the subsequent burst will cause market fluctuations. Yet, the fluctuations develop in a spiral way. For example, when the U.S. stock market plunged on October 19, 1987 (the Black Monday), the

Dow Jones index was then lower than 3,000 points, yet it rose 12,000 points after 13 years.

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RESEARCH FIELDS OF FICTITIOUS ECONOMY Research fields of fictitious economy include:

Relationship between Fictitious Economy and Real Economy First, there is the relationship between the price of fictitious capital and on which the real price it is attached. The ownership certificate per se contains no value, its price is based on people’s confidence in the certified entities. For

example, the price earning (P/E) ratio of a certain stock generally maintains

lower than the reciprocal of the bank deposit interest rate. If returns on stock investment equal interest income, there is no need for people to buy any stock.

Although, in reality, most listed Chinese companies keep the P/E ratio higher than the reciprocal of bank deposit interest rate, people who invest in the stock market do not bet on the current value but the future value. That is, they would

put a future price of the fictitious capital much higher than the existing price of

its associated entity. Take another example, in the futures market, commodities’ forward prices are different from their spot prices.

Second, the relationship between the operational cycle of the fictitious

economy and that of the real economy. The real economy is universally

recognized to be periodic. The author believes that the fictitious economy is also periodic, yet its cycle is not totally consistent with that of the real economy for a variety of reasons.

It is said that the stock market is the barometer of the economy’s health.

This makes sense, but is not absolutely right. Under some circumstances, the operational cycle of the stock market in turn depends on that of the real

economy. For example, since the stock market is based on listed companies and relies on the real economy, its performance should roughly reflect the real

economy’s long-term health. The indicator of real economy can be represented by GDP, while that of the stock market is usually represented by the stock

index (such as the Dow Jones Industrial Average). The stock market cycle may sometimes advance or lag behind the economic cycle, though a prolonged deviation from the regular economic cycle is definitely abnormal. It should also be noted that due to a variety of stocks, the stock index is usually obtained by

selecting several weighing figures using statistical methods. Therefore, it cannot reflect the overall operation of the stock market.

Some people recently doubt the traditional “barometer” role of the stock

market, claiming that the stock market’s performance is not necessarily linked

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to the economic conditions, because there are times when the economy slows down, the stock market rises, or the economy develops vigorously while the stock market declines. From the perspective of complexity science, the relationship between the stock market and real economy is not simply a linear relationship, but a non-linear relationship determined by various complicated factors. First, GDP fails to fully demonstrate conditions of the real economy and the stock index cannot fully represent conditions of the stock market. Second, they are influenced by abundant factors, such as the international economic environment, social systems, government policies, people’s confidence, etc. Moreover, these factors have different impacts on the GDP and the stock index. Third, due to the existence of various factors, it is often seen that the stock market situation would deviate from real economic conditions in the short or medium term. The stock market and the real economy do not develop in a fully synchronized manner. Finally, due to the above-mentioned reaction of the stock market to the real economy, the relationship between the two becomes more and more complicated, making it difficult for people to see the mutual influence. What deserves special notice is that with the existence of excessive speculation, malicious manipulation, excessive policy influence and other abnormal situations, the development of the stock market would deviate from that of real economy. In addition, the stock market’s influence on the real economy also depends on its size. The total market value of stock markets around the world is about 93% of the world’s GDP, while that of stock markets in developed countries is 130% of their GDPs. Since most stocks in China have not been in circulation yet, the size of tradable stocks is less than half of the country’s GDP, thus not being able to serve as the economic barometer. For example, from 2001 to 2005, China saw rapid economic growth, yet its stock market remained a bear market, while from 2006 to 2007, China’s economic growth rate was slightly higher than that in the previous years, despite the stock market “Big Bang.” Besides, the Shanghai Stock Exchange Composite is not a strong representative of China’s overall stock market. That is because it represents only 70% of China’s stocks by excluding stocks traded in Shenzhen Stock Exchange and it is calculated by the weighting total market value of all the stocks traded in Shanghai stock exchange market. Therefore, the large-cap stocks over-weighted in the market, exaggerating rises or declines. Third, the “risk transfer” relationship between the fictitious economy and the real economy. Risks of the fictitious economy will also be transferred to the real economy. Therefore, we should study the procedures, the mechanism and the influencing factors, etc. in the transfer process.

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Fourth, the fictitious economy may promote or harm the real economy. The fictitious economy is a double-edged sword, exerting both positive and negative influences to the real economy. Therefore, studies should be carried out to minimize its disadvantages.

Institutional Factors in Fictitious Economic Activities The word “institution” has been widely used in recent years. It is generally believed that the institution refers to a set of rules and norms that provide certain procedures for people to follow in order to work. Academics believe that institutions are political, economic and cultural systems formed under certain historical conditions. The school of institutional economics emerged in the U.S. in the early 20th century, focusing on institution studies and the role of institutional factors in social and economic development. They advocated that the organization and control of economic systems outweighs resource allocation, income distribution, level of income and commodity prices. Therefore, they highlighted the enormous role of social, historical, political, psychological and cultural factors in the social and economic life and proposed adopting institutional analysis and structural analysis to address problems. The institutional economics inspire us to pay attention to the important role of institutional factors in the fictitious economy. As mentioned before, system and mechanism are mutually dependent. System is the starting point and the final result, while mechanism is the evolutionary process. The interaction among institutional agents and that between the institution and the external environment will produce a selforganizing function inside the institution, forge the layer and functional structure of the institution and drive the institution in a certain direction. In the development history of the fictitious economy, institutions are the fruit of the gradual evolution of fictitious economy. The saying “trade comes before rule” is still valid in the field of fictitious economy. For example, prior to equity financing control regulations, the South Sea Bubble had already taken shape. The bubble was caused by the lagged regulation after the spontaneous emergence of fictitious trading relationship. Besides, although the Mississippi Bubble spurred a strong opposition to the stock market and equity financing, the chattel mortgage and credit bank set up by Bienville brothers successfully detoured financial regulations and involved in the business now known as “investment bank.” It can be seen that where there is no fictitious economy, there is no fictitious economic institutions. Besides, we should be aware of the counteractive effects of institutions

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towards trading behaviors. The interaction between institutions and trades enables institutions to become the main factor that would hinder the further development, even change the development direction of fictitious economy. There are abundant examples in terms of macro-regulation since the Keynesianism. Besides, the financial and monetary policies influenced by the monetarism and the supply-side economics changed the internal operation of the financial systems in the U.S. and Europe, as well as the strength and approaches of financial systems toward the real economy. Since the mid-20th century, regulatory modes and different regulatory rules have had increasingly significant impacts on the behaviors of all types of members in the system of fictitious economy. The author holds that the institutional rules in the fictitious economy consist of three tiers: 1) formal legal institutions that function to regulate the behaviors of market subjects, basic market relationships and competition orders, all of which are rooted in different cultures and play a fundamental role in fictitious economic trading; 2) relevant regulatory measures, including various rules and regulations, instructions, opinions and suggestions formulated by administrative regulatory agencies under the guidance of legal principles and administrative discretion; and 3) the so-called “hidden rules,” developed on the basis of common trading practices in the field of fictitious economy. These three tiers are supplementary, which can be created by the mandatory institutional transition (Hetero organization effect) or evolved from the induced institutional evolution (self-organizing effect). In terms of the operation of fictitious economy, established institutional rules can stabilize trading subjects’ expectations. Within the established institutional framework, trading subjects clearly know what rules others will follow when taking actions, because everybody believes that others are rational. If so, the institution is appropriate and stable. Should the trading subjects be unable to play their roles within the institutional framework and realize business opportunities, it indicates that the institution needs change. It is through such interaction and mutual influence between the general institutional environment and market subjects that the self-organizing effect and Hetero organization effect integrate, thus pushing forward the development and evolution of fictitious economy. Normative and empirical research methods should be adopted and various advanced theories and methodologies in terms of psychology, sociology, management science, mathematical finance, behavioral finance, uncertain decision making techniques, computer simulation, etc. should be widely absorbed when studying financial institutions. It is necessary to explore both

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the micro-foundation of the institutional evolution and the macro-effect of institutional changes and clarify the policy research and theoretical studies.

Generation and Prevention of Risks in Fictitious Economy Risk refers to the gap between the anticipated benefits and the actual income. However, some claim that only a negative gap can be called risk and the positive gap does not count. That is to say, it is risk only when benefits are lower than anticipated. Actually, it is the problem of whether unilateral or bilateral risk measurement matters most. Currently, most people prefer the former measurement, but the author advocates the latter. If the actual return is higher than anticipated, it may be indicated as excessive investment, because less investment could also achieve the anticipated income. Therefore, if unilateral measurement of risks is adopted, people may risk wasting resources when pursuing cost-recovery or more benefits. While bilateral measurement will encourage people to struggle to make the anticipated benefits closer to the actual income and maintain a balance between security and profitability. Risks are caused by the uncertainty of the objective world. People’s limited understanding of the objective world and people’s subjective estimates of the anticipated profits. The author believes that risks are divided into two categories: objective risks and subjective risks. The former comes from the uncertainty and people’s limited understanding of the objective world. Due to the fact that the objective world is in constant change, people can never fully understand it. As Lenin said we must grasp and study clearly all of its aspects, links and “intermediary agents,” which were always beyond our capabilities. Besides, according to the chaos theory, in a certain system there are uncertain factors. For example, the butterfly effect is the result of a series of small-probability events being piled up. Therefore, people cannot foresee the uncertainties of the objective world. For example, the rational price of a stock should be the cash value of the future profits of the listed company and should depend on the company’s future profits and discount rate, both of which are closely related to economic fundamentals and need to be predicted based on the past and the present data. But as a matter of fact, future profits and discount rate are uncertain. Future profits depend on the uncertain business performance of the investment objects. The discount rate is based on interest rate, which will fluctuate with the market. Since both profit and discount rate in the future are unpredictable, the rational price actually cannot be calculated. These uncertainties bring risks. However, such risks are objective and do not change with people’s subjective will because

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people cannot fully understand the future tendencies of the fundamentals of both the real economy and the fictitious economy. Despite great progress in forecasting techniques, such as data mining, knowledge discovery in databases, symbolic data analysis, group decision-making techniques, etc., people still cannot correctly predict the future. Therefore, objective risks always exist. Subjective risks appear when people make subjective estimates of the expected future profits. Stock market, backed up by people’s optimistic anticipations, is fueled by profound speculations, bubbles and risks. If all investors were rational and capable of correctly predicting the future, stock prices would have been stable with no trading volume at all. Speculators do not focus on the discounting of future profits, but the estimate-based price difference in each trade. When people are far too optimistic, they may buy a certain stock at a price higher than its rational price. Therefore, bubbles come with speculations and bring subjective risks. Such risks respond with a positive feedback which is easy to be amplified. Under general circumstances, people tend to overestimate their risk tolerance. Risk tolerance refers to a certain probability and the ability to guarantee security with normal luck. For example, A and B (referring to two men) are gambling by coin tossing. A tosses a coin and B will lose USD1 if it is head, otherwise A will lose USD1. The question is: How much money will enable A , in 90% of cases, not to lose all his money? Most people would say that A needs to have USD2, for the probability of a head or a tail is 50-50. Actually, the probability of having a head by tossing a coin twice is only 75%. According to the binomial theorem, to secure the possibility more than 90%, A will need at least USD4. Probability in statistics follows the Bernoulli theorem, which means, when tossing a coin 1,000 times, the chances of getting head or tail are more or less the same, however, it is not necessarily true while tossing the coin only four times. It is very likely that it is all tails, then cause A will lose money. Therefore, people tend to overestimate their risk tolerance. For example, in case of bull market, some people mortgage their house to the bank and use the loans to speculate in the stock market, which is extremely dangerous. In terms of the principles of complexity science, in a complex system participated by individuals, subjective estimates vary a lot. However, the mutual influence and the role of the external environment in guiding people’s behaviors will help generate a self-organizing effect, promoting the system to move toward a certain direction. Subjective risks in the stock market will accumulate due to such self-organizing effect and keep being amplified due to positive feedback, resulting in actual stock prices being much higher than their rational prices.

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Evaluation System of the Fictitious Economy According to the principles of systems engineering, establishing an evaluation system may involve the following five steps: 1) establishing an evaluation index system, which is supposed to be composed of a number of indices; 2) establishing measurements of all indices; 3) establishing ways of expressing the measurement results, some of which are quantitative expressions and others are qualitative expressions; 4) selecting the methods for assessing the quality of each measurement result; and 5) determining the method of judging the comprehensive quality of all measurement results, which is, the way of integrating the measurement results and evaluating the overall quality of the system. Weighted composite method is widely adopted by now. It multiplies each index by the corresponding weight and then does the sum-up. However, its limitations lie in overlooking the mutual influence between indexes, hence requiring further studies and improvements.

RESEARCH METHODS OF THE FICTITIOUS ECONOMY There are mainly six methods of researching fictitious economy.

Complexity Science Complexity science, the advanced development stage of systems science, is a science that studies complexity and complex systems. The mutual influences between system members and the interaction between the system and the external environment will help produce a self-organizing effect inside the system and form the hierarchy and functional structure, thus pushing the system to evolve in a certain direction. Currently, complex science generally has five major schools, of which the mainstream one is the self-organizing, self-learning and self-adapting theory advocated by the Santa Fe Institute in the U.S. For example, in the market economy, each enterprise makes its own decisions, operates independently and assumes full responsibility for its profits and losses. However, when making decisions, each enterprise will be influenced by other enterprises as well as the external environment. When new competitors appear, it is very likely that the enterprise will have to adjust its behaviors, improve product quality, reduce production volume and develop new products. Considering the external environment, say cost changes of bank loans due to shifting monetary policies, the enterprise will also have to change its decisions accordingly. Some state-owned enterprises in China expanded blindly, thus suffering losses

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even bankruptcies due to the rupture of the capital chain under a tightened monetary policy. In the long run, the self-organizing effect spread in a certain direction, helping to forge the rise and fall of the economy. It is also true in the stock market where every investor independently decides, at his own discretion, which stock to buy and what time to buy or sell. However, due to external influences, if the general trend is to buy a certain stock, it is very likely that individual investors will not sell the same stock they are holding. Also, the external environment will, in all likelihood, influence the decisionmaking process. For example, when the public boasts that “million points to be expected,” “stock market golden time,” etc., one might think it is the right time to invest in stock market. Thus the self-organizing effect helps to create the bull market and the bear market. The first thing we have to study is how the self-organizing effect builds its structure. There are two types of structures—hierarchical structure and functional structure. For example, the organizational structure of an enterprise may be top-down hierarchical, consisting of teams and groups, workshops, factories, divisions and the headquarters. In addition, there may be crosshierarchical functional structure in an enterprise composed of financial subsystem, personnel subsystem, production subsystem, logistics subsystem and so on. Besides, we have to study how the self-organizing effect manages to push forward the system’s evolution, namely self-organizing, self-learning and self-adapting. That is to say, a system can not only organize itself but also accumulate experience through self-learning and adapt to the ever-changing external environment. In order to be effective, any policy has to be able to influence the behaviors of system members. If it fails to change its members’ behaviors, the policy is not effective. Some governmental departments in China assume that policies are omnipotent. They firmly believe that a new policy, whether applicable or not, will definitely change the behaviors of market subjects. As Mao Zedong once said, “External causes are the condition of change and internal causes are the basis of change, and that external causes become operative through internal causes.” Policy is the external cause, which can function only upon the change of the behaviors of system members. For example, during the stock market boom in the first half of 2007, China raised the interest rate several times, increased the stamp duty, including issuing special government bonds, etc., to prevent the stock market from becoming overheated. However, the general public believed that the stock market would by no means decline before the opening of the 17th NPC, even the Beijing Olympic Games. Given such a mindset, formulating new policies will not halt the buying of

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stocks at high prices. When the bubble burst at about 6,100 points, the stock market crashed and investors inevitably suffered enormous losses. We have to study not only individual behaviors, but also organizational behaviors. Organizational behaviors depend on the self-organizing effect produced by the mutual influence between individuals and groups and that between the organization and the external environment. However, organizational behaviors will react to organization members’ behaviors. We need to incorporate the institutional economics with the characteristics of fictitious economy when studying the organizational behaviors. Complexity science adopts the following four basic methods: Combining qualitative judgment with quantitative calculation. Some Chinese economists prefer qualitative methods, while others favor quantitative ones. Actually, these preferences reflect two schools: those who study Marxist economics without training in quantitative calculation and do not adopt any mathematical tools in their works. However, they equip themselves with good economic foundations and experience and are capable of making sensitive and qualitative judgments; and those who used to engaging in engineering prefer making quantitative calculations, yet are weak in academic foundations. Their calculations sometimes are wrong if judged based on general economic knowledge. Therefore, we have to learn the techniques and methods of quantitative calculations, lay a solid grounding in economics, know how to make qualitative judgments, establish the conceptual models of the overall system and each subsystem through qualitative judgments, try to convert them into mathematical models, draw quantitative conclusions after finding the solutions or simulation and make qualitative induction of the conclusions so as to eventually solve the problem. Combining micro-analyses with macro-integration. The purpose of making micro-analyses is to understand system components and hierarchical structure; and the purpose of macro-integration is to understand the functional structure and the formation of the system. For example, when studying the stock market, we have to understand certain stocks as well as the entire stock market. But the entire stock market is not simply the sum of individual stocks. Stock market bubbles start with individual stocks. Stock holders would sell the over-valued stocks for benefits. When it is a bull market, people who have made money will choose to stay and speculate in promising stocks (e.g. rubbish stock, theme stock, concept stock, etc.), thus producing more bubbles. These bubbles gathered to ultimately create the stock market bubble. Individual bubbles and the stock market bubble are different. Some people argue in favor of the stock market bubble, claiming that “bubbles in the Chinese stock market are structural.”

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Because in any stock market there may exist some healthy, bubble-free listed companies. For example, even if during the devastating “Black Monday” in 1987, there were still 16 rising stocks. Combining reductionism with holism. Reductionism focuses on explaining macroscopic appearances from regional mechanisms and micro structures, such as using the law of physics to explain a biological phenomenon, which is onesided. While holism holds that the interrelations between all system components and their roles determine the macroscopic properties of the system. However, without a profound understanding of regional mechanisms and microstructures, people cannot understand the overall system. It can be said that research methods since Newton are mainly based on reductionism, which divides a system into several subsystems and thoroughly studies all the problems in these subsystems. However, people have found that research methods based on reductionism cannot truly solve a problem. Instead, they need to combine with holism methods, which is one of the reasons for inventing the complexity science. Holism requires people to study not only each component, but also the mutual influences and other influences between components. That is, holism advocates the principle of “the whole is greater than the sum of the parts.” When studying fictitious economy, people cannot tear it apart by focusing on a single field, say the stock market, the exchange rate or the currency market. They have to study the interrelationships and mutual influences between these components. For example, changes in the currency market, the foreign exchange market or the real estate market will inevitably influence the stock market, and vice versa. Combining scientific reasoning with philosophical analyses. Scientific theories are conceptual systems with a certain logical structure and having withstood experimental tests. When expressing scientific theories, scientists struggle to formalize them so as to make the scientific theories precise axiomatic systems. However, the development of science has proved that no theory is seamless and that there will be abnormal phenomena and events. Such phenomena and events have to be explained from such philosophical angles as necessity and contingency, the unity of opposites, negation of negation, etc.

Decision-making under Uncertainty The fictitious economy per se is highly risky, confronted with subjective risks and objective risks. Therefore, decisions might be made under uncertainty. The decision-making under uncertainty can be divided into the following four types. Quantification of qualitative variables . Variables can be quantitative,

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semi-quantitative and qualitative. Of qualitative variables, there are ordinal variables and nominal variables. The ordinal variables are variables without any numerical value, but are mutually different. They can be ranked according to a certain index. For example, they can be ranked as high, middle and low variables. Ordinal variables may be dealt with using certain approaches, such as multi-dimensional scaling, generalized quantization, etc. Nominal variables per se do not possess any meaning. For example, player No. 5 may not necessarily technically better than player No. 1 in a basketball game. Another example, when studying transportation, people have to assign a value to each and all ways of transportation, like 1 for road transport, 2 for railway transport, 3 for water transport, 4 for air transport and 5 for channel transport, etc., so as to facilitate model-building and computer calculation. Determination of empirical probability . It includes data mining, knowledge discovery in databases, intelligent mining, etc. Generally, it means inferring the future based on past and existing data. Normally, the longer the time span of the inference is, the greater the error will be. Therefore, it is applicable to only short to medium term predictions. Improvement of the subjective probability . Subjective probability refers to the probability given by experts according to their analyses and judgments. Group decision-making approach should be adopted in this course. Integration of case study and prior information . Conducting research requires people to collect statistical data, possess the predictive ability and write case studies. Case studies focus on separate cases, yet we can find a lot of specific problems from these individual events, even exceptions to general rules. However, we should not assume the results to be universal rules, because the case study focuses on single cases, thus cannot represent the general trend or behaviors. Apart from case study, prior information is of great necessity when conducting researches. Subjective judgments should never be made prior to case study, though prior information is necessary in preventing us from being confused by surface phenomena.

Group Decision-making Expert judgments are very important to decision-making. Group decisionmaking is an effective way of improving expert judgments. The author divides group decision-making into collaborative decision-making and coordinated decision-making. Collaborative decision-making refers to the case when all participants in the decision-making process have consistent objectives. It studies how to gradually

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concentrate separate opinions to make the optimal decision. In this process, the group decision-making will be more effective and efficient than any group members’. Collaborative decision-making was first named as the “Delphi Method,” (Delphi is the god of prophecy in Greek myths), referring to the process of inviting a group of experts, asking each of them to make their own judgment, integrating their judgment and feeding the integrated judgments back to the experts to allow each of them to make revisions. After several rounds, different opinions may be gathered into a unanimous conclusion. Thanks to the computer, which can provide decision makers with adequate information in advance, different opinions could thus be integrated and the optimum decision making could be obtained more efficiently and accurately. Coordinated decision making is applicable to the case when all participants have conflicts of interests, yet they hope to come up with a mutually satisfactory decision. It requires them to study the ways of using cooperative game theories to find common grounds, including Shapley value. Dividing a budget is a typical coordinated decision-making process. Several departments are struggling for a solution on how to divide the budget yet each party hopes to get the largest share. Therefore, in such coordinated decision-making process, there are conflicts of interests, as well as compromises. In group decision-making, the following factors matter: differences of knowledge and experience between participants, influences of asymmetric information and participants’ behaviors in group decision-making so as to prevent the authority effect or the bandwagon effect from influencing optimal decision. The so-called authority effect means that there may be an authoritative individual in the group, whose opinion other participants dare not defy, thus it may weaken the role of the group in group decision-making. Bandwagon effect means that everybody follows suit. Both of these undermine the role of the group in the course of group decision-making.

Complex Data Analysis for Decision Support Decision-making requires two types of knowledge: knowledge on system quality and on system evolution. In order to make assessments and predictions, both types of knowledge need to be extracted from vast amounts of data. Therefore, the mastery of analytical methods of complicated data is necessary. Such widely-used methods include mainly principal component analysis, factor analysis, cluster analysis, correlation analysis, regression analysis, regression trees, logical data analysis, as well as the relatively-new partial least squares, symbolic data analysis, data analysis functions, etc.

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Mathematical Finance Mathematical finance is a subject that uses mathematical tools and models to study financial issues. The following four methods are needed when studying the fictitious economy: Pricing of financial assets . According to the principles of fictitious economy, the pricing of financial assets is in fact related to the real economy to which it is attached. For example, the pricing of an enterprise’s stock is definitely related to the enterprise’s assets and performance. But as a matter of fact, there are three types of pricings in an enterprise. First, the pricing of tangible assets, which may be carried out using a set of established theories and methods in terms of accounting and finance, such as depreciation, physical loss and intangible loss, etc. Second, pricing of intangible assets. Although a great number of state-owned Chinese enterprises have basically drained the original tangible assets, they still have value thanks to their intangible assets like trademarks, customers, techniques, mechanics, etc. That is why some people are still willing to merge with or acquire those state-owned enterprises. But the pricing of intangible assets has always been a headache. It may risk losses of state assets if pricing them too low, but nobody will buy them if pricing them high. Third, dynamic pricing, that is, to predict future value. There are a number of equity investments, especially investments in private placement, which require people to focus on the future value of the investment objects. Private placement is used mainly for mergers and acquisitions. An enterprise’s business management and other systems have to be improved after being merged or acquired so as to appreciate the value of the enterprise. The final step is to sell the enterprise because the private placement is not aimed at establishing any enterprise group but at exploring the potential value of the enterprise, akin to venture capital investment. Discovering an enterprise’s future value requires in-depth studies. Without appropriate evaluation methods, it will indeed make no sense arguing losses in mergers and acquisitions (M&A), for nobody ever knows the exact value of the enterprise. If, after the M&A, the enterprise’s future value increases significantly, no party will suffer any loss. The merging party harvests relatively higher benefits, while the enterprise gets its share, too; otherwise, losses will be inevitable if there is not any sign of growth after M&A. Fractal market analysis . Fractal theory is a branch of non-linear science that describes the structure and pattern of complicated systems each with a disordered structure. A fractal is a rough or fragmented geometric shape that can be split into parts, each of which is (at least approximately) a miniature of

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the whole. Fractal dimension, as the name suggests, refers to the dimension expressed by non-integers. It is the quantitative characterization and essential fundamentals of a fractal. The fractal market hypothesis was proposed upon the failure of the traditional efficient market hypothesis, aimed at explaining the real trends of price behaviors on the capital market. While fractal market analysis tries to analyze the capital market in a broad sense using holism, it is more capable of explaining investors’ diversity. Fractal market analysis has overcome the limitations of the efficient market hypothesis and taken into account investors’ irrational expectations and the non-linear relationship between market reaction and information. When investors with different investment periods are active in the market, market liquidity is guaranteed, so is the market stability. Auto-regressive Conditional Heteroskedasticity (ARCH) analysis . Proposed in 1982, ARCH (n=1) has been considered as a better non-linear financial time series model. To make it more flexible, some researchers expanded ARCH into General Auto-regressive Conditional Heteroskedasticity (GARCH). Empirical studies have shown that volatility of stock returns is time-varying (Conditional Heteroskedasticity) and non-linear. By describing volatility as the linear equation of previous predictive mean square error, uni-variate GARCH models have captured the dynamic behaviors of volatility to some extent. However, GARCH model parameters are unstable in the time dimension. Some studies have also pointed out that prediction results based on simple GARCH models sometimes are not precise. To this end, researchers have made a variety of improvements of ARCH, including non-linear ARCH (NARCH), threshold ARCH (TARCH), asymmetric ARCH (AARCH), quadratic ARCH (QARCH), fractionally integrated ARCH (FIGARCH), ARMA, ARCH, etc. ARCH, as an important means in mathematical finance, is widely used in futures analysis, stock market analysis and other financial analyses. But because it is a “black box approach,” so it is better to organically combine ARCH analysis with mechanism analysis. Theory of financial risks . Theory of financial risks includes the definition, measurement, treatment, control and management of risks. With the accumulation of vast amounts of financial data and the development of statistical analysis methods, traditional theories of financial risks, such as the theory of option pricing and hedging, are facing great challenges.

Computer Simulation The last method adopted by complexity science is computer simulation. There are generally two types of computer simulations: first, the discrete event

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simulation, including General Purpose Simulation System (GPSS), SymScript, etc., which is traditional; second, the agent-based simulation which has been widely used in the studies of complexity science. The latter type of computer simulation has mainly two tools: Swarm Simulation Toolkit developed by the Santa Fe Institute and NetLogo developed by Northwestern University, both in the United States. Other relatively famous simulation tools include Artificial Life, Cellular Automata and Co-opitition, etc. Completed on October 8, 2008

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Chapter

China’s Venture Capital Investment

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It has been a decade since the proposal of Several Opinions Concerning Accelerating the Development of Venture Capital Investment Cause in China was put forward by the Central Committee of China Democratic National Construction Association in March 1998 at the 1st Plenary Session of the 9th CPPCC, and was selected as the “No. 1 Proposal,” thus paving the road for China’s venture capital investment. Besides, the Central Committee of China Democratic National Construction Association, along with other departments, has held an annual China Venture Capital & Private Equity Forum. In this chapter, the author plans to review the development of venture capital investment in China in the past decade at the macro-level, and offer suggestions on the future acceleration of China’s venture capital investment.

CHINA’S VENTURE CAPITAL INVESTMENT IN THE PAST DECADE Since China’s reform and opening up, groups of Chinese scholars were sent to the U.S. for advanced studies. Some of these scholars, including the author, began to notice the role of the U.S. venture capital investment in facilitating its economic development and hi-tech industrialization and tried to introduce venture capital investment to China. In Decision on Reforming the Science and Technology System issued by CPCCC in March 1985, it proposed that “certain venture capital investments are needed for developing rapidly-changing and highly-risky advanced technologies,” thus marking the beginning of China’s venture capital investment. In September 1985, the State Council officially approved the establishment of the first national financial institution in Mainland China specializing in venture capital investment—China New Technology Start-up Investment Company. In 1986, the Ministry of Science and Technology put forward, for the first time, the strategic principle of developing venture capital investment in China in its Science and Technology White Paper . In line with the principle, some local governments and departments began to build some small companies mainly engaged in technology financing. However, due to institutional obstacles, China’s S&T and economic reform failed to keep abreast of progress. Besides, the obstructed financing channels, less-developed capital market, incomplete contractual relationships, irrational distribution system, implicit intellectual properties, etc., development of China’s venture capital investment slowed to crawl. Some venture capital investment companies even went astray, betting their capital on loansharking, stocks, futures and real

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estate, finally being forcibly closed by the government due to serious violations of laws. Since the 1990s, some China investment funds established by overseas investors, including IDG Capital Partners and China Walden Venture Fund, began to target Mainland China. Some managers of these funds were experienced in venture capital investment, yet most of them believed that the environment for developing venture capital investment in China had not yet established, so they chose to invest in the expanded reproduction of existing enterprises instead of truly engaging in venture capital investment. Since the author was selected as the chairman of the Central Committee of China Democratic National Construction Association in December 1996, he has begun to consider effective ways of pushing for the development of venture capital investment in China. In September 1997, he held a seminar for domestic and foreign venture capitalists. All participants agreed that China was basically prepared for developing venture capital investment and expressed their opinions and provided some suggestions. In March 1998, after dedicated investigation, the Central Committee of China Democratic National Construction Association submitted to the 1st Plenary Session of the 9th NPC the proposal entitled Several Opinions Concerning Accelerating the Development of Venture Capital Investment Cause in China , thus greatly energizing China’s venture capital investment. Generally, conditions for developing venture capital investment had also gradually improved; while the development of China’s socialist market economy had also encouraged venture capital investment. The construction of the socialist market economy in China at the time fueled the development of venture capital investment. Besides, China had made a great number of valuable S&T achievements; and teams of high-quality enterprise operators were expanding. Moreover, China had enormous bank deposits to make direct investment (more than RMB5 trillion at the time). Industries of technical, financial and legal consultancy services were growing vigorously. Finally, the Chinese securities market became increasingly mature. All of these have created favorable conditions for the development of China’s venture capital investment. It was stressed again in the Decision of the State Council of the People’s Republic of China on Reforming the Science and Technology System during the 9th Five-year Plan Period issued in 1996. Some local governments and districts were also active in exploring and pushing forward the development venture capital investment. T h i s “ N o . 1 p ro p o s a l ” w o n i t s s u p p o r t f ro m re l a t e d g o v e r n m e n t departments. The State Council actively implemented the proposal and

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National Development and Planning Commission (now known as the National Development and Reform Commission) fully affirmed the proposal. Local governments quickly took actions. In particular, Beijing, Shanghai and Shenzhen took the lead in developing policies and measures for pushing forward the development of venture capital investment. Besides, both domestic and foreign investors were optimistic about China’s prospects. For example, the Ministry of Science and Technology actively sought to cooperate with IDG and others. Some capable investment companies in China also were itching to try. Hi-tech Chinese enterprises began to seek support from venture capital for self-development. Studies and discussions on venture capital investment were developing vigorously in China at the time. Related seminars were held frequently. Both the National Natural Science Foundation of China and the Ministry of Science and Technology arranged key research projects on venture capital development and made many suggestions on the legislation, management and financial supports concerning venture capital investment. Finally, China’s media sensitively captured the original topic and kept publicizing it, playing a great role in promoting the development of venture capital investment. Despite institutional and legal obstacles, as well as problems and mistakes in the development process, venture capital investment had maintained a rapid development in the following decade. According to statistics, from 1998 to 2001, venture capital investment was developing fast in China. The number of venture capital firms in China was only 53 by the end of 1997 but grew to 246 by the end of 2001, approximately five times as many. The total amount of capital controlled by venture capital agencies was only RMB5.1 billion by the end of 1997, but that increased to RMB40.5 billion by the end of 2001, growing about eight times. Beijing, Shanghai and Shenzhen have gradually become the centers of venture capital development in China. As of the end of 2001, the total number of venture capital firms in these three cities reached 150, accounting for 60% of the national total; and the aggregate amount of venture capital in these three cities hit RMB28.78 billion, accounting for 70% of the national total. These three cities each developed in its unique direction. Beijing has established Zhongguancun, a place where many innovative enterprises gather; Shanghai has set up Shanghai Zhangjiang Hi-tech Park supported by hi-tech industries; and Shenzhen has dominated the high-tech industrial belt driven by its annual China Hi-tech Fair. Since 2002, during the world economic slowdown and the downturn of international venture capital investment, China’s venture capital investment entered a period of adjustment. Table 5.1 provides an overview of venture capital investments in China during 2001–2007.

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Table 5.1.

Year

Annual survey sample of China’s venture capital investment, 2001–2007

Number of samples

Aggregate venture capital (RMB100 million)

2001

—

405.3

2002

—

2003

Proportion of foreign capital (%)

Number of investment projects

Investment amount

21.9

210

50.0

—

—

—

55.9

180

325.3

5.0

335

37.1

2004

141

438.7

15.0

325

37.8

2005

150

441.3

33.9

434

117.6

2006

151

583.9

43.7

371

143.6

2007

275

1,205.9

55.6

741

398.1

During 2001–2005, due to the absence of laws, regulations and policy support to encourage venture capital investments, and the sustained domestic capital market downturn, the value of some enterprises shrunk greatly, trapping the capital of most venture capital firms in the mainland, making them unable to get profits or withdraw, and greatly weakening their capabilities to reinvest. Venture capital growth and the number of venture capital firms have also greatly declined. However, overseas venture capital investment firms were confident in China’s economic prospects and kept injecting venture capital in China. Both the number and the amount of investment projects showed an ascending trend. On the surface, the total amount and volume of venture capital in China was rising steadily, yet the influence of venture capital investments in Mainland China kept waning. Some venture capital firms in China have shifted to providing financial and intermediary services, some capital has even been completely withdrawn from the field of venture capital investment. With the rapid and sustained economic development in China and the recovery of global venture capital investment, China’s domestic venture capital investment has stepped into a new development stage since 2006. According to the survey carried out by China Venture Capital Research Institute, as of the end of 2006, the total amount of venture capital in China reached RMB58.39 billion, up 32.31% over the RMB44.13 billion in 2005. The total amount of China’s venture capital investment was RMB14.36 billion in 2006, up 22.17% year on year. More than 371 Chinese enterprises were supported by venture capital

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investments in 2006. Altogether 116 venture capital investment projects, totaling

RMB14.83 billion, have succeeded in divestment throughout 2006, of which 37 were listed companies, 72 transferred their shares and 3 were liquidated.

In 2007, driven by the relatively fast economic growth, the booming stock

market, the soaring price of the real estate and the push of excessive liquidity,

China saw an explosive increase of venture capital investment. Totally 109 venture capital companies expanded their capital base or raised new funds, raising as much as RMB89.34 billion, four times more than the total amount

of the newly-raised capital in 2006. As of the end of 2007, the total amount

of venture capital invested in the mainland by domestic and foreign venture capital firms reached RMB120.59 billion, more than double year on year. The total amount of venture capital investments in 2007 reached RMB39.81 billion,

growing more than 2.5 times over that in 2006. Of which, the total amount of venture capital injected by foreign agencies exceeded RMB30.25 billion,

accounting for 76% of the total; and that by domestic firms was only RMB9.55

billion, accounting for 24%. The number of venture capital investment projects reached 741, more than double year on year. In 2007, 157 investment projects

succeeded in divestment, of which, there were 125 projects whose capital amount reached RMB9.26 billion (of which, 50.24% succeeded by going public, 45.46% through equity transfer, and 4.30% through liquidation). Altogether 77 enterprises with the background of venture capital investment succeeded in

going public in the capital markets in the U.S., Japan, Singapore, South Korea and Mainland China, raising a total amount of RMB156.94 billion.

The author proposed a “three-step strategy” (san bu zou ) for developing

venture capital investment in China in 1998. The first step is to establish venture capital consultancy and management companies so as to assess and recommend projects for domestic and foreign venture capital investors before

being commissioned by the investors to manage the projects. The second step is to establish venture capital funds and develop corresponding laws, regulations and management measures to absorb funds from domestic and foreign investors. The third step is to establish a second board market to provide

divestment channels for venture capital and form a relatively complete venture capital system. It was estimated at the time that the strategic steps would be completed in 5 to 10 years. Although China’s venture capital investment has

been much influenced by domestic and foreign factors, the strategy would be

basically forged if the growth enterprise market (GEM) could be opened in time in the first half of this year.

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EXPERIENCE OF CHINA’S DECADE-LONG VENTURE CAPITAL INVESTMENT In the context of a highly-developed socialist market economy and emerging knowledge economy, venture capital stands out, becoming a new investment pattern. To introduce this exotic pattern into China, where its socialist market economy is still underdeveloped, it will absolutely be “unacclimatized.” In the past decade venture capital investment development, there have been controversies, arguments, even detours in theories and practices build-up. The author holds that the following several experience deserve our attention.

Adhering to the Basic Principles of Venture Capital Investment Venture capital investment features high risks, diversified portfolios and longterm return. However, under the influence of the swelling bubbles of hi-tech stocks in the U.S. during 1998–2000, triggered by the dot-com stocks, many actions which breached the basic principles of venture capital investment also appeared in China’s venture capital investment market under the influence of the “No.1 Proposal.” 1) Since venture capital investment mainly supports innovative technologies and products, it brings high technical, economic and market risks. The success rate is only about 30%. According to some experienced U.S. venture capitalists, of the projects they once invested in, only one third were described as “extremely” successful, another one third turned out to merely break even, and the rest one third were suffered losses or bankruptcies. However, since successful projects can not only make up for the losses caused by failed projects, but also bring considerable returns to investors thanks to their high rate of returns, they attract some investors to speculate. However, in order to attract investors, some people downplay the risks of venture capital investments, even deny the basic “risk-return symmetric” principle by calling them low-risk and highly-rewarding venture capital. Such arguments once lured so many investors into the tide of venture capital investment. The author believes that venture capital investors should first realize the risks of venture capital investment and that high risk exactly means the chances of high returns. 2) To diversify risks. Venture capital is usually invested in a project group composed of a number of sub-projects and uses the high returns from helping successful sub-projects go public or from achieving divestment by selling successful sub-projects to make up for the losses caused by failed sub-projects and generate profits. Though this kind of portfolio investment is totally different

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from individual investment, many venture capital companies in China adopt the traditional way of investing, attract investors with individual projects, and measure their performances by the success or failure of individual projects, which makes a great number of venture capital managers dare not take the risk or offer low prices in negotiation with patent owner. Thus, many good projects have been taken up by overseas venture capitalists. Considering the innovative Chinese companies listed in NASDAQ, most of them have the backing of overseas venture capital investment. 3) Normally, it takes three to seven years for venture capital to withdraw and enjoy returns, during which constant capital injection is needed by promising projects. However, Chinese investors tend to pursue short-term performance, which encourages venture capital managers to be short-sighted and invest a great deal of capital in merging enterprises with great possibilities of getting listed, even in stock and real estate speculation, completely violating the original intention of using venture capital to support innovative business start-ups. 4) Venture capital is a kind of equity capital, not debt capital. Therefore, it focuses on the development prospects and asset appreciation. Enterprises supported by venture capital (known as venture businesses) need to expand their scale and develop new markets. Yet, they always sport a negative cash flow. Venture capitalists, however, are capable of exploring investment opportunities from these enterprises’ fundamental techniques, commercial patterns and growth potential. Even though, during China’s venture capital investment rush, many venture capital companies were feverish on the concept of speculation while ignoring characteristics of various businesses, thus subjectively predicting the market trend, measuring the value of the businesses based on their short-term performance. The prevailing mindset gave rise to a great number of “moneyraising” and “money-devouring” companies which consequently caused enormous losses to investors. 5) Venture capital investment provides capital for innovators, and venture capitalists with profound knowledge, experience and extensive social connections actively participate in the management of venture enterprises. Together with innovators they put forward suggestions on reforming the organizational structure, determine the business direction, strengthen financial management, and outfit the leadership of such venture enterprises. However, venture capital investment projects in China are managed in the traditional way due to the lack of venture capital investment talent. Venture capital investment firms merely focus on obtaining benefits from the enterprises they invest in, instead of truly helping them. This results in a problem that many major issues of the enterprises’ are determined by patent owners at their own discretion and that even investors

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are excluded from knowing enterprises’ businesses and finance situations. Some

innovators, after a successive start-up, try all means possible to shrink returns to venture capitalists.

Although China’s venture capital investment grows fast in recent years, it is

still necessary for China to develop the above several concepts in accordance with its conditions.

Clarifying the Key Areas and Key Periods of Venture Capital Investment The author has pointed out many times that China does not develop venture

capital to simply get a tool of direct investment. Instead, it aims to inspire the vitality of its vast S&T workers in making innovations, promote the conversion

of the great amount of its innovative S&T achievements into new techniques and products, and achieve the industrialization of high technologies so as to build China into a “body country” that introduces and uses knowledge as well as a

“brain country” capable of producing and exporting knowledge before achieving the grand objective of building an innovation-oriented country. Therefore, the key areas of venture capital investment in China should be hi-tech industries

and the key period should be business start-up period. However, for a long time, some people in China have held the idea that venture capital investment should be expanded to the general high-growth enterprises, small and medium-sized

enterprises (SMEs) or private enterprises, which actually would decentralize the limited amount of venture capital and weaken the support for S&T innovations.

Among the insiders of the venture capital industry in China, some people

advocate “venture” investment before devoting most of their energy to the

relatively mature companies which are very likely to go public soon. To be specific, they focus on the late stages of a venture capital investment. Though

during the global downturn, many overseas venture capital funds did show a

trend of shifting their focus to the late stages, venture capital investment in China (especially venture capital investment made by the government) should still

focus on the earlier stage (namely the start-up period) under the grand objective

of building an innovation-oriented country. In the files of the National Science and Technology Conference held in early 2006, the wordings “risk investment in business start-ups” was put forward, which actually highlighted more of the focus of venture capital investment. Still, some people explained it away as

investment in business start-ups (risks), that is, risk investment in business start-

ups could also be called venture investment, and they objected to shifting the focus of venture capital investment to the earlier stages.

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Creating a Favorable Environment for Venture Capital Investment It will be a long-term and arduous task to establish venture capital investment that is in line with China’s national conditions at a time when China is still an underdeveloped market economy and in the midst of industrialization. Although government supports are necessary, they should be legal, appropriate and effective based on the characteristics of the socialist social market economy so as to create an environment favorable to the development of venture capital investment. In short, the government should develop and implement laws and regulations conducive to promoting the development of venture capital investment. In the tide of venture capital investment during 1998–2001 in China, venture capital companies mushroomed, raising a great deal of capital and giving birth to large groups of various companies waiting for the support of venture capital. Due to the lack of experience and regulations, there were chaos and legal disputes. According to the “trade ahead of institution” principle such situations were no surprise, but should be gradually regulated in order to achieve a better development. In the past decade, with the development of venture capital investment, China has been pushing forward legislation on venture capital investment. The NPC Standing Committee decided to review the Company Law of the People’s Republic of China on December 25, 1999, determining that “supporting eligible hi-tech limited liability companies to enter the securities market and raise funds directly was conducive to the development of high-tech industries. National industrial policies should be adhered to and the hi-tech requirements should be met when such companies raise development funds in the capital market. Because of the characteristics of hi-tech limited liability companies, their listed stocks shall be traded in a separate trading system in the existing stock exchange. Considering its lack of experience in such field and the high risks, China should carry it out in a planned, phased, positive and proper way. In case of a hi-tech limited liability company, the ratio of capital contributions made by the company’s founders with industrial properties and non-patented technologies, as well as the conditions for the company to issue a new stock or apply for going public shall be otherwise provided by the State Council.” The former Company Law required hi-tech companies to have at least RMB50 million in registered capital and be profitable in three consecutive years, setting two biggest obstacles for high-tech companies to go public. Since hi-tech companies in their growth period usually are relatively small in scale and have a negative cash flow due to the need for making constant capital investments,

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the revision also created conditions for hi-tech companies to go public and a channel for the divestment of venture capital. Meanwhile, the NPC Standing Committee also enacted legislation on funds for investment, intent on including funds for investment in securities, funds for investment in industries and funds for investment in venture capital. However, many people believed that conditions for establishing the latter two forms of funds were not mature. Law of the People’s Republic of China on Funds for Investment was in the end made into Law of the People’s Republic of China on Funds for Investment in Securities before being adopted on October 28, 2003. The Standing Committee also passed Trust Law of the People’s Republic of China , establishing a law for the trust industry to follow in its development process. On October 27, 2005, the revised Company Law and Securities Law were adopted by the 18th session of the Standing Committee of the 10th NPC before taking effect on January 1, 2006. The revision of these two laws has not only absorbed international experience, but also taken into consideration China’s national conditions, playing a significant role in the development of Chinese enterprises and the country’s capital market, as well as the development of venture capital investment in China. The revision of the Company Law was actually an overall modification of the former Company Law . As for the number of the revised articles, only 20 or more articles in the existing Company Law remained unchanged; others were added or deleted in parts. The revised Company Law has 219 articles in 13 chapters. Though there are fewer articles, the Company Law features more-scientific and advanced legislation concepts, a more rigid and rational structural system and more feasible and regulated contents. Compared with the former Company Law , the revised version was more favorable to venture capital investment in that: 1) It lowers the threshold for establishing companies. Approval by the State Council-authorized departments or provincial people’s government was no longer needed. As long as being qualified in accordance with the provisions of the Company Law , any investor can establish a joint-stock company. It even allows the establishment of a sole proprietorship. The total amount of registered capital required to establish a joint-stock company has been lowered from between RMB100,000–500,000 to RMB30,000 for a limited liability corporation; and that to establish a corporation limited from RMB10 million to RMB5 million, which was conducive to the establishment of small and medium-sized innovative companies.

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2) It institutes the registered capital installment payment system, allowing companies to pay their registered capital in full in two years; for investment companies, five years. Therefore, it allows investors to make investments according to their business needs and avoid an excessive backlog of capital of companies at the initial stage so as to improve the efficiency in the use of capital. 3) It relaxes the past provision that the total outward investments of a company should not exceed 50% of its net assets, which used to be an obstacle to venture capital companies. If only half of the net assets were allowed to be used as investments, the rest would have nowhere to go. The new Company Law provided that any company may invest in other enterprises and there should be no restriction over the ratio of the total amount of venture capital investment to the net assets. 4) It has greatly diversified the forms of capital contributions by shareholders. As the new Company Law provides: “except for assets forbidden to be used as contribution by laws and administrative regulations, a shareholder may make its capital contributions to a company in currency or by contributing such noncurrency property as material objects, intellectual property rights and landuse rights that can be evaluated in the form of currency and transferred in accordance with the law.” Therefore, creditor ’s rights, stock equity, mining rights, exploration rights and other rights to things could all be used as capital contributions. Other forms of capital contributions might account for as much as 70% of a company’s registered capital. It abolished the original provision that capital constructions through intellectual property rights could not exceed 20%, which was conducive to the development of venture capital. If the ratio was too low, some holders of better technologies would not be willing to cooperate with domestic venture capital companies. 5) Shareholders of a limited liability corporation might provide in the corporation’s bylaws that shareholders did not have to get dividends or make capital contributions, or exercise their voting rights based on the proportions of their respective investment. Meanwhile, it strengthened the protection of shareholders’ rights and interests, clearly providing that shareholders have the right to request to check the company’s books. Prior to the establishment of a limited partnership, all these rules and provisions were conducive to intensifying venture capitalists’ control over the enterprises in which they had made investments. The revised Securities Law has expanded the means and scope of securities trading. First and foremost, for the five types of problems used to be put under stringent control, namely separate business operation, separate supervision, spot trading, financing and securities lending, speculation in stocks by state-owned

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enterprises and the entry of bank capital into the market, it has relaxed control by allowing the State Council to otherwise develop laws, regulations and rules. It has changed the past management measures adopted by securities companies while further improving the risk control mechanisms of the securities companies. Second, it has strengthened the authority of the supervising departments, intensified constraints of their exercising authority, and provided corresponding legal responsibilities. Third, it has further improved legal responsibilities by increasing penalty articles by a third to 47 articles in total. Fourth, it has strengthened the protection of investors’ rights and interests, established funds for protecting securities investors, and provided that investors’ trading funds shall be put under the custody of a third party and that client securities and funds shall not be embezzled or put under forcible execution. Finally, it has improved the transparency of information disclosure and clearly defined the legal responsibilities of such market subjects as securities issuers, listed companies, the top management of listed companies and various intermediary agencies. All of these revisions have laid a legal foundation for opening the second board market. On November 14, 2005, approved by the State Council, 10 ministries, including China National Development and Reform Commission, jointly issued Interim Measures for the Administration of Startup Investment Enterprises which later took effect on March 1, 2006. The introduction of the Measures officially recognized the position of venture capital investment in China before gradually solving various discriminations and problems in the development of the industry. Meanwhile, based on the Company Law and the Securities Law , China made related provisions on such behaviors as investment, financing, divestment and corporate construction in venture capital investment, as well as legal protection and regulation. Although the current Measures are not flawless, it does play a role in promoting the development of venture capital in China. On August 27, 2006, the NPC Standing Committee adopted the new Law of the People’s Republic of China on Enterprise Bankruptcy , which has taken effect since June 1, 2007. The new law reworded the cause on bankruptcy from “… fails to clear off its debt as due…” to “…fails to clear off its debt as due, and if its assets are not enough to pay off all the debts or if it is obviously incapable of clearing off its debts…” The rewording not only helps innovative enterprises in development avoid declaring bankruptcy when being dunned, it also facilitates venture capital agencies in applying from the court for reorganizing or liquidating those enterprises without any development prospects, yet in which they have invested. It has also added some articles to protect the rights and interests of staff and workers and the secured.

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On August 27, 2006, the NPC Standing Committee passed the newlyrevised Partnership Law of the People’s Republic of China which began to take effect on June 1, 2007. The revised Partnership Law adds to the content of limited partnership and clearly stipulates that general partners in charge of the company’s operation and management have to undertake unlimited liabilities for the debts of the partnership company, realizing the connection of rights and liabilities. The new law stipulates that a partnership with limited liabilities should be composed of 50 or fewer partners, one of which should be the general partner. Partners with limited liabilities do not carry out partnership affairs, no represent the partnership with limited liabilities externally. Under the new law, the definition of “founders of the partnership” is expanded to cover natural persons, legal persons, public utilities, social groups and other organizations. However, wholly state-owned companies, state-owned enterprises, listed companies, public welfare institutions and social groups are not allowed becoming the general partner. Besides, the new law has also made provisions on the bankruptcy of a partnership. It can be seen that implementation of the revised Partnership Law has created conditions for establishing venture capital funds in the form of partnership with limited liabilities. The Real Right Law of the People’s Republic of China and the Law of the People’s Republic of China on Enterprise Income Tax were adopted at the 5th Plenary Session of the 10th NPC on March 16, 2007, the Real Right Law of the People’s Republic of China clearly guarantees the equal legal status and development rights of all market subjects and places various types of market subjects in the same equal position in a unified market, granting them equal rights and requiring them to undertake the same responsibilities. On November 28, 2007, the Implementation Rules of the Law of the People’s Republic of China on Enterprise Income Tax was adopted at the executive meeting of the State Council before taking effect on January 1, 2008 together with the Law of the People’s Republic of China on Enterprise Income Tax . It has not only unified the domestic enterprise income tax law and the foreign enterprise income tax law and expanded the 15% preferential tax rate on hi-tech enterprises in national hi-tech industrial development zones to across China, it also devised preferential policies for venture capital institutions. It provides that investments made by venture capital institutions in key areas whose development needs national supports and encouragement can be deducted from the taxable income at a certain percentage of the investment amount. The Implementation Rules also clearly provides that as for the tax deductions toward taxable income of a venture capital enterprise having invested in the shareholdings of small and medium-sized hi-tech enterprises for more than two years, 70% of the

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investment amount in small and medium-sized hi-tech enterprises may be deducted from the taxable income of the venture capital enterprise for the year when the two-year holding period is over. In the event that the deductible is not fully utilized in that year, the unused amount is allowed to be carried forward to the following tax years. All of the above legislations are exactly what the people engaged in the venture capital circles have been dreaming of for years. That some of their concepts and suggestions that are embedded in legal articles through legal proceedings will sure play an important role in promoting the development of venture capital investment in China.

Broadening the Channels for the Divestment of Venture Capital After successfully cultivating an enterprise, venture capital investment companies must realize their owners’ equity through divestment. The most commonly-used approach is to make an IPO of the venture business or sell their stock equity (to large enterprises by ways of M&A in most cases; or enterprise employees or business start-ups sometimes). Although venture businesses grow fast, they are usually small in scale. Plus, they need constant capital increase in the growing process. So their performance indicators may not be able to meet the requirements of the traditional securities market, making SMEs-oriented securities markets necessary. For example, the small-scale NASDAQ capital market in the United States has relatively low requirements on the conditions an enterprise should have if it wants to go public in NASDAQ. It is therefore particularly good for small and mediumsized hi-tech enterprises to finance and provides divestment channels for venture capital. Such kind of markets is often called second board market (or the regulated market). Once mature, listed companies can be upgraded and go public in the NASDAQ national market (main board market). This dual- market structure also makes it convenient for enterprises to get listed again upon leveraged buyout. The first choice for China venture capital investment projects to go public overseas is the small-scale NASDAQ capital market. Ever since the first Chinese enterprise successfully went public, another 30 Chinese enterprises have succeeded in going public in NASDAQ, forming a “China board.” Thanks to China’s economic outlook, hordes of Chinese enterprises have successively gone public in NASDAQ, including Sina, Netease and Sohu in the early days, as well as Shanda, Focus Media and Baidu in recent years, all of which boasted a good score in the market. In 2005, Suntech-power in Wuxi went public in the

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New York Stock Exchange before generating very good results. Some Chinese enterprises going public in Hong Kong’s main board market or GEM or in Singapore have also sported great results. During 1997-2000, during the boom of global venture capital investment, some people in China called for setting up a GEM to provide an outlet for venture capital. The author believed that it would be very risky to set up the GEM, for many enterprises were start-ups and it was difficult to tell whether they would succeed or not. To allow them to raise money on the captain market was to actually shift the risks supposed to be undertaken by venture capital agencies to the general investors. To promote the development of venture capital and to pay special attention to preventing risks, the NPC Standing Committee revised the Company Law at the close of 1999, allowing hi-tech enterprises to go public on the technology market in the Shanghai Stock Exchange and the Shenzhen Stock Exchange. Despite this decision, some people still advocated with all their might for the opening of the GEM and claimed that “without GEM, there would be no venture capital investment,” greatly hindering the effective implementation of the above decision. After the global venture capital investment declined, China had failed to set up the technology market, let alone the GEM. To push forward the building of the second board market, the author proposed a “three-step plan” in 2002: first, gathering 20 to 50 high-tech small cap stocks that had been approved by the Securities Regulatory Commission Stock Issuance Examination and Verification Committee before setting up a separate market. Since the requirements on enterprises going public remained unchanged, this step was quite well-received. What’s more, such enterprises were not so many in China as to have a great impact on the market; second, appropriately relaxing some conditions to gradually expand this market; third, separating out the market when the time was right to make it an intact and independent second board market. After repeated research and careful preparation, the SMEs market was launched in Shenzhen Stock Exchange on May 28, 2004; on June 2, 2004 the first public offering of the first stock of SMEs was issued. Since some people believed it hard to identify hi-tech enterprises, the name SMEs market was used. SMEs market is now an important part of the existing main board market. The laws, regulations and department rules it follows are the same as those followed by the main board market. To go public on the SMEs market, enterprises must meet the requirements on listing and information disclosure on the main board market. However, the SMEs market operates independently. It is different from the main board market in terms of monitoring, codes and indexes.

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Some people questioned, since the listing “threshold” of the SMEs market was examined and verified based on the existing issuance examination and verification standards on the main board market, some small enterprises having better performances, yet having not reached the conditions for going public would be refused. However, after weighing the pros and cons, in order to launch the SMEs market as soon as possible, it would be wise to maintain the past conditions for enterprises to go public before relaxing requirements gradually when the time was right. The launch of the SMEs market marked the beginning of the construction of a multi-tiered capital market in China, which would provide SMEs with a new means of financing through the capital market, a channel for venture capital to withdraw from the market and a new opportunity of investment for the vast investors. However, it was only the first step of a long journey. More arduous efforts were needed to build the Shenzhen Stock Exchange into a NASDAQ-like multi-tiered capital market. Since the establishment of the SMEs market, Shenzhen Stock Market has focused on its institutional construction following the requirement of “establishing the concept of strict supervision to create a market of integrity.” The SMEs market kept growing stronger and stronger and boasted good results. As of the end of 2007, 202 companies have issued stocks on the SMEs market, with the total capital shares valuing RMB33.96 billion (of which, RMB12.67 billion was for negotiable shares), and the total market value reaching RMB1.07 trillion (of which, RMB382.4 billion was negotiable). The market has become an important component of the Chinese capital market, whose turnover accounts for about 10% of that of the main board market in the Shenzhen Stock Exchange. The overall quality of the listed enterprises in this market is higher than that in the main board market. The shareholding ratio of the institutional investors led by funds has exceeded 30% in this market.

PROSPECTS OF CHINA’S VENTURE CAPITAL INVESTMENT At the 2007 China Venture Capital & Private Equity Forum, the author pointed out that venture capital investment in China had entered into a new development period since 2006, mainly for the following several reasons. First, the rapid and sustained economic development in China has provided driving forces for the development of venture capital investment. Since 2003, the annual GDP growth rate in China has been at above 10%, to 10.1% in 2004, 10.4% in 2005, 10.7% in 2006 and even 11.4% in 2007. Despite the economic slowdown in 2008, China will still top a 10% growth rate. Rapid economic

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development usually leads to rapid accumulation of social wealth, thus giving rise to the need for developing various investment tools, including venture capital investment, to meet the demand of the general public for increasing their property income. Second, the proposal of the objective of building China into an innovationoriented country has helped attract more attention to venture capital investment. The CPCCC and the State Council held a China National S&T Conference in early 2006, proposing the grand objective of building China into an innovation-oriented country. An innovation-oriented country is a country whose development is driven mainly by innovations. In building an innovationoriented country, venture capital investment plays an important role. Without the support from venture capital, innovators cannot realize their dream of starting new businesses, convert their innovations into products, technologies and real productive forces or play their role as innovators in the economic development. Third, the enthusiastic entry of overseas investors has provided much more capital and experience. In recent years, more and more overseas investors become confident in China’s development for the following reasons: 1) China is politically stable; 2) China’s economy has been growing fast; 3) China presents an enormous market; 4) labor in China is quality, yet costs less; 5) China is strong in doing research and launching R&D activities and has a great number of technical talent; and 6) the investment environment in China has been improved constantly. Thanks to these favorable conditions, a great deal of capital has entered China from abroad, showing a more active entry of venture capital. Of the annual amount of venture capital investment in China, the portion of foreign capital is increasing and growth rate of it is higher than that of domestic capital. Fourth, laws and regulations on venture capital investment have increasingly been perfected and the investment environment has been improved. Fifth, the deepening of the financial reforms in China has been conducive to the entry and withdrawal of venture capital. With the opening up of capital accounts in China in a steady and orderly way, the access and acquisition of foreign capital will be more regulated and efficient. Moreover, the institutional construction of China’s stock market has continued to improve based on the successful non-tradable shares reform. The construction of the multi-tiered capital market is pushed forward steadily and the second board market (the regulated market) will soon be set up, which will definitely play a role in promoting the development of venture capital. Sixth, venture capital investment around the world has recovered. Since global venture capital investment entered the trough in 2001, then it grew

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slowly in 2003 and 2004. Yet things changed in 2005. According to statistics from Venture One, in 2006, the total amount of venture capital investment was USD26.86 billion in the United States and EUR4.38 billion in Europe. Of the three major European countries, the UK, France and Germany, the comparable amounts were EUR1.42 billion, EUR785 million and EUR524 million, respectively. The gradual recovery of global venture capital investment will definitely stimulate the development of venture capital investment in China. China has had many favorable conditions for developing venture capital investment, though it faces many severe challenges: 1) market development in China is not mature; government functions have to be transformed; and market-oriented operation of venture capital investment will encounter many difficulties; 2) China exports insufficient capital and knowledge currently has a weak foundation and a low level of financial capital, which will curb the efficiency and quality of venture capital investment in mainland China; 3) the rule of law has yet to be improved in China; related laws and regulations have to be further expanded and improved and more efforts have to be made to ameliorate law enforcement; and 4) China is short in talent, especially venture capitalists who are familiar with finance and laws, know China’s national conditions well, and have superb management skills.

SUGGESTIONS ON FURTHER PROMOTING CHINA’S VENTURE CAPITAL INVESTMENT In the coming decade, venture capital investment will see golden opportunities, as well as severe challenges in China, requiring us to have the visions and work diligently based on the obtained achievements. To further push forward the development of venture capital investment in China, the author suggests that China should do the following:

Strengthening the Institutional Construction and Regulating China’s Venture Capital Investment Although the word “institution” has been widely used in recent years, different people have a different understanding of the nature of institution. It is generally believed that institution refers to a set of rules and norms that provide certain procedures for people to follow in order to work. The academia believes that institutions are political, economic and cultural systems formed under certain historical conditions. The author used to adopt complexity science to analyze institutions, concluding that an institution should include two aspects: system

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and mechanism. “System” refers to the state and structure of the institution at a specific time, were as “mechanism” refers to the process of and driving force for the evolution of the institution. System and mechanism are mutually dependent. System is the starting point and result, while mechanism is the evolutionary path. The interaction among institutional agents and that between the institution and the external environment will produce a self-organizing effect inside the institution, form the institutional layer and functional structure, and push the institution forward in a certain direction, allowing the institution to present certain orderliness and stability at the macro-level and in the long run. Government policies should guide the general public’s behaviors. However, they should, by no means, be implemented simply in a mandatory manner, but rely on changing people’s decision-making code and behaviors before changing the intensity and (or) direction of the self-organizing effect. It can be concluded that in developing venture capital investment, China must pay special attention to institutional innovations. Since China has not introduced venture capital investment for long and lacks specific experience, it must gradually standardize venture capital investment in the development process step by step. The author suggests that China proceed to develop Law of the People’s Republic of China on the Promotion of Venture Capital Investment as soon as possible based on existing laws and regulations so as to regulate the behaviors of such market subjects as innovators, investors and venture capitalists, the basic relations between these market subjects, as well as the competition in the venture capital market.

Guiding China’s Venture Capital Flow Being innovative is the soul of national progress and a constant motivating force for national prosperity. An innovation-oriented country is a country whose development is mainly driven by innovations. Although China is a big technical power, it is by no means a strong one. Its dependence on foreign technologies is as high as about 50%. The construction of an innovation-oriented country is closely related to the overall modernization of China. So China has to effectively strengthen its ability to make independent innovations as the strategic base of developing science and technologies, adjust its industrial structure and convert its growth pattern, as well as a national strategy to be thoroughly followed in all aspects of the modernization. To achieve this, it must pay attention to being focused and guiding venture capital in China to serve its strategic objective of building an innovation-oriented country. In the U.S. venture capital is mainly invested in IT, bioscience and other hi-

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tech industries, promoting information network, bio-engineering, financial engineering, healthcare and semi-conductor to become the fastest growing industries. Each year, thousands of hi-tech projects in the U.S. would receive the support of venture capital. Venture capital has been invested in various industries in recent years in China. For example, in 2007, the amount of venture capital absorbed by tourism and the catering industry increased significantly. In the author ’s opinion, the commercial behaviors of pursuing high profits using such mega-events as the Beijing Olympics and the Shanghai World Expo is understandable. However, the government should guide venture capital to support mainly the development and application of IT, bioscience, new materials and other advanced technologies. Upgrading of the traditional industries using advanced technologies should focus on saving energy and reducing the emission of pollutants. Meanwhile, it should guide venture capital to support business start-ups and prevent, after the establishment of the GEM, venture capital from shifting its focus in the pursuit of short-term benefits. With strong aggregation effects in venture capital investment, China will resist a “large-scaled prosperity.” For example, venture capital investments in the U.S. are mainly concentrated in the Silicon Valley, Route 128 and a few other places. Over 80% of the venture capital investments in China converged in Beijing, Shanghai and Shenzhen. The amounts of venture capital investment in the above three cities are 36.8%, 28.8% and 17.1%, respectively, of the national total of venture capital investment. It is suggested that China is dedicated to supporting the development of venture capital in these three cities to make them the bases of venture capital investment.

Creating an Entrepreneurial Culture The entrepreneurial culture that encourages business start-ups, tolerates failures and advocates risk-assuming is the “soft strength” of the development of venture capital investment and needs to be cultivated for a long term. In China’s transition from the centralized planned economy to the socialist market economy, China encountered massive problems in terms of legal systems, governmental practices, procedures and methods of administrative management, as well as people’s values and ideologies, thus making it hard for China to meet the requirements on developing venture capital as a new investment tool. All of the problems were formed in history for cultural and conceptual reasons, so they cannot be completely solved in a short term. Therefore, China should make the efforts to cultivate a culture conducive to developing venture capital and gradually change the outdated concepts.

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The author holds that a culture conducive to the development of venture capital should have the following characteristics: Entrepreneurship . Entrepreneurship is closely related to venture capital investment. The word “entrepreneur” does not cover all business operators. Those without an entrepreneurship cannot be called entrepreneurs. Therefore, we should cultivate entrepreneurship, encourage business operators to show their creativity, make innovations, dare to take risks, and tolerate failures. Integrity . In the venture capital industry, the construction of an integral culture is very important. Many problems faced by China now are related to integrity. For example, investors commit themselves to an investment, yet are slow in investing the funds or even do everything possible to withdraw the funds soon after the investment. A technology owner promises his technology to an enterprise and signs a contract with it before finding another better enterprise and reneging on the contract and instead working with the latter. Venture capital investment uses real capital to support knowledge capital, social capital and other forms of fictitious capital before integrating them into helping business start-ups. However, the biggest problem of venture capital is its uncertainty. Its true value cannot be determined until it is realized. Therefore, without the support of venture capital investment, it would be impossible for people to use fictitious capital before realizing its value. However, without knowledge capital and other forms of fictitious capital, venture capital investment would have nothing to support. Venture capital investment can only succeed based on the mutual trust and cooperation between venture capitalists and innovators. Free-flowing discussions . It is believed that free-flowing discussions and communication can fine tune an idea and make it recognized gradually. To provide a platform for people engaged in China’s venture capital investment to exchange information, communicate with each other, express their opinions freely, and brainstorm. The Central Committee of China Democratic National Construction Association has been holding a seminar in every April since 1999 together with other related departments. The seminar was named China Venture Capital & Private Equity Forum in 2001. Since the 6th China Venture Capital & Private Equity Forum, the Central Committee of China Democratic National Construction Association has begun to work with the Ministry of Science and Technology of the People’s Republic of China, Guangdong Provincial People’s Government and Shenzhen Municipal People’s Government in holding it. Major speeches at each forum have been collected and made into a symposium after the forum before being published by the Democracy and Construction Press.

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With 10 years of efforts, the forum has become one of the highest-level, largest and most influential forums in China. The author suggests that related parties make common efforts to continue organizing the forum with a prudent attitude, expand its influence, and make it more practical so as to build it into a platform that gathers collective wisdoms, helps people exchange ideas, and helps find and cultivate venture capital investment talents.

Building Capable Venture Capital Investment Teams The greatest problem in the development of venture capital in China is the lack of professional talent, in particular, qualified venture capitalists or qualified managers of venture capital funds (general partners). Although their investment in funds may account for only 1%–2%, they have to assume full responsibility for the management of venture capital funds. Usually, there are experts specialized in a professional field and familiar with laws, management and finance. They are key figures in venture capital investment, because they are the ones to judge whether the investment would succeed or not. They are responsible mainly for raising capital and making investments using their expertise and experience. Besides selecting promising projects from among proposals and making decisions using their knowledge and experience, they have to join the board of directors of the enterprise to which they have made investments so as to inform and help its development. Apart from their salaries, which are included the annual management expenses (which usually accounts for 2.5% of the total amount of funds), general partners may get a 20% reward from the investment returns of the funds, encouraging them to increase the investment returns of the funds and win the investors’ trust with excellent performance before being given due rewards. The main role of venture capitalists is to help innovators start businesses and investors speculate. Therefore, venture capital investments must be carried out by professionals. The issue is urgent for the following three reasons: First, China has an enormous number of S&T achievements that needed to be converted, yet does not have any assessment or evaluation of their commercial prospects. It is where talent with technical, management and financial expertise are needed. Currently, most venture capital funds in China are not invested mainly due to the lack of the ability to assess these projects. Second, technicians are passionate for starting businesses, yet most of them do not have finance and management knowledge and experience. A few technicians may be very capable of making innovations, yet they fail to grow the enterprise and commercialize their innovative achievements. They need to cooperate with venture capitalists.

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Third, both foreign capital and private capital have the intention to engage in venture capital investment, yet it is difficult to find trustworthy agents. In most cases, competent agents are not trustworthy, while trustworthy agents are not competent. Before they are able to find themselves a competent and trustworthy agent, so neither foreign capital nor private capital would make any investment. Venture capitalists have to attend the board meetings of the venture company to supervise its finance (e.g. regulating financial management and making decisions on key issues like capital increase, business suspension, listing, etc.), and assist the company in building a strong and forceful management core composed of the CEO, CTO, CFO and vice presidents in charge of sales and market development. In the agreement, it should be made clear that the venture capitalist shall have the final say over the company’s major financial and personnel issues. There is a concept popular among Chinese innovators—technical competence would make a good president, which is actually not true. Based on the statistics in the U.S., only about half of the innovators would end up serving as the president of the business they have initially founded and the rest are unable to hold the position due to incompetence. According to Randy Komisar, an American venture capitalist, an enterprise engaged in network technologies development would have different requirements on its present qualities in different development phases. At the initial stage, the president should have an innovative mind and show persistence; at the growth stage, the president should have superb organizational skills and keen market orientations; while at the mature stage, the president should have the strategic management ability, being able to stick to the established strategic direction and adapt to the environment. It is hard for innovators to have all of the three qualities at the same time, so enterprises need to select the most appropriate president for different stages. China’s innovators should know their limitations and never hold the position as president without appropriate management skills, or they would ruin the enterprise. When assisting innovators in starting businesses, a venture capitalist will have the following five tasks: 1) assess the commercial prospects of the innovators’ achievements relying on his experience, commercial sense, or even intuition; 2) help the innovators make business development plans, or the socalled commercial plans; 3) organize innovators to introduce their achievements, business development plans to investors so as to attract investors; 4) assist investors and innovators in signing the agreement on establishing venture capital companies while engaging in the organization; 5) attend board meetings of the enterprises on behalf of the investors, make decisions on the enterprises’ major financial and personnel issues, and be responsible for reorganizing and divesting the enterprises.

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Venture capitalists help investors’ speculation in the following four aspects: First, they help investors select the most commercially-promising projects. Second, they talk with innovators and cooperate with them, by which they judge people’s quality, moral standing and capabilities. The most important capability of a venture capitalist is his ability to judge other people’s overall quality. When meeting with innovators, a venture capitalist assess their quality, moral standing and capabilities by their talks and cooperation. If the innovator is not competent or morally trustworthy, the venture capitalist would never invest in the project no matter how good it is, for there will be problems. Third, they join the enterprise’s board of directors on behalf of their investors to supervise and instruct operators so as to help the enterprise succeed. Fourthly, they achieve divestment by going public or other ways before bringing high returns to the investors. A good venture capitalist should possess the following five basic qualities: First, enterprising and responsible with a keen business sense, and capable of spotting potentially profitable projects and decisive in divesting from lowyield ones; Second, experienced in interacting with people and picking out qualified, capable and trustworthy talents; Third, proficient in management business, financial operations and familiar with related laws and regulations. Generally, innovators are technically potent, yet they lack management, finance and legal knowledge, and that is where venture capitalists can come into play; Fourth, equipped with professional knowledge and practical experience in a specific domain. The author has met many venture capitalists who used to be technicians before learning finance and management. After obtaining their MBA, they are able to engage in venture capital investment; Fifth, able to maintain good relationships in the financial circle, the S&T circles, the legal field and politics, which is part and parcel of operating businesses in China. Although some people being invited from abroad to China to serve as managers of venture capital companies are armed with a PhD or an MBA, proficient in both technologies and management, and experienced in venture capital investment abroad, they do not master China’s real situation or how to get along with people and deal with matters in China, thus greatly hindering their potential to produce good performance. To cultivate its own venture capitalists, China must first find and practically cultivate potential talent, send Chinese managers experienced in venture capital investment abroad to get trained, and hire overseas Chinese experts engaged in

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venture capital from abroad and invite them to come back and work in China; and finally, establish a venture capitalist incentive mechanism. It is expectable that driven by the objective of building an innovationoriented country, venture capital investment in China will be expanded gradually and institutional construction will be constantly strengthened with the rapid economic development in China and the advance of the construction of a well-off society in an all-round manner. The author is willing to make joint efforts with all people related to venture capital investment to try to build China into a venture capital investment power, second only to the U.S. and Europe in a decade. Completed on February 14, 2008

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China’s GDP share of global total increased from 1% in 1978 to over 5% in 2007; its share of total export-import volume of global total increased from less than 1% in 1978 to about 8% in 2007. China’s economic development has provided a broad market for international capital. The accumulated actual use of foreign investment by China has exceeded USD780 billion. Direct foreign investment made by Chinese enterprises has been growing significantly, too. Since 1978, the average annual growth rate of imports of China has reached 16.7%, first in Asia’s and third in the world’s import market. China’s contribution to the world’s economic growth exceeds 10% and its contribution to international trade growth exceeds 20%. Since 2001, the average annual import volume has been close to USD560 billion, creating about 10 million jobs for related countries and districts. At the World Economic Forum held in Davos in January 2007, the author pointed out that the “China collapse theory” had been heard a decade before, and that there were people who refused to believe in China’s economic growth by saying that the country would soon collapse. These people even predicted the doomsday would come in 2005. However, China still thrives. And the subsequent “China threat theory” and “China responsibility theory,” as the author mentioned in Davos, stemmed from the world’s attention to China’s economic development. However, China has positioned itself as a developing country with low per capita GDP. China was not a superpower, nor would it become a superpower any time soon. So it can only undertake appropriate responsibilities based on its level of development and economic strength. Currently, China is a developing country in the middle of industrialization with fast growing heavy and chemical industries. On this issue, some Chinese scholars hold that it is not necessary for China to develop heavy and chemical industries and that China should focus on developing light industries. Personally, the author thinks it is necessary in light of the economic development history of all countries around the world. It is well known that heavy industries are represented by iron and steel and chemical industries are represented by ethylene. Both iron and steel and ethylene have been developing fast in China. In 2007, iron and steel production in China reached 568.9 million tons, up 21.3% year on year; ethylene production reached 10.48 million tons, up 11.4% year on year. The author mentioned at the Davos forum that China’s iron and steel production has been ranked first in the world was good news, yet China realized that it was simply a period of economic development. Historically, the world’s No. 1 iron and steel producer was the UK, then replaced by the U.S., the former Soviet Union, Japan and China in succession. Maybe in 10 or 20 years, India will become the world’s No. 1 iron and steel

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producer. It is the process of industrialization. Since China is in the middle of industrialization, it is natural that its heavy and chemical industries would develop faster. By the time China completes the 11th Five-Year Plan in 2010, its economic output may exceed that of Germany and rise to the world’s No. 3. As a matter of fact, China’s economic output is already so close to that of Germany’s. It was simply due to the faster appreciation of euro than RMB against the U.S. dollar in 2007 that China’s GDP was slightly lower than that of Germany’s if denominated in dollar. By 2010, GDP per capita in China will very possibly reach USD3,000. If the U.S. dollar keeps depreciating, it will be an easy target. Otherwise, it will require more efforts. By 2020 when China will finish building a well-off society in an all-round manner, its GDP per capita may reach USD5,000. By 2049, the 100th anniversary of its founding, China will become a moderately developed country with its economic output ranked among the world’s top. By then, its GDP per capita may exceed USD10,000, which is of course a relatively conservative estimate. Two questions were frequently asked when the author gave speeches in Hong Kong, Germany, Switzerland, Israel, the UK and Italy: 1) Could China maintain its high economic growth rate? 2) Has the economic downturn in the U.S. influenced the Chinese economy? Recently, one more question added: How great is the influence of the Wenchuan earthquake on the Chinese economy? The author will, based on his studies and understanding, discuss the above three questions in this paper.

WILL CHINA MAINTAIN ITS HIGH-SPEED GROWTH? Many foreigners doubt if China could maintain its 8% or higher average annual economic growth rate, so do many Chinese scholars. In the author ’s opinion, favorable conditions for China’s economic development include: It has a relatively stable society; its people are eager to improve their lives by development and becoming rich; its economy develops fast; it has an enormous market potential; and its investment environment keeps improving. The total mileage of highways in China is more than 50,000 kilometers, No. 2 in the world, after only the U.S. (80,000km). Network services also develop fast in China. The population of “netizens” in China has reached 253 million, second to none in the world. China has made great progress in promoting the hardware of the investment environment and has revised laws relevant to its commitment to the WTO. In addition, China has sufficient cheap yet high-quality labor. International firms investing in China generally consider the Chinese employees

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smart, modest and hard-working. Compared with the international level, the price of human resources in China is relatively low. In 2003 at Davos, a foreign friend told me during the group discussion that the Chinese had taken away all of the businesses from his country. The author responded that it might be true. If, according to the statistics published in the Financial Times , the average hourly wage of Chinese workers was USD0.5, that of Mexican workers was USD4 and that of U.S. workers was USD16, to which country would he make investments if he were an investor? He smiled and chose China. The author would like to make two more points here. First, although the average hourly wage of Chinese workers is only USD0.5 and that of U.S. workers is USD16, it does not mean the living standard of Chinese workers is only 1/32 of that of American workers, because of the strong purchasing power of RMB. Calculated at PPP, the price may be double. That is to say, things that could be bought in China with the money equivalent to USD0.5 may cost USD1 or more in the U.S. Second, with the development of the Chinese economy, the income of Chinese workers will continue to increase, which is obvious. During this process, some labor-intensive industries may be transferred from Eastern China to Western China or from China to other developing countries, where labor force is even cheaper. But anyway, compared with developed countries, China would maintain its labor cost advantage for a quite a long period, which is a fact. Despite the above favorable factors, there are existing problems in the economic development in China. First, the widening wealth gap between the rich and the poor poses risks of social stability. Current Gini coefficient in China is about 0.46. According to popular understanding, a 0.4 or higher Gini coefficient can undermine regional stability. With the wealth gap between the rich and the poor keeps widening, it can affect social stability. Another problem is the unbalanced development among different regions and the urban and rural areas. China has a dual economic structure featuring vastly differing development levels of the urban and rural areas. The per capita income of urban residents is three times higher than that of rural residents; the purchasing power of the former is four times stronger than that of the latter. Besides, urban residents enjoy better social security, cultural education and public services than those for rural residents. Seen from another angle, why isn’t there severe social instability in China even though its Gini coefficient has reached 0.46? Because of the existence of the dual economic structure, the income gap between the poorest people in rural areas in Western China and the richest people in urban areas in Eastern China becomes extremely large. The Gini coefficients in the rural areas and the urban areas, respectively, are below 0.4. Of course, from the

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academic point of view, the dual economic structure is one of the reasons that have led to a high Gini coefficient in China, an objective phenomenon requiring us to understand dialectically. A unified economic structure will no doubt lower the Gini coefficient in China. The dual economic structure is a historic legacy. After the Opium War in 1840, China became a semi-feudal and semi-colonial society. Since then, its urban and rural areas have taken different development paths. Urban areas were more colonial, while rural areas were feudal. The “New China” failed to solve the problem after its foundation in 1949 due to historical reasons. It was economically backward at the time. To achieve industrialization, it needed to 1) accumulate capital through the scissors gap between the prices of industrial and agricultural products; 2) its farmers to work in urban areas so as to strengthen its labor force. For example, in the early 1950s, an egg cost only a quarter of what a stamp cost. To send a letter, farmers needed to trade a stamp with four eggs. How big the scissors gap was then! Today, when China is in the middle of industrialization, the problem must be solved. Therefore, the CPCCC gives priority to the issue of “agriculture, rural areas and rural residents.” To realize modernization, China must solve the problem of the dual economic structure. The third problem comes from the environment and energy use restrictions. Since China is now in the middle of industrialization when its heavy and chemical industries are developing really fast, it will greatly influence the environment and energy consumption. The environmental situation in China is not satisfactory. Though great efforts have been made to alleviate it, environmental pollution in China remains severe in general. In 2007, 30.2% of the monitored cities had an air quality below Level II; some big and medium– sized cities saw more smoggy days; the trend that pollutions were transferred to rural areas has not been effectively curbed; and the number of environmental emergencies kept increasing. As the world’s second largest energy producer and consumer, China has witnessed growing energy consumption since 2000, during which the average annual growth rate of its energy consumption hit 9.7%. In 2007, its total energy production reached 2.37 billion tons of standard coal and its total energy consumption hit 2.65 billion tons, up 7% and 7.8%, respectively, year on year. Consumption growth is faster than production growth. Take water resources as an example, per capita water resources in China account for only one quarter of the world’s average, let alone the uneven distribution. We did a study recently trying to analyze the environmental resource price China has paid for developing its industries, only to find that the price was pretty high. For example, China paid RMB2.75 trillion for resource consumption, ecological degradation and environmental pollution in 2005, while the concurrent GDP

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was only RMB2.24 trillion. It has been somewhat improved in the recent two years, yet it still deserves special attention from the public. The last problem is China’s lack of financial and management talent. The development process of a country involves four levels, namely being resourcedependent, product-dependent, capital-dependent; and knowledge-dependent. Currently, China is resource-dependent and product-dependent. In the three decades since its reform and opening up, China has introduced USD780 billion of foreign investments and exported about USD100 billion of capital accumulatively, accounting for one-eighth of the total amount of foreign investments it has introduced. Of the USD100 billion exported, most of them went to Canada and Cayman Islands. Since Cayman Islands do not have any industry or service industries, to invest there is actually “domestic sales of commodities originally produced for exports.” That is, we register companies there before taking the registered capital back to invest in China. Therefore, the actual amount of capital exported by China accumulatively in the past three decades is less than USD100 billion. As for the use of capital, there are three levels. The first level is industrial capital-oriented, which has been the case in China for years. In particular, the “production determines circulation” principle highlighted in the planned economic system has lasted even till today. In terms of the use of capital, currently China features domination by the industrial capital of large-scale state-owned enterprises, such as Baosteel, CNPC, Sinopec and China Unicom. The second level is commercial capital-oriented. Products need the market and market circulation before being sold as commodities on the market. For example, Walmart, the largest retailer in the U.S., invites enterprises to sell their products in its supermarkets. It charges the enterprises slotting fees when the products remain unsold, let alone paying the enterprises for the products. The third level is financial capital-oriented. All developed countries today use financial capital to control their national economic operations. They cannot develop their industries and commerce well without the support of financial capital. Currently, China is at the stage of being industrial capital-oriented. It has sufficient capital, but few talents capable of using capital. For example, China uses about one-third of its foreign exchange reserves to purchase U.S. bonds. That is to say, it lends its capital to financial capitalists in the U.S. who will repay China with interests and keep the rest of the profits. In addition, there is also a lack of management talent in China, especially professional managers, who are responsible for the operation and management of enterprises after the separation of the ownership and management rights. Current situation in China is that managers of state-owned enterprises are “quasi-

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government officials” with quite varying management capabilities; and most of the managers of privately-run enterprises are either the owners or their immediate relatives. The author believes that it will be hard for China to succeed in reforming its state-owned enterprises unless mangers of state-owned enterprises become professional managers in the real sense. Managers of some state-owned enterprises may put enormous energy into establishing a good relationship with government officials, instead of focusing on the operations and management of the enterprises, so as to get preferential treatments or even become government officials. It is understandable that manager of a privately-run enterprise is held by the owner of the enterprise or his immediate relative. However, he or his immediate relative must be competent. People say that privately-run enterprises cannot remain prosperous for over three generations. It is because their level of management keeps declining from generation to generation. Generally speaking, favorable conditions for China to maintain a high economic growth rate outweigh the problems it is facing now. As long as China pays attention to solving existing problems, properly facing challenges, and ameliorating adverse conditions, it is possible to maintain an economic growth rate that is above 7.5%.

THE RIPPLE EFFECTS OF THE U.S. ECONOMIC DOWNTURN Since the second half of 2007, the U.S. economy has begun to decline rapidly. In the last quarter of that year, it economic growth was negative. The economic growth rate of the United States was 0.9% in the first quarter and 2.8% in the second quarter of 2008, mainly because of two reasons: the subprime crisis and the rise of the oil prices. The so-called “subprime lending” means making loans, by U.S. leading agencies, to ineligible people, mainly including those with low credit ratings or low income, on loosened conditions. Usually, such loans tend to have a higher interest rate than the prime rate offered on traditional loans. After purchasing the house, the buyers will have to repay the loan at a fixed rate in the first few years, then a floating rate. Since 2001, the U.S. housing market continued to boom, plus the relatively low interest rate, the subprime loan market in the U.S. has developed fast, leading to over-optimistic expectations of the U.S. real estate market. In case of loan defaults, banks may recover the houses to auction them off and still make money. Besides, the U.S. Congress and government encouraged banks to make home loans. Borrowers expected their houses to appreciate so as to repay their loans easily and re-mortgage their houses to the bank to borrow money.

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Since the second half of 2006, with the decline of the U.S. housing market, homebuyers begun to have difficulties re-mortgaging their houses for financing. In addition, with the rise of the short-term interest rate, the rates on subprime mortgage loans rose, too. Many borrowers in dire straits felt the great pressure to repay the loans, and they defaulted. For the above two reasons, a large group of borrowers of subprime mortgage loans failed to repay the loans on time, leading to a rise in the default rate (which reached 18% as of the end of this June). Banks were unable to recover the loans, causing the “subprime loan crisis.” To promote market liquidity and transfer risks, American banks adopted the practice of packaging the principal and interests of loan receivables into capital pools before selling them to investment banks and other agencies to securitize them and issue mortgage-backed security (MBS). It needed credit enhancement and insurance cover. Investment banks then further securitizing MBS before issuing collateralized debt obligation (CDO) using MBS as the pledged assets. That is, they recombined and repackaged MBS and issued securities with low average income for the difference. CDO investors benefitted from the cash flow of the capital pool and the credit enhancement done for making up for the credit risk of the capital portfolio. Credit enhancement often took the form of overcollateralization guaranteed by big commercial banks, insurance companies, government agencies and financial insurance companies, all with the highest credit ratings. Besides, investment banks also collected a group of creditor’s rights before packaging them and signing a credit default swap (CDS) with a third party (an insurance company in most cases). It is more like insuring creditor ’s rights, where investment banks pay the royalties on a regular basis and receive full or part of the compensation set in the swap in case of defaults. It formed a financial supply chain, namely, commercial banks granted loans to borrowers after investment banks had provided liquidity for commercial banks after insurance companies had provided insurance for investment banks. While the real estate prices continued to rise in the U.S., MBS, CDO, CDS and their derivative products were lucrative and safe. Many investors scrambled for them and a large amount of financial institutions supported such kind of products, too. Since the subprime mortgage crisis hit, risks spread and extended down the chain. Some rating agencies “added fuel to the flames” by rapidly reducing the ratings of some financial institutions and products. Some hedge funds took the chance to go short, causing huge losses to a great number of commercial banks,

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investment banks, insurance companies and other financial institutions, which applied for bankruptcy protection. In addition, since many investment funds in the U.S. and Europe bought a large number of securities investment products derived from subprime mortgage loans, they too were badly hit. Affected by the panic of a great number of investors, the securities market in the U.S. shrank dramatically, down 28.3% in the first quarter of 2008 on a year-on-year basis, of which, CDO fell 93.7% and asset-backed securities fell 82.6%. U.S. stocks also fell substantially, with prices falling by as much as 45%. For more than a year, the continuous downturn of the U.S. housing market has led to the slowdown of its overall economic growth. However, it is unlikely that the continuous downturn of the housing market and the subprime crisis would lead to economic depression in the U.S. or around the world. It is mainly because the current economic fundamentals of major economies are good and the central banks of the U.S. and Europe have sufficient means to regulate the economy. To stop the financial crisis from turning into economic crisis and to protect its public creditability, the U.S. government issued a bailout of USD850 billion. After the Paris summit, EU15 members have decided to join hands to rescue the market situation. The amount is estimated to be as high as EUR1.3 trillion which is supposed to make tangible results step by step. However, in the short run, the influence of the U.S. subprime loan crisis will be reflected more in its shocking the global financial market. It is very likely that it will lead to large-scale oscillation of the global financial market. The author estimates that it may take two to three years for the global financial market to adjust itself and recover fundamentally. The second reason for the U.S. economic declining was the soaring oil prices. In the past two years, oil prices have been rising all the way, which even exceeded USD140 a barrel. However, different people have different opinions on what has caused the price to rise. According to the U.S., it is the result of an unbalance between supply and demand. When supply falls short of demand, the price soars. Oil producing countries believe it the result of financial speculation and oil futures speculation. At the World Economic Forum held in Davos in early 2008, there was this lady, the head of a stock exchange in an African oil producing country. When asked whether she felt guilty about the soaring oil price, she responded with a negative answer, saying that the rise in oil price had greatly increased the foreign exchange reserves of her country and that she was glad about it. When asked about the rational oil price, her answer was USD60. She was telling the truth. If we estimate roughly, the cost of oil extraction is about USD30. If coupled with environmental compensation and

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other costs, the price of USD60 is rational. USD20 a barrel in the past was by no means normal, so is the price of over USD100 a barrel. When delivering his speech in Davos in early 2008, the author pointed out that it was impossible for oil prices to stay high for long. He gave two reasons. Firstly, the price increase would lead to reduced demand. The world’s daily oil consumption is about 87.5 million barrels now, equivalent to about 12.5 million tons. It would be hard to maintain such a high demand for oil after the price increase. Secondly, oil price increases would stimulate the development of substitutes. For example, when all countries imposed an oil embargo on South Africa during the 1960s due to its apartheid policy, South Africa developed a coal-to-liquid (CTL) technology of its own and constructed three sets of devices. Due to the high oil prices, coal-to-liquid, bio-fuels and other renewable energy resources will all get developed. Substitutes will not stop production because of oil price decline. For example, the three sets of CTL devices are still in use today. In the long run, the upswing of oil price will harm not only the consumer countries, but also the oil producing countries. Therefore, the author asserted that oil price would reduce to below USD100 a barrel. On October 16, 2008, the international oil price had fallen to USD70 or below. It is thus predictable that the economic grow rate of the U.S. will be somewhere between 1%–1.5%, declining significantly year on year (the rate in 2007 was 3.2%). However, economic depression (negative economic growth) is less likely to happen. The author estimates that during 2009–2010, the U.S. economy will keep growing at a low rate, which will change and show an ascending trend by 2011. As for whether China would be affected by the American economic downturn in 2008, global economists have different opinions. The author took part in a discussion entitled “If U.S. sneezes, will the world catch a cold?” in Davos in early 2008. On his right was Fred Bergsten, one of the most famous American economists and founder of the Institute for International Economics in the U.S. He put forward the “theory of decoupling,” believing that concurrent growth momentum in China and Asia was so strong that it would go through the U.S. economic downturn without being greatly affected. The author then retorted, “Fred, I’m afraid I do not agree with you. It will be affected. China’s exports to the United States would be reduced, so would its trade surplus with the United States. Trade conflicts would increase. The Chinese economy would definitely be affected by the U.S. economic downturn. I estimate that economic growth rate in China this year will reduce to about 10% from 11.9% last year. Trade surplus with the United States will drop by around 20%.”

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IMPACTS OF THE WENCHUAN EARTHQUAKE ON CHINA’S ECONOMY On May 12, 2008, an earthquake disaster ravaged Wenchuan and other places in Sichuan Province, China. The serious damages, the number of casualties and the great difficulties in helping people in disaster areas were unprecedented. Though natural disasters are low-probability events, they are destructive. Since they are destructive in nature, they will affect economic growth. Some say that the earthquake will not influence China’s overall economic performance significantly, for it ravaged a small region with a less developed economy. The author holds that specifically, it would not affect China’s overall economic growth largely because the output value of the disaster areas accounts for very little of the national total; plus, both disaster relief and post-disaster reconstruction would increase the GDP. However, taking an in-depth look, the increase in disaster relief spending will affect the fiscal input in other areas; corporate donations will reduce enterprises’ financial strength; and personal donations will harm individuals’ power of consumption. All these factors will affect economic growth in a profound way, the results of which will gradually show. China should summarize and learn the lessons from the earthquake disaster, make efforts to improve the scientific level of its forecast of various disasters, develop plans to prevent and deal with various disasters, and carry out drills. It should establish a unified scheduling and commanding system for rescuing victims of natural disasters and post-disaster reconstruction.

COUNTERMEASURE: FROM “TWO PREVENTIONS & ONE TIGHTENING” TO “ONE PREVENTION & ONE CONTROL” At the Central Economic Work Conference held in late November 2007, targeting the global economic situation and its own excessive liquidity, China proposed the principle of “two preventions and one tightening” (shuang fang yi jin ) namely, preventing its economic growth from overheating, preventing regional increase of commodity prices from triggering significant national inflation, and tightening its monetary policy.

Economic Growth Speed and Efficiency China has maintained a double-digit economic growth rate since 2003, which was 10.1% in 2003, 10.4% in 2004, 10.7% in 2005, 11.4% in 2006 and 11.9% in 2007. In the author’s opinion, it is not overheated, but a little bit fast. During the

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development process of all countries around the world, there were precedents which maintained their economic growth rate at somewhere between 11%– 12% within a period. During the 1960s, Japan launched an Income Doubling Program, aiming at doubling its people’s income within a decade and increasing its economic growth rate to 11.6%. Therefore, in terms of economic growth, China is not overheated. However, investment has indeed become overheated, lowering its efficiency. The relationship between the GDP growth rate and the fixed investment growth rate during recent years is expressed in Fig. 6.1. The two were basically the same in 2000, but fixed investment growth rate has been higher than that of the GDP since then. According to Neoclassical economics, economic development equation is usually expressed as: Y=A+αK+βL Of which, Y is the growth rate of the total output (added value); K is the growth rate of capital investments; L is the growth rate of labor investments; α is the elastic coefficient of capital input-output; β is the elastic coefficient of labor input-output; α+β=1; and A is the economic growth rate caused by the total factor productivity (TFP). The elastic coefficient of investment in China during 2000–2007 is illustrated in Fig. 6.2, from which we can see that it has been declining in recent years due to the rapid growth in investment. Every 1% increase in the total investment in fixed assets today could only pull 0.3%–0.4% increase of the GDP in China. If integrated elements can contribute 30% to China’s economic growth, the role of the growth of labor force in stimulating economic development is negligible, but still at least 0.7%. Another indicator is current year fixed asset investment conversion rate. That is, suppose you invest in RMB100, how much will it be converted into GDP? We all know that due to the construction process, investments cannot be completely converted during the year. However, the speed of such a conversion somewhat indicates investment efficiency. The current year investment conversion rate is shown in Fig. 6.3. From Fig. 6.3, we can see that current year investment conversion rate was 45.4% at the highest point. However, it has been maintained at around 20% in recent years. Overheated investment will lead to the unbalance between investment and consumption. From Fig. 6.4, we can see that in the early 1990s, China maintained its

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Fig. 6.1.

China’s investment growth rate and GDP growth rate (calculated at the constant price in 1990)

% 30 25 20 15 10 5 0 2000

2001

2002

2003

2004

2005

2006

2007

Year

GDP growth rate Total investment in fixed assets growth rate

Fig. 6.2. 0.80

Capital input-output elasticity coefficient

0.65

0.60

0.46

0.40

0.38

0.35

0.30

0.37

0.41

0.28

0.20 0 2000 Note:

2001

2002

2003

2004

2005

2006

2007

Year

0.7 × Investment elasticity coefficient = 0.7 × GDP growth rate / Investment growth rate (based on the constant price in 1990).

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Fig. 6.3.

Current year investment conversion rate

% 50

45.35

40 30

39.76 35.94

33.54

28.25

30.60

22.40 21.92 21.64 18.55 17.79 23.63 22.75 21.77 20.20 18.66

26.98

20 10

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0 Year

investment rate at about 0.28. That is, investment accounted for 28% and consumption accounted for 72%. From the mid-1990s till the beginning of this year, China’s investment rate had been maintained at about one-third, yet it has

been rising rapidly in recent years to the current 56%, leading to unbalanced investment and consumption.

Overheated investment will inevitably cause a number of problems: first, less Fig. 6.4.

Investment rates since 1990

% 70 60

Investment-GDP Ratio

50

41.60

40 25.06

30 20

51.06

24.20

32.18

30.82 27.49

32.18

32.73

31.53 32.20

33.38

34.24

32.93

56.24

45.38

36.61

10

144

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

0 Year

China’s Economic Challenges and Countermeasures

attention would be paid to the role of technology, education and management due to the pursuit of development; second, excessive pursuit of GDP growth would lead to a neglect of energy saving, environmental production, people’s livelihood, as well as less attention to the quality of development; and finally, more emphasis on speed would easily create a passion for introducing technologies; less attention would be paid to independent innovations, because innovations would take a pretty long time. Therefore, at the Central Economic Work Conference held in December 2006, China reworded “fast and sound development” into “sound and fast development.” To solve the problem of overheated investment is exactly to improve the efficiency and quality of economic development. At Davos, the author was asked whether he is satisfied about the newlyreleased economic growth rate of China in 2007, which was 11.4%. The author answered with “happy yet unhappy.” He was happy because China’s economy developed fast. He was unhappy because the NPC set the percentage at 8% with the purpose of allocating more resources to develop technology and education, save energy, protect the environment, improve people’s livelihood, and improve public services, etc. However, it was a big difference between 11.4% and 8%, indicating that China has failed to complete realize the goal. The principle of preventing the economy from being fast-growing to being overheated has shown that China should never pursue a way overlyfast economic growth, but maintain a balanced economic growth. Economic development in China should be the unified development of its economy, culture, society and politics. The key is to rein in overheated investment, the key to which is to control the number of new projects. Newly-launched projects are the root of overheated investment. A great number of newly-launched projects need constant investments during the construction. They could produce products after being completed and it is not sure whether the products would be profitable or not. Therefore, efforts must be made to strictly control the new capital construction projects. Appropriately lowering down the overheated investment would help truly prevent the economy from being overheated. Starting from this year, under the influence of the U.S. economic downturn, the economic growth rate in China has shown a decline. Based on comparable prices, the year-on-year economic growth rate in China was 10.6% in the first quarter of this year, 10.4% in the first half of this year, and 9.9% in the first three quarters of this year. Therefore, it is safe to draw such a conclusion: The danger that China’s economic growth would become overheated from being a little bit fast is already gone.

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Excessive Liquidity and Inflation Another “prevention” in “two preventions and one tightening” is to “prevent regional increase of commodity prices from being significantly inflated.” Inflation does not mean the rise of prices of all commodities, but the overall upward price movement of goods and services and downward movement of the purchasing power of money. Inflation in China may be driven by excessive liquidity or pushed by costs. Though there has not been a strict definition on excessive liquidity, abundant social capital is an indisputable fact. To put it simple, liquidity refers to completing a number of trades at low costs with speed. Theoretically speaking, it includes four aspects: speed, (transaction time); price, (transaction cost); depth, (transaction volume); and elasticity, which is the ability of the price to recover rapidly after deviating from the equilibrium price level. At the end of 2007, the balance of M2 of China was RMB40.3 trillion, up 16.7% year on year; that of M1 of China was RMB15.3 trillion, up 21.1%; that of M0 was RMB3 trillion, up 12.2%. M0 refers to cash; M1 refers to cash plus demand deposits; and M2 refers to: the sum of cash, demand deposits and fixed deposits. Actually, today, some financial assets with great liquidity have also been integrated into M2. Three sources contribute to market liquidity in China: The first source is the difference between bank deposits and loans. At the end of December 2007, total bank deposits were RMB40.11 trillion and total loans were RMB27.77 trillion in China, the difference between which was RMB12.34 trillion. As of the end of March 2008, total bank deposits had reached RMB42.66 trillion and total loans had reached RMB29.39 trillion, the difference between which was RMB13.27 trillion. It can be seen that till the end of the first quarter, the difference between deposits and loans had increased by about RMB1 trillion. People say that China has made great achievements with its tight monetary policy, which I believe should be “initial achievements,” if being more rigid. The second source is foreign exchange reserves. At the end of December 2007, the foreign exchange reserves in China were USD1.53 trillion and funds outstanding for foreign exchange were RMB11.52 trillion. As of the end of March 2008, China’s foreign exchange reserves has reached USD1.68 trillion, increasing USD150 billion. Under the circumstances of export slowdown and trade surplus decline, foreign exchange inflow increased rather than decreased. In 2007, foreign trade surplus was USD262.2 billion and foreign investment that was actually introduced was USD74.8 billion. Foreign exchange reserves increased about USD500 billion in 2007, USD150 billion more than the sum of foreign surplus and foreign investment that was actually introduced in the same year.

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Someone said that all of the USD150 billion was “hot money,” which the author does not agree. Because there are the appreciated euro reserves, the income of foreign labor contracting and foreign exchange appreciation generated from residents’ bank deposits. Deducting the above several items, the author believes that the hot money inflow in China in 2007 was approximately USD100 billion; and about USD30–50 billion in the first quarter of 2008. The third source is the increase of currency held by individuals and enterprises. Currently, idle currencies held by individuals and enterprises keep increasing, because some people, to protect their wealth after the implementation of real-name savings deposit system, hold a great deal of capital in their hands. It is a strange phenomenon unique to China that Chinese entrepreneurs are not willing to see their names appear on the Fortune list. They are afraid of their wealth situation being made public. The above three types of capital may be overlapped sometimes. For example, after being converted into RMB, foreign exchange has to seek ways to maintain and appreciate its value, leading to the overheated investment, the stock market violent rise and the violent rise of the housing price in 2007. Due to the sluggish stock and housing markets, some capital may be deposited in banks in 2008. Cash-push inflation involves three aspects. First, price increase of agricultural products. Since September 2006, the world’s food prices have been showing an upward trend and maintained at a higher level. As of the end of 2007, wheat prices soared by 112%; soybean prices rose violently by 75.1%; corn prices surged by 47.3%; and rice up by 3.1% on the international market. The total output of grain in China was 5.06 trillion tons in 2007, ranked No.4 in the world. According to a study done a few years ago, the per capita share of grains in China should not be lower than 400kg. Taking 1.25 billion as the base population, the total demand for grains in China was 500 billion kilograms, that is, 500 million tons. It may be slightly lower today due to changes in the food structure, but 500 million tons should be an important benchmark. In 2007, the rate of increase of grain prices in China became greater. Grain prices grew by 10.3%, up 9.3% year on year, of which the price of cereals grew by 8.95%, that of beans 22.6%, and that of potatoes 9%. Second, the growing demand for oil. According to the Annual Report on China’s Energy Development (2008) issued by the Chinese Academy of Social Sciences, it is estimated that oil consumption in China will maintain a high growth rate during 2007-2020. Of which, oil consumption in China will reach 407 million tons and 563 million tons, respectively, in 2010 and 2020, up 17.4% and 62.5%, respectively, than that in 2006. The annual growth rate of the demands for oil products will increase by 5.5%. Third, the rapid rise of the demand for and the imported price of iron ores. In 2007, it grew by about

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70% in 2007. In 2008, the contract prices of iron ores rose by 65%, suddenly and sharply, on a year-on-year basis. If the rate of inflation is the same as the increase of people’s monetary income, it means that the standard of living of the general public has not improved. Therefore, it is important to prevent inflation. Frankly speaking, from the principles of fictitious economy, inflation is the general trend and the overall commodity prices will rise gradually. However, efforts should be made to control the rise of the overall commodity prices within a certain range so as to avoid significant inflation. It is generally believed that an inflation rate below 5% would make the inflation affordable and moderate. According to the Central Economic Work Conference held in 2007, the First Plenary Session of the 11th NPC held in 2008 decided that the inflation rate should be controlled below 4.8% so as to prevent the appearance of significant inflation. However, judging from the data during January to September 2008, we may find it a little difficult to achieve the goal. China’s CPI increased by 7.9% year on year in the first half of 2008, 6.3% in July, 4.9% in August, and 4.6% in September in the same year. Data on CPI and CPI growth rate during January 2007 to September 2008 are shown in Fig. 6.5. It can be seen from Fig. 6.5 that since March 2008, though CPI in China has kept increasing, the rise has become comparatively gentle. A decreased growth rate indicates that measures taken by China have begun to play an effective role. Yet, the commodity prices are still rising, but in a slower way. We must stay alert. Since CPI grew very fast in the second half of 2007, the CPI growth rate during July to August 2008 declined greatly comparing with that. The author estimates that the annual CPI growth rate in China in 2008 will be somewhere between 6%–7%. For the CPI data released by the National Bureau of Statistics of China, we noticed the following two points. First, they are adjusted seasonally. For example, vegetable prices are quite different in the off-season and the busy season. Second, the link relative ratio is what we should pay attention to. For example, if the ratio of CPI this month against that of last month is bigger than one, it is inflation; otherwise, it is deflation. According to the author ’s study, if within one year, the link relative ratio is bigger than one for more than nine months, it is usually thought to have had the inflation. Currently, measures for taking under control the inflation mainly include money supply and price control, which calls for strengthening and improving macroeconomic regulation. However, macroeconomic regulation should never violate the three basic laws of the social market economy: the law of value, the law of supply and demand and the competition law. Money supply and price control are expedient solutions, neither real nor final. For example, to control oil prices,

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Fig. 6.5.

China’s CPI and its growth rates, January 2007–September 2008 %

122 120 118

6.5

116 114

2.2 3.3 2.7

3.1

3.4

4.3

6.2

6.9

6.5

7.1

10 9 8

8.5 8.3

7.7 7.1

7

6.3 4.9 4.6

6 5 4 3 2 1 0

Jan 2007 Feb 2007 Mar 2007 Apr 2007 May 2007 June 2007 July 2007 Aug 2007 Sep 2007 Oct 2007 Nov 2007 Dec 2007 Jan 2008 Feb 2008 Mar 2008 Apr 2008 May 2008 June 2008 July 2008 Aug 2008 Sep 2008

112 110 108 106 104 102

5.5

6.5

8.7

CPI (Fixed base)

CPI year-on-year growth rate

China fixes the prices of oil products and provides necessary subsidies, leading to such a problem that lots of vehicles from Hong Kong and Macau getting their filled in Shenzhen, not just the tank, but also the oil drum and the plastic barrels they are bringing with them; flights of foreign airlines would get filled up in China before taking off and leaving; and the smuggling of petroleum products out of China becomes more and more serious. Therefore, there are good reasons for China to regulate the prices of oil products according to the prices on the international market. Fixing the prices of agricultural products would affect farmers’ production initiative. The author believes that rise in the prices of agricultural products is conducive to increasing farmers’ income. However, soon after such price increases, China should raise the subsidies for low-income urban residents.

Tight Monetary Policy In recent years, monetary policy in China has experienced three transitions: the active fiscal policy and prudent monetary policy in 2002, the prudent fiscal and monetary policy proposed in 2004 and the prudent fiscal and tight monetary policy put forward in 2007. There are three tools of monetary policy: First, the deposit reserve ratio. In 2007, China raised the deposit reserve ratio 10 times. As of the end of August 2008, China had raised it five times, even up

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to 17.5%. For a RMB40 trillion deposit, about RMB7 trillion of liquidity can be recovered, helping reduce the amount of currency in circulation. However, this is limited. Second, the interest rate. During 2003 to 2007, the PBOC raised the oneyear benchmark deposit rate eight times and altogether by 2.16% in succession (including six times in 2007 alone) and raised the one-year benchmark lending rate nine times and by a total of 2.16%. From January through August 2008, China adjusted its interest rate to mainly prevent international speculators from carrying out arbitrages. Third, open-market operation. The PBOC regulates monetary supply by purchasing and selling securities. Currently, open-market operations in China are not quite developed. Still, China give it a try this year, recovering RMB1 trillion of liquidity. Tight monetary policy must be used correctly, or it will affect economic development. First, we need to strengthen and support the weak links in social and economic development, decisively control the expansion of demands for investments, and take under control those low-tech projects unable to meet the restructuring requirements, especially those highly-polluting projects requiring high resource consumption. Priority should be given to agricultural and hitech industries and meet their demands for capital. In particular, enterprises’ demand for current capital must be satisfied, or it would harm their survival and future development. Since commercial banks dare not offend large stateowned enterprises and other quality consumers, capital becomes a severer issue to SMEs. Second, we need to get into the groove, try to avoid “hard braking,” strictly compress newly-built projects, and give priorities to different in-process projects. Third, measures must be taken to prevent the inflow of “hot money” in the disguise of investments and trades. Fourth, efforts should be made to crack down on illegal financial activities and underground banks. Fifth, we should guide private finance to get properly developed. When implementing tight monetary policies, we should maintain a certain degree of flexibility and make adjustments in accordance with the real situation. To solve the problem of inflation, we cannot simply rely on the monetary policy, but should combine it with appropriate fiscal policy.

“One Maintain & One Control” In view of the changes of domestic and foreign situations, the Politburo of the CPCCC held a conference on July 25, 2008, proposing to thoroughly implement the scientific thought of development, make it the prime task of macroeconomic

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regulation to maintain the stable and rapid economic development and control price hikes, and place it in a prominent position to inhibit inflation. It indicates that China is going to change the guideline of its economic development from “two preventions and one tightening” to “one maintain and one control” (yi bao yi kong ). Changes of the economic growth rate in China in the past three decades are shown in Fig. 6.6. Fig. 6.6.

Changes in economic growth rate in China, 1979–2007

% 14 12 10 8 6 4 2

14.2

15.2

16

13.5 11.6

10.9 7.8 7.6 5.2

9.1

11.3

13.1 9.2

8.8

14 10.9 10

9.3

8.4 9.1

7.8 7.6

8.3

10.1 10

11.6

11.9

10.4

4.1 3.8

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0 Year

From Fig. 6.6, we can see that an economic cycle of China lasts about 10 years. The previous two economic cycles in China were during 1981–1991 (during which the annual economic growth rate was 15.2% at its highest level and 3.8% at its lowest level) and 1992–2002 (during which the annual economic growth rate was 14.2% at its highest level and 7.6% at its lowest level, respectively). In the first half of 2008, China’s GDP grew by 10.4%, down 1.8% year on year. It was the first drop in the economic growth rate of China since 2002. In addition, a series of economic data on industrial production, investment, exports, etc. have also served to show that China’s economic growth is slowing down. It indicates, in the author ’s opinion, that after six years of high speed growth (with the highest annual economic grow rate at 11.9%), China’s economy has entered into the declining period of the current economic cycle. A few years ago, when China’s economy was growing rapidly, some people denied the existence of economic cycle in China, which obviously fell short of dialectics. As Deng Xiaoping pointed out, “It seems…that, as a rule,

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at certain stages we should seize the opportunity to accelerate development for a few years, deal with problems as soon as they are recognized, and then move on.” According to the reality of its population growth and employment pressures, China should maintain its annual economic growth rate at somewhere above 6%. Therefore, in the declining period of its economic growth cycle, China should make the efforts to maintain a stable and rapid economic development and try hard to keep its economic growth rate at somewhere above 7.5% in the following two to three years. However, it should also be noted that there are conflicts between maintaining economic growth and controlling inflation. How to keep a balance between the two is a question that deserves careful studies. The author believes that if China succeeds in maintaining its economic growth rate at about 10%, CPI increase at somewhere between 6%–7%, it would be a very good balance. If China, to control the inflation, takes some far-too-harsh measures, which reduce its GDP growth to 8% or below, it will encounter a lot more difficulties; otherwise, if it keeps paying too much attention to GDP growth, commodity prices would be like a runaway horse, making regulation in the following year more difficult. Special attention should be given to economic downturn when the growth rate of CPI slows down. Investment, consumption and net exports are the “holy trinity” that pulls economic growth. Their respective contribution to economic growth in 2007 was 39%, 38% and 23%, respectively. From January to July 2008, urban investment in fixed assets in China was RMB8.49 trillion, up 27.4% year on year. Converted at 10% of the price indices of investment in fixed assets (20.2%) in the first half of 2008, the growth rate of urban investments in fixed assets in real terms was 17%, down 3.2% compared with 12.5% in 2007. The cumulative total retail sales of social consumer goods were RMB 6.84 trillion, up 21.9% year on year. After the CPI-based adjustment, the increase in real terms was 18%, up 5.5% compared with 12.5%. In 2007. (According to statistics from customs, the total value of China’s import and export from January to August 2008 reached USD1,723 billion, up 25.7% year on year, of which, the total value of exports was USD937.69 billion, up 22.4%; and that of imports was USD785.69 billion, up 30% year on year; the accumulated trade surplus was USD151.99 billion, down 6.2% year on year. Since the stimulation of increased consumption cannot make up for the effects of reduced investments and net exports, China’s economic growth began to slow down in 2008. The first step to stimulate investment is to properly relax the monetary policy. China has lowered bank reserve ratio of small and medium–sized financial institutions by 1% since September 25, 2008 and that of deposit

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financial institutions by 0.5% since October 15 of the same year. On September 16, 2008, it lowered one-year RMB benchmark lending rate by 0.27% and remained the deposit rate unchanged. Since October 9, 2008, it lowered the oneyear RMB benchmark both the deposit and lending rates by 0.27, and provided to make corresponding adjustments of the RMB benchmark deposit and lending rates on other different terms. The tight monetary policy has brought SMEs greater difficulties. To relieve fund shortage of SMEs, the PBOC has instructed commercial banks to offer more supports to SMEs and has expanded the credit scale of national commercial banks by 5% and that of local commercial banks by 10%. However, since loans to SMEs always present greater risks and higher trade costs, it is yet to see if the policy can be truly implemented among commercial banks. A special fund that values RMB3.51 billion has been allocated from the central finance for SMEs. If fully utilized, it will be conducive to promoting economic growth. Proper efforts should be made to intensify investments in agriculture, hi-tech industries, infrastructure, among other fields. Vigorous efforts should also be made to develop the finance industry, the information industry, the consultancy industry, the logistics industry, agencies and the exhibition industry, among other industries providing modern services. In the first half of 2008, influenced by the weakening external demand and other integrated factors such as “three rates and two prices” (the exchange rate, the interest rate, the export tax rebate rate; the price of labor force and that of raw materials), in China’s export slowed down significantly and many small and medium–sized textile and garment enterprises were faced with difficulties. In view of that, the Ministry of Finance and the State Administration of Taxation announced to adjust the export rebate rate on textile, clothing and a number of other goods since August 1, 2008. It will help China maintain a balanced and steady development of foreign trade and lessen the pressure of the textile industry facing the slowdown in exports. The export rebate rate on labor-intensive products and mechanical and electrical products with high added values should also be reduced so as to support advantage enterprises and product exports. On the whole, the above measures are not enough to help China maintain a steady and fast economic development. The key is to stimulate domestic demand and increase consumption, which requires China, in the first place, to strengthen the purchasing power of the general public and to enhance people’s confidence in inflation at times of rapid price rises by adopting the guiding method. To achieve all this, efforts should be made to increase people’s real income on the one hand, like raising the threshold of personal income tax; effectively implementing such fiscal policies as tax reduction and exemption,

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financial discount for small-amount secured loans, subsidies for vocational trainings among other policies that aim at promoting the employment; and establishing a system of wages and deposit interest rate that adjust with CPI, etc. On the other hand, efforts should be made to exploit hot consumer items, such as housing, electrical and hybrid-power cars, continuing education, tourism, body-building, organic foods, etc. Due to various international and domestic factors, economic development in China will slow down in 2008. It is estimated that the GDP growth rate will be maintained at about 10%, trade surplus will decrease by 20%, and the CPI growth rate will be somewhere between 6% and 7%. However, it will help China adjust its industrial structure, improve its foreign trade structure, improve the level of foreign investment utilization, and increase the input in energy-saving, reduction of emissions, public services, and improvement of people’s livelihood. Completed on October 19, 2008

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Chapter

Toward a Healthy Development of China’s Stock Market

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

In his paper Systematic Analysis of the Chinese Stock Market and Proposed Adjustments , the author did a profound analysis of the situation and problems of the China’s stock market in the first decade and proposed some adjustment measures. Since the China’s stock market entered a bear market in 2002, the author has published a number of papers and delivered speeches, calling for investors to deal with the plight of the stock market, strengthen the fundamental construction of the China’s stock market. Despite of a bull market in 2006, the author has written papers and delivered speeches to alert investors the potential expansion of stock market bubbles so as to make the stock market healthier.

NORMALIZE THE STOCK MARKET—ON CHINA’S STOCK MARKET IN ITS ADJUSTMENT PERIOD Introduction The need of trading stocks breeds the stock exchange markets in UK and the U.S. successively in the second half of the 18th century. Subsequently, a number of countries set up their stock markets. When it came to the 20th century, especially after WWII, stock markets developed rapidly around the world. According to World Bank statistics, the total market value of global stock markets had reached USD9.4 trillion, accounting for 50.7% of the sum of the world’s GDP. By 2000, the same value soared to USD36 trillion, accounting for an unprecedented 119%. The total number of listed companies had also increased from 25,424 in 1990 to 49,612 in 2000. In developed countries, the stock market has become not only the barometer of economic situation, but also an important factor capable of stimulating economic development and causing economic fluctuations. The earliest stock in China was issued by China Merchants Steamship Navigation Company founded in 1873, while the China’s stock exchange had not appeared until the early 20th century. The Northern Warlords Government of China issued the Stock Exchange Act in 1914 and established Beijing Stock Exchange in 1917. The stock market of modern China was set up under the instructions of Deng Xiaoping after the reform and opening up. Shanghai Stock Exchange was set up in December 1990, marking the beginning of the securities market of new China. In June 1991, Shenzhen Stock Exchange was set up. In October 1992, Securities Committee of the State Council and China Securities Regulatory Commission were established and the issuance of stocks was expanded to cover the entire China, marking the official formation of China’s national securities market.

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It behooves us to make the efforts, overcome various difficulties, and keep exploring the most suitable development path for China so as to establish a securities market in the world’s biggest developing country. The author once organized a group of experts and scholars to carry out a systematic analysis of the first decade of China’s stock market (ranging from December 1990 to December 2000) during 2001–2002, and led the law enforcement inspection group of the NPC Standing Committee to overlook the implementation of the Securities Law in 2001, only to find that the China’s stock market was at its initial stage and that there seemed to be great achievements at the macro-level, yet actually there were a great number of problems at the micro-level. After the bull market during May 1999 to June 2001, the Chinese stock market kept depreciating. It had fallen 20.3% as of the end of 2002 comparing with that as of the end of 2000 (of which, the market value of tradable stocks accounted for 22.5%). It is safe to say that the Chinese stock market has entered into an adjustment period. We should waste no time in carefully summing up the experience of the China’s stock market in the past decade and make proper adjustment. The author believes that the primary task, in the adjustment period of the stock market, is the market normalization.

Brief Review Since Shanghai Stock Exchange and Shenzhen Stock Exchange were established and began to issue A-shares in December 1990 and June 1991, respectively, RMB special shares (B-shares) and overseas listed foreign shares (or H-shares) have also been issued initially in 1991 and 1993, respectively. However, due to the flaws of China’s stock market in the early days, investors, listed companies, securities companies and China Securities Regulatory Commission were all young and inexperienced, thus encountering twists and turns during their development. Behind volatile stock market, there existed a series of problems, such as insider trading, distribution of false information, fraud to investors, market manipulation and excessive speculations. Within a decade, the China’s stock market started from scratch, and became stronger and stronger. Both the market size and level have been substantially improved. As of the end of 2000, the total market value of stocks in China had reached RMB4,809 billion (of which, the total market value of tradable stocks was RMB1,609 billion); altogether 1,088 companies have gone public in the territory of China; the total number of investor accounts in Shanghai Stock Exchange and Shenzhen Stock Exchange has exceeded 5,600. Besides, there had existed 34 securities investment funds with a total value of more than RMB55 billion.

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China’s stock market has played an important role in concentrating scattered social capital and converting it into large amounts of long-term capital. As of the end of November 2000, the cumulative amount of funds raised by the stock market inside and outside China reached RMB944.32 billion, of which RMB484.61 billion was raised by domestic listed companies and RMB143.91 billion (USD17.38 billion) by overseas listed companies; and RMB315.8 billion (USD38.14 billion) was raised by the “red chips.” That a large number of state-owned enterprises that went public in the past decade have opened direct financing channels for pushing forward the upgrading of traditional industries, lowered the level of asset liabilities, stepped up the technical reform and the promotion and application of advanced new technologies, and pushed forward industrial and product restructuring. More importantly, going public has vigorously motivated state-owned enterprises to transform their operational mechanisms, enhanced listed companies’ vitality, enabled listed companies to have initially set up a corporate governance system based on the requirements of the modern corporate system, and sped up the process of making decisions more scientific, operations more market-oriented, supervision more socialized and operational responsibilities more legalized. It has thus played a leading role in the reform of state-owned enterprises to establish a modern corporate system and laid a solid foundation for improving the overall quality of the national economy. On July 1, 1999, the Securities Law aimed at regulating the Chinese securities market began to take effect. The issuance and implementation of the Securities Law has pushed forward the legalization and standardization process of the Chinese securities market. The functional positioning of the securities regulatory departments became clearer; the level of standardized operation of listed companies, securities companies and other market subjects were improved constantly; investors’ legal awareness was strengthened; and investors became more confident in the development of the Chinese market. The development of the China’s stock market in the past decade has demonstrated that it is completely possible and necessary to borrow boldly from the shareholding system, the stock market and other advanced operational and management methods capable of reflecting the production rules in modern society. Just as former President Jiang Zemin once pointed out, “the securities market is a natural product of the social market economy. Setting up and developing a healthy and orderly securities market with safe operations will play an important role in optimizing the resource allocation, adjusting the economic structure, raising more social capital, and promoting the development of the national economy.”

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However, it should be clearly noted that China’s stock market is still at its initial stage and calls for long-term and arduous efforts before getting developed and improved. China should carefully study and absorb the experience and lessons of foreign stock markets, while thinking carefully about and exploring the development paths that are in line with its national conditions. The author holds that the development of the Chinese stock market must adapt to the market economic system. The social market economy, in nature, aims at giving full play to the fundamental role of the market in resource allocation and improving the efficiency of economic development on the one hand; while guaranteeing social fairness and equality on the other. Therefore, China must, on the one hand, dedicate on foreign experience in shaping the stock market, so as to secure the healthy growth of its own stock market, and empower the stock market in optimizing resource allocation; and on the other, pay special attention to regulating and supervising its stock market and crack down on various illegal behaviors so as to provide all investors with a fair and equal chance to earn profits.

Stock Market—An Efficient Investment and Financing Vehicle Once people have idle money on their hands, they would want to not only expand consumption and increase savings, but also invest the money for earnings. From the viewpoints of fictitious economy, all of the financial market instruments are fictitious capital. When investors purchase financial market instruments with their idle money, they are actually swapping their usufruct of the money for an equity certificate which will allow them to claim the future income and assets of the issuer of the financial market instruments. Therefore, when making an investment decision, investors must think about three questions: How much are the expected earnings? Whether the expected earnings could be obtained, or not? Whether or not they could be withdrawn rapidly in case of emergencies? That is to say, prior to making an investment decision, investors must weigh the profitability, safety and liquidity of the financial market instruments they intend to purchase. Theoretically speaking, the profitability of the financial market instruments presents a negative correlation with the safety and liquidity of the financial market instruments, making the safety and liquidity a positive correlation. A variety of financial market instruments appeared to meet diversified demands of the investors. According to their terms of credit (being longer or shorter than one year), the financial market instruments can usually be divided into two types: capital market instruments, including stocks, mortgages, corporate bonds, treasury

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bills with terms of longer than one year, consumer loans and commercial loans from banks; and monetary market instruments, including treasury bills with terms of shorter than one year, large-amount negotiable certificates of deposits, commercial papers, bank acceptances, repurchase agreements, interbank lending agreements, etc. Based on the investments’ different natures, financial market instruments can be divided into equity instruments and debt instruments. Investors can only get bonuses instead of recovering the principals from the issuer of the equity instruments, yet they can recover the principals from the issuer of the debt instruments. The existence of the secondary financial markets enables investors to sell and cash in on the financial market instruments they hold, helping improve the liquidity of the financial market instruments greatly. However, due to the uncertainty of the prices of the financial market instruments in the secondary market, investors may get higher returns or suffer enormous losses when cashing them. That is why some people have dubbed financial market instruments “paper money.” In light of this concept, the monetary market may be viewed as a market of debt instruments that emphasizes liquidity, the bond market a market of debt instruments that highlights safety, while the stock market a market that focuses on profitability. In the development process of fictitious economy, we can see that securities are the products of the socialization of interest-bearing capital while the stock market is the product of securities marketization. Basically, the stock market creates opportunities not only for investors to make direct investments, but also for enterprises to get direct financing. For investors, since the stock market presents higher risks, they expect a higher rate of returns from corporate stocks than from securities. Enterprises thus have investment values. On the other hand, since enterprises require investors to share the risks, they should also share higher returns with investors so as to attract investors and their capital. According to a study done in China, major problems existing in the development of China’s stock market in the first 10 years could be generalized as follows: small and superficial; a majority of stocks non-tradable; able to go long instead of short; policy influence too significant; the trend of excessive speculations too severe; capital bubbles too many; short-term behaviors too prevalent; and malicious manipulation too rampant. These problems have greatly influenced the healthy development of China’s stock market. Therefore, the guiding ideology of regulating China’s stock market should be giving full play to the basic role of the stock market and recovering the true nature of the stock market. On the one hand, investors should be able to invest their

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capital into enterprises they think have investment values and decide, at their discretion, whether or not they want to hold the stocks and wait for bonuses or sell the stocks to get cash; on the other, enterprises with a good profitability yet insufficient capital should be able to absorb, from the market, the capital they need. Only by doing so can the role of the stock market in resource allocation be given full play. All stock markets are not only for investments, but also for speculations. Generally speaking, “investment” means the behavior of making long-term investments, with the expectation of enjoying higher dividends and an increase in value; while “speculation” refers to the behavior of making short-term investments, with the expectation of selling the stock soon under favorable conditions so as to get profits. As a rule, moderate speculations do no harm to the securities market, but contribute to its operations. A mature stock market is a market full of moderate speculations, the ones capable of maintaining a dynamic balance between investments and speculations; maintaining stable operations despite market fluctuations caused by the external environment; and bringing satisfactory returns to most investors while playing its role in promoting economic development. However, in case of a market overflown with speculations, investors would ignore the enterprises’ business performances, spurn high growth stocks, and favor those stocks that present room for speculation, greatly weakening the role of the stock market in allocating resources. Excessive speculation would also encourage short-term market behaviors and create conditions for dealers to manipulate the market illegally. Enormous risks that come with excessive speculations will become hidden troubles that may cause severe market turbulence and harm the economy and society. Therefore, China must resolutely prevent excessive speculations in the stock market, never allow the stock market to become a venue for a minority of people to speculate for colossal profits, nor a venue for some enterprises to “expropriate” wantonly and seek out low-cost financing.

Strengthening the Market Supervision In October 1992, the State Council of China decided to set up Securities Committee of the State Council and China Securities Regulatory Commission to take charge of a unified supervision and management of the national securities market while extending trials of stock issuance from Shanghai, Shenzhen and a few other places to cover the entire China. In accordance with the Securities Regulatory Agencies Institutional Reform Program issued by the State Council, China Securities Regulatory Commission completed the system reform of

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implementing vertical leadership over local securities regulatory agencies. Nine securities administration offices, two offices under the direct leadership of China Securities Regulatory Commission and 25 resident offices were soon established across China. In accordance with the requirements of the Securities Law , securities regulatory departments cleared and closed related trading places existing prior to the implementation of the Securities Law , changed the past examination and approval system into a system of approval, reiterated the information disclosure obligations of listed companies and related agencies, urged listed companies to perfect their corporate governance structure, separated listed companies from the assets, personnel and finance of the holding shareholders, intensified the daily supervision over listed companies, implemented classified management over securities companies, strengthened the supervision and instruction of investment advisory and other intermediate and service agencies, and reformed the securities registration and settlement system, thus playing a positive role in maintaining the normal operation of the securities market and preventing behaviors in violation of the Securities Law and other irregularities. China Securities Regulatory Commission investigated a number of listed companies and securities agencies and found some financing irregularities, insider trading, market manipulation, frauds and other illegal activities. Procuratorial organs around China put on record before investigating some violations of the Securities Law . The People’s courts at all levels concluded a number of securities crimes. China Securities Regulatory Commission, as the statutory securities regulatory and management agency, must make more efforts to meet people’s demand and legal requirements. Therefore, there is a proposal to promote the efficiency of China Securities Regulatory Commission in the following four aspects: First, the responsibilities of securities regulatory agencies should be clarified. It should be made clear that the primary responsibility of such agencies is to maintain the fairness and equality in China’s securities market and help the stock market resume its basic role as a venue for direct investments and financing. On the one hand, an equal investment environment should be provided to all investors to enable them to seek out rational returns under the premise of assuming the risks by themselves. Since small and medium–sized investors are weak in obtaining overall information and undertaking risks, they are the disadvantaged groups in the stock market. Therefore, various illegal behaviors, such as plundering the wealth of small and medium–sized investors, must be strictly and timely investigated. Meanwhile, “single dominant stock” and ignorance of the lawful rights and interests of small shareholders in listed

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companies must be stopped institutionally. On the other hand, an equal, fair and open system of approval should be established to provide equal market entry opportunities for enterprises with different ownerships, allow excellent enterprises capable of bringing higher returns to investors to have more financing opportunities, eliminate the risk-free arbitrage condition in the issuance market, and prevent the stock market from becoming a venue for some enterprises to “expropriate money.” Securities regulatory agencies should not be held responsible for the rises and falls of the stock market, nor should they prevent stock prices from rising or save the stock market as owners of stateowned assets. Under special and necessary circumstances, securities regulatory agencies may require the government to appropriately interfere with the market through statutory procedures. Second, market supervision should be focused. Disclosure of false information is a problem rampant among listed companies when issuing stocks to raise capital, going public, allotting shares, and making annual reports. In order to issue stocks and go public, some enterprises overestimate their assets, give false reports on their profits, and use fake packages; other listed companies severely breach investors’ willingness and arbitrarily change the investment direction of the raised funds, leading to false information. According to the author’s inspection in Shanghai, as much as 40% of the listed companies will change the direction of the use of the capital raised within two years; and those enterprises that will change the direction of the use of the capital raised within one year accounts for more than 10%. A considerable part of the funds raised flows back to the stock market before being used in stock speculations through a number of channels. A few listed companies even disclose false information on purpose. To cooperate with dealers in speculating their own stocks, some companies even work with dealers to disclose information that would mislead investors at different stages. According to statistics from the city of Xiamen, of the 16 listed companies there, those disclosing information in a substandard way account for about 20%. According to the law enforcement, the problem is even more serious in other places. It can be seen that securities market regulation should focus on information disclosure. Effective measures should be taken to prevent fake packages from entering the market, avoid listed companies from changing the investment directions of the funds raised arbitrarily and harming investors’ rights and interests. Efforts should be made to further improve the standards on information disclosure, promote the internationalization process of accounting standards, and guarantee the truthfulness, accuracy, intactness, compliance and timeliness of the information disclosed by listed companies and related

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intermediary agencies. Information disclosure will not only improve the asymmetric information held by different investors and prevent a few people from obtaining insider information or cheating others using false information, but also create favorable conditions for discovering problems. After information disclosure, chartered financial analysts (CFA), other professionals and investors will make analyses by themselves and try to find problems before submitting the problems to securities regulatory agencies, which may make public the problems after verification and take punitive measures based on the seriousness of such problems. More attention should be paid to strengthening the management over securities companies, listed companies, intermediary agencies, specified media and some stock analysts; and preventing them from colluding with one another or disclosing false information to mislead public opinions and the vast investors. Besides, more attention should be given to the role of the market. Although the healthy development of the stock market cannot be achieved without government regulations, special attention should be given to displaying the self-organizing effect of the market. Means of administrative examination and approval should be lessened when dealing with such matters as issuing stocks, going public and trading stocks. Enterprises may submit an open application, which will be examined and approved following proper procedures or they may make their own decisions based on the market situation before being put on the record by securities regulatory agencies. Meanwhile, the role of the stock exchange, securities industry associations and other self-discipline organizations in bridging the government and the market should be given full play to, such as carrying out annual examination and assessment of their members’ financial status, business performance and service quality, guiding members to do businesses, investigating and handling members’ irregularities, resolving conflicts between members, protecting the legal rights and interests of the members, providing legal and business education for members, organizing members to exchange ideas on doing businesses, and accrediting certain professional positions. Finally, the means of supervision should be constantly strengthened. Advanced information technologies should be adopted to establish a national network of real-time stock trading system and supervision and prewarning systems. Abnormal stock price fluctuations and other abnormalities should be timely discovered so that necessary measures can be taken. Legal procedures should be followed to empower China Securities Regulatory Commission to conduct necessary investigations and take punitive measures

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so as to prevent capital flight and the fleeing of suspects. Construction of the securities regulatory agencies should be further strengthened, so are the political and ideological quality, business quality and professional skills of securities regulators. The staff of the regulatory agencies must abide by the law, be fair and clean, and not seek illegal interests by taking advantage of their positions. China Securities Regulatory Commission, banks, courts and procuratorates must intensify mutual cooperation, establish a centralized law enforcement coordination mechanism, and increase the strike of major securities irregularities.

Quality Improvement of Listed Companies Many listed companies in China are low in quality and do not carry any investment value. In the first half of 1999, 2000 and 2001, respectively, the return on assets of the listed companies in China was only 4%, 3.6% and 1.8%. Meanwhile, since counterfeit products cost less, about 20% of the enterprises in China were suspected of fraud. It has been found that after excluding these fraud suspects, listed companies are trapped in a dilemma where the capital and profits grow together, yet the value created fall significantly. According to our investigation, that listed companies lack rational and efficient corporate governance is one of the most important factors that lead to poor performance and the lack of the long-term development ability of listed companies. As of the end of 2002, listed companies within China reached 1,223. Since most of them were transformed from state-owned enterprises, the proportion of state shares that has not been listed on the Chinese stock market was as high as 40%, or even above 80% at some listed companies. Corporate governance is also known as corporate governance structure. It is an institutional arrangement that determines the allocation of a company’s basic rights (including the right to appoint and remove senior leadership, the right to allocate the company’s resources, the right to distribute net profits, etc.). Mainly, it determines what people at which times shall have the above-mentioned rights. It is set up to resolve the disparities of the often-seen objectives between enterprise owners and operators upon the separation of the ownership and right of management of enterprises. Some people also argue that corporate governance is a whole set of institutional arrangements for an enterprise’s owner to supervise and regulate the enterprise’s operational management and performance. Some listed companies in China are strictly controlled by their large shareholders; some other listed companies even fail to separate personnel,

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properties and assets of holding shareholders, making listed companies the “ATM” of large shareholders or group companies. Few listed companies in China ever distribute bonuses. Even when they do, they do it in the form of providing free shares instead of cash dividends. Some of them perform excellently, yet refusing to distribute cash dividends on the pretext that they are badly in need of capital so as to develop production. According to statistics, from 1996 to 1999, only 26 listed companies in China provided cash dividends, accounting for only 3% of all listed companies. As of the end of 1999, only eight companies in Shanghai Stock Exchange and Shenzhen Stock Exchange have provided more than RMB1 billion of dividends cumulatively over the years. In 2000, the stamp duties paid by Chinese stock market and the commissions paid by investors to brokers were RMB90 billion or more, while the gross profits of listed companies in China were slightly more than RMB50 billion, of which only RMB14 billion was taken out and distributed as tax-inclusive dividends. Since investors were unable to profit from bonus distribution, they had to chase after the bid-ask spread, thereby increasing the speculative degree of the market. Local governments’ interference in market entry, operational process and withdrawal mechanism of listed companies has greatly weakened the role of China’s stock market in optimizing resource allocation. For example, it is provided in the Securities Law that listed companies should suspend or stop going public if failing to meet the statutory listing requirements. However, due to the inference of related local governments, a group of companies that have long failed to fulfill the listing requirements remain in the market, severely affecting the operational efficiency of the securities market. The restructuring of listed companies’ property rights should focus on diversifying property rights. The Decision of the Communist Party of China Central Committee on Several Major Issues Concerning the Reform and Development of State-owned Enterprises pointed out that “diversification of the property rights is conducive to forming a standardized corporate governance structure. Companies with multiple investors, except for a few enterprises that must be monopolized by the state, must be actively developed.” Equity diversification is not only conducive to implementing the principle of taking public ownership as the mainstay and allowing a variety of ownerships to coexist, but it is also helpful for China to solve the problem of enterprises relying too much on the government and the government has to assume unlimited responsibilities for enterprises by having investors in place. Unclear property rights, ownership and management confusion and other problems existing among collective and private enterprises in China should also be solved through equity diversification.

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Theoretically speaking, in a company with diversified equities, the board of shareholders is the highest authority. However, due to the great number and liquidity of its shareholders (equity transactions through the securities market are frequent), the board of directors of the company would exercise owners’ powers on behalf of the vast shareholders. Because of highly-centralized stock ownership and the dilution of public shareholders, the board of directors is manipulated or controlled by insiders in most cases, making it difficult to form a mechanism where an independent board of directors is established to guarantee sound operations and decision making. According to a questionnaire survey, only about 3.4% of the respondents think that the board of supervisors is the main binding force inside a listed company. Since their interests cannot be protected through a transparent mechanism due to the irrational equity structure, a great number of enterprise managers tend to obtain private gains for shareholders, or for themselves when making decisions, significantly harming the interests of the vast small and medium–sized shareholders. Under such circumstances, a company’s performance depends largely on its managers’ quality and good conscience, or whether or not its shareholders are enlightened. Solutions to the problem of “single dominant stock” must be permanent. On the one hand, effective measures should be taken to solve the problem of large shareholders impropriating the assets of listed companies. Mutual guarantees between listed companies and large shareholders should be supervised strictly in accordance with the law. Listed companies must be forbidden to provide guarantee for large shareholders unilaterally. Related transactions must be carried out according to the law and disclosed as required. Independent directors’ qualifications, conditions, remuneration, rights and responsibilities of should be clarified in related instructional documents so as to give full play to their role as supervisors. On the other hand, the equity structure of listed companies must be adjusted. Under the premise that it is, currently, impossible to increase the proportion of tradable shares, transfer of shares may be carried out among state-owned enterprises to allow each listed company to have at least three large shareholders. Besides, the meeting system of the board of shareholders, the board of directors and that of supervisors needs to be improved.

The Ideology Shift and the Cultivation of Institutional Investors The vast small and medium–sized investors are not only active participators, but also the disadvantaged group in China’s stock market. When fine-tuning its securities market, China needs to not only protect the rights and interests of the vast investors with a variety of legal and political means, but also strengthen

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the education of small and medium–sized investors and guide them to change their concepts. First, investors’ awareness of the stock market needs to be corrected. Investors must be warned that investing in the stock market is risky. The higher the returns, the greater the risks. Without a good risk tolerance, investors would lose all in long-term speculations, even if they succeed in short-term speculations. In particular, small and medium-sized investors must avoid making excessive speculations and try to select listed companies with higher investment values before making long-term investments. Second, investors’ analytical ability must be improved. Investors should be encouraged to analyze the values and trends of individual shares independently, make their own investment decisions, and avoid losses due to various reasons. Finally, investor’s legal awareness has to be strengthened. According to the author ’s investigations in Shanghai, Shenzhen and Wuhan, many small and medium–sized investors have never read the Securities Law of the People’s Republic of China . They even do not know their legal rights and interests. To this end, investors should be allowed to understand how to exercise their stock ownership, the right of free disposal of stocks, the right to know related information, the right to know major issues of the listed companies, and the right to distribute the companies’ surpluses and residual properties. Currently, tradable shares are scattered on China’s stock market and the proportion of institutional investors is too tiny. Statistics show that of the total stock accounts in Shanghai Stock Exchange at the end of 2000, those belonging to individual investors accounted for as much as 99.6%; and those belonging to institutional investors accounted for only 0.4%. The situation in Shenzhen Stock Exchange was more or less the same. The equity of tradable public shares is highly scattered among individual shareholders, making public shareholders unable to effectively control listed companies and present a tendency of “taking free rides.” Cultivating institutional investors is of crucial significance to improving the investment structure of China’s securities market. China needs to further develop securities investment funds, focus on developing open-ended funds, and try to make open-ended funds the mainstream of the fund industry in the next five years; implement the system of setting up and issuing funds step by step, create an environment favorable for market institutional innovations, explore new varieties of funds suitable for insurance and social security, and launch bond market funds and monetary market funds at the right timing; expand the business scope of fund management companies, allow such companies to engage in private placement and entrusted asset management,

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etc.; make efforts to relax qualification limitations on fund management companies and fund sponsors, allow a variety of agencies and natural persons to participate in establishing fund management companies in a phased manner, explore new ownership structure of management companies, and select qualified fund management for pilot listing. Besides, the cultivation of insurance institutional investors must be accelerated. Efforts should be made to explore flexible ways for insurance funds to enter the market, encourage fund management companies to make bold innovations and design fund varieties in line with the characteristics of insurance funds so as to better serve the insurance companies. Insurance companies should be allowed to launch special trials, independently or together with other insurance companies, to manage the insurance funds. When conditions are ripe, insurance companies should be allowed to initiate the establishment of fund management companies so as to further develop China’s fund industry and its securities market. Lastly, active efforts should be made to establish a professional and market-oriented social security fund management system. When such funds have developed up to a certain scale, efforts should be made to loosen investment limitations gradually, open the securities market to such funds step by step, introduce competitions, explore ways to establish a professional and market-oriented social security funds management and supervision system led by the management of entrusted professional institutions. A variety of social security fund management set-ups, including endowment insurance, investment-linked insurance and participating insurances, etc., where fund management companies are entrusted to manage and life insurance companies are entrusted to launch, should be actively explored.

The Transformation of Securities Companies to Modern Investment Banks and the Standardization of Other Intermediary Agencies Securities companies have kept growing with the development of the Chinese securities market. As of the end of 2002, there existed 126 securities companies and over 3,700 securities exchanges across China. In general, most securities companies operate well. Yet, it happens occasionally that some securities agencies get involved in illegal operations and manipulate the market. Some securities companies even become dealers and manipulate stock prices, severely disturbing order in the market. There are also securities companies overdrawing clients’ accounts or embezzling customers’ deposits. A few securities company even participated in malicious speculations, provide finance for customers,

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trade stocks on behalf of customers or establish individual accounts, and become self-operating traders. Therefore, effective measures must be taken to correct and deal with some illegal operations and criminal behaviors carried out by some securities operation and service agencies, such as manipulating the market, maliciously speculating in stocks, overdrawing customers’ accounts and embezzling customers’ deposits, etc. Currently, most securities companies in China are small, presenting a great gap with foreign investment banks in terms of capital strength, business scope and operational experience. To sum up, the registered capital of all securities companies in China is still less than that of a single well-known foreign investment bank. The gap would be greater in terms of their financing capacities. Securities companies in China are mainly engaged in stock underwriting and securities brokerage. Businesses in M&A, leveraged buyout, project financing, assets management, corporate finance and risk investments are yet to be opened. Securities companies in China now are incapable of securities underwriting on the international market, far from being able to meet the development requirements of transnational corporations in China. To this end, it is suggested that two to three securities companies each with a good foundation should be supported in a focused way so as to promote them to develop into modern investment banks. Great efforts should be made to improve the moral and professional qualities of personnel in securities companies, establish proper incentive mechanisms, and punish those who embezzle public funds, use pubic recourses for private gains, or conduct other illegal behaviors. The Securities Law requires accounting firms, legal firms, asset evaluation organizations and other intermediary services to provide necessary services for securities issuance and listing in compliance with the law. However, to seek out private gains, some institutions violate professional ethics, and help enterprises falsify accounts and provide false certificates; others even meet the illegal or irrational requirements of listed companies, do whatever it takes and issue whatever reports such listed companies want, making it more convenient for fake packages to enter the market. For example, in the first half of 2000, of the four audit cases concerning suspected irregularities of listed companies in Sichuan, three accounting firms and one asset evaluation organization were involved. Industry self-regulation of intermediary agencies should be intensified, the quality of practitioners should be improved, and the supervision and restraints of intermediary agencies should be strengthened. Accounting firms should

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display their main function as certified public accountant (CPA) auditors; provide independent, objective and fair audit reports and related materials; take responsibilities for the vast investors, the companies that issue stocks and the society; abide by professional norms and related technical standards; improve their professional ability; and safeguard their good images and trustworthiness. Accounting firms that cause losses to the objects being audited or other interested parties due to breach of contract, negligence or fraud must be investigated into their administrative, civil and criminal responsibilities. Meanwhile, qualification examination and determination must be strengthened. It is suggested to establish as soon as possible a chartered financial analyst system needed by China and up to international standards. Law firms engaged in securities businesses must ensure the truthfulness, accuracy and intactness of the legal opinions and various legal documents they issued, be forbidden to provide false certificates for the clients, improve the eligibility criteria of lawyers to be engaged in securities legal services, and gradually cultivate professional securities lawyers. The asset evaluation report issued by asset evaluation organizations is an important basis for the shareholding reform of state-owned enterprises and the assets reorganization of listed companies. Therefore, it must be accurate, objective and fair, and should never be falsified just to meet the requirements of the object being evaluated. International norms should be followed to formulate asset appraisal methods and procedures in line with China’s national conditions. In particular, the appraisal of intangible assets needs to be strictly standardized. Special attention should be paid to cultivating a group of qualified certified public valuer (CPV). In addition, some investment companies, investment advisers and finance companies begin to engage in helping the clients with their finances, speculate in stocks after holding control of a great deal of capital, causing adverse impacts on the market, thus have to be regulated through legal means.

Fine-tuning the Securities Law System Since some of its contents are principles only, the Securities Law , upon its publication and implementation, required securities regulatory departments to formulate supporting laws, regulations and related implementation measures, to further clarify the past related rules in accordance with the Securities Law , and to waste no time in formulating some new implementation measures based on legal rules and market development. As of the end of June 2001, upon State Council’s approval, China Securities Regulatory Commission issued five

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administrative rules, including Regulations of the Stock Issuance Examination and Verification Committee and Procedures of the China Securities Regulatory Commission (CSRC) for the Stock Issuance Examination , formulated and released more than 130 departmental rules and regulations, including Measures for the Administration of the Listed Companies Issuing New Shares, Measures for the Examination of Securities Companies . Meanwhile, as required by law, it clarified more than 250 laws, regulations and regulatory documents issued prior to the promulgation of the Securities Law and abolished 114 of them. The Shanghai Stock Exchange and Shenzhen Stock Exchange also clarified and formulated a slew of business rules in accordance with the Securities Law and supervisory and regulatory measures, ensuring effective law enforcement. Even so, the implementation measures promulgated were still unable to meet the development demand of the securities market. Some established standards were not consistent with the provisions of the Securities Law ; and other were not well-coordinated. First, the Securities Law provided that in case the issuer releases falsified or misleading information which caused losses to investors during trading, the issuer, its directors, supervisors and managers should be held liable. However, without concrete measures, it was difficult for investors to lodge a complaint or for the prosecutor to testify in some cases. Courts even found the provision to be vague and made it hard for them to accept and hear such cases. Second, industrial and commercial departments, public security departments, prosecutorates, courts and other law enforcement departments interpreted the threshold of putting on record a securities criminal case differently, affecting the investigation of some cases. Third, the relationship between the Securities Law and some contents of the Civil Procedure Law of the People’s Republic of China and other laws was inexplicit, making it so easy for some law enforcement units to execute customers’ deposits of securities companies, even arrest people, severely affecting the order of securities trading. Since China promulgated the Securities Law in the middle of the East Asia financial crisis, to effectively guard against risks, it included in the law some rigid contents and made no provisions on a few other contents. The securities market developing to a new level, a series of new problems appeared, affecting the further implementation of the Securities Law . It is suggested that, in accordance with the development demand of the securities market, in-depth studies should be carried out and legal countermeasures be made on such problems as mixed operations, stock index futures, the entry of social security funds into the market, the development of China’s securities market after China’s entry to the WTO and the law enforcement authorities of securities

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regulatory agencies. For some principal provisions in the Securities Law , related implementation rules, including securities market supervisory regulations, listed company supervision ordinance, and regulations on the administration

of securities companies, should be formulated to fulfill them. Studies on the

relationships between the Securities Law , the Company Law , the Trust Law ,

the Civil Procedure Law , the Criminal Law and the Criminal Procedure Law of

China must be strengthened. Modifications or interpretations of related laws

may be carried out when necessary to make them more coordinated, providing

effective supports and guarantees for law enforcement. Securities regulatory departments have to find new situations and problems in practice constantly,

make institutional innovations, and further develop and improve China’s securities market.

The Securities Law is the basic law for China’s securities market, the effective

implementation of which could be guaranteed only when the vast securities

regulators and practitioners and investors know and understand it and act in accordance with it. Therefore, China must further study, publish and implement the Securities Law , and encourage all news media, securities supervisory and operational agencies to adopt various approaches in publicizing the Securities

Law and supporting laws and regulations. The practice of Shanghai Securities Administration Office requiring securities companies to present the Securities

Law to all investors who have recently opened an account should be promoted. Government leaders, supervisors and leaders of securities institutions at all levels must take the lead in studying and applying the Securities Law , never interfere with the stock market illegally, and serve as good examples in administering, supervising, and managing the securities market. Listed

companies, securities institutions, securities investment advisers, securities practitioners and related news media have to, based on their respective businesses, intensify the study, publication and education of the Securities

Law so as to better understand it. The vast investors must improve their risk

awareness and self-protecting awareness, and protect their legal rights and interests through learning.

China’s stock market is right now at a low point, making it the right time to

make necessary adjustments. The author believes that under the leadership of the CPC and the State Council, China’s stock market will recover its true colors and take the path of healthy development with two to three years of efforts.

Completed in January 2003

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LAYING A CORNERSTONE FOR THE HEALTHY DEVELOPMENT OF THE STOCK MARKET Compared with the real economy, the fictitious economy is another economic pattern existing in the economic system. As an important component of the market economic system, its healthy development is closely related to the improvement of the economic system. Having a highly efficient and healthy stock market is an internal requirement for developing fictitious economy in China. Institutional construction of the stock market must give play to the basic role of the market in resource allocation and improve its efficiency on the one hand; and establish the fairness of market trading and that of rules and information on the other hand. Equal efforts should be made to regulate and develop the stock market.

Protecting Small and Medium–sized Investors In the process, special attention should be given to better protecting the disadvantaged. On the stock market, small and medium–sized investors are the disadvantaged. It is the core mission to protect the legal rights and interests of investors. Why is it? They are the disadvantaged. To protect the small and medium–sized investors is not a short-term measure necessary only when the stock market is at a low point, but a basic rule of a standardized stock market and a long-term arduous task. Small and medium–sized investors are weak in capital strength and the ability to get information, so they are easily misled by some people. In an immature market, insiders of listed companies and intermediary agencies would easily take advantage of the weak position of small and medium–sized investors and harm their interests for unfair gains. Compared with other financial assets, the potential benefits and risks of stocks are relatively high. The stock market in itself is risky. That is why people are warned of entering the market. It needs investors to be prudent when selecting stocks and patient when holding stocks. Investors should understand that they have to assume full responsibilities for their investments in the stock market. However, a compensation mechanism should be set up when the interests of small and medium–sized investors are harmed by false information, insider trading and malicious manipulation. Though there are principle provisions in the Securities Law , corresponding and operational enforcement rules have not been in place for long. The Supreme People’s Court has released corresponding judicial interpretation, facilitating the establishment and improvement of the investors’ compensation mechanism.

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The compensation mechanism for securities frauds touches upon group litigation, which is quite common abroad. China should learn from it before substantively constraining listed companies. In the absence of group litigations, individual small and medium–sized investors would find the litigation costs fall short of its expected return if they lob a lawsuit through related intermediary agencies (law firms). Therefore, it is impossible to encourage them to try to get compensation through litigation. Proceedings rules and compensation mechanisms should all be developed, targeting false information, malicious manipulation of the market and insider trading so as to fully implement the provisions of the Securities Law and the principle of being fair, open and justified.

Addressing Structural Problems Standard operations of the intermediary agencies in the securities market play an equally significant role in protecting the interests of the vast investors. Taking funds as an example, the operation of funds has become relatively standardized upon the release of Law on Securities Investment Funds of the People’s Republic of China . Yet the operational level of the funds industry in China is to be improved. It is generally believed that funds are operated by experts and that investing in funds is rational. Theoretically speaking, some funds may not bring returns as high as those smarter investments, but on average, such returns should be higher than those of private investors. However, no significant difference has been found. To be honest, the management and investment capacities of fund managers now are not satisfactory. Even open-ended funds are under the pressure of being redeemed. Within a certain period, fund returns depended on the right of funds to purchase original issue stocks, giving birth to consequent problems that had to be solved. Abnormal collective behaviors of funds would also have an enormous impact on the stock market. On the one hand, regulatory departments should strengthen the regulation over fund companies; on the other hand, fund managers should constantly improve their management level. However, currently, funds may disperse risks through portfolio investments, yet may not be profitable. Only by improving the management level can it be possible to construct a basis for profitability. The problem of full-circulation is the concern of most investors, which has the greatest impact on small and medium–sized investors. It calls for prudent attitudes and trials. Theoretically speaking, equity division leads to different qualities of the same shares, behind which are different rights of the same

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shares, leading to different interests between tradable shareholders and nontradable shareholders. That’s why non-tradable shareholders still hope to increase stock issue even if the stock market keeps slumping. The problem of equity division must be solved. However, possible difficulties in the process should be fully anticipated. People’s behaviors and market directions are unpredictable, so trials are needed. Without launching trials, it may cause disastrous damages to the stock market, harming the interests of the vast investors. It depends mainly on current conditions as to whether or not a newly-issued share can be traded. For example, the SMEs market may not have been launched even today if all newly-issued shares at its launch were required to be tradable. In actual policy design and operation, the obstacle from full-circulation has to be lessened to the maximum level in order to ensure the smooth implementation of the policy. The behavioral standardization of listed companies in the SMEs market has also stirred controversies. Despite the “Jiangsu Qionghua event,” the mainstream is positive. We cannot deny the SMEs market simply because of “Jiangsu Qionghua Hi-tech Co., Ltd. event” and similar problems. Actually, many problems, including listed companies’ releasing false information, insider trading and intermediary agencies frauds, can also be seen in the main board market. However, the event did reflect that the supervision pattern of China’s stock market is questionable and the level of its supervision is yet to be improved, and that it has weakened investors’ confidence in the SMEs market.

Avoiding the Policy-oriented Market Efforts have to be made to better guide and supervise listed companies, the cornerstone of the stock market, improve their quality, and help form a group of trustworthy blue chips with an excellent performance. The author believes that in supervising and regulating the stock market, regulatory departments should be responsible for guaranteeing the fairness, equality and openness of the stock market, but not the booms or slumps of it. Starting with information disclosure, the supervision should be performed in the following four steps: Disclosure . To begin with, information disclosed should be timely, intact and correct. Analysis . People should be allowed to analyze the information upon its disclosure. Hubei Lantian Co., Ltd., fund conspiracy and similar cases were discovered after information analysis. Analysis is an important link in screening the information of listed companies and distinguishing the information disclosure quality and assets quality of the listed companies. Not only the management departments, but also China Securities Regulatory Commission, the vast investors and professionals can all analyze the information.

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Announcement . Results of the analysis should be announced and made public. There might be black-box operations and the analysis can be manipulated in the absence of due transparency, bringing great harms to the investors. Punishment . China Securities Regulatory Commission should start with supervising the truthfulness of information disclosure, deal with a variety of possible irregularities and hidden problems existing in the process of information disclosure by listed companies and intermediary agencies in a timely and effective manner, and take remedies as required. China has made a special mention of the same problem in its Securities Law . On the other hand, the influence of the policy-oriented market should be lessened as much as possible to protect the vast investors. Prices, returns and fluctuations in an efficient and healthy securities market are influenced mainly by the situation of the real economy, and react to policies moderately. In any country or district, the local stock market reacts to the introduction of related government policies or major information disclosure. At abnormal fluctuations in the stock market, any government would introduce policies to influence market orientation. But if the government interferes too much with the securities market, or the market overreacts to the introduced policies, or market prices, returns and fluctuations are driven by such policies in the long term, it means that the market has severe shortcomings and cannot play its essential role in resource allocation and that it is a policy-oriented market. Based on the history of the stock market and our studies, the 25 highest and lowest points of Shanghai Stock Exchange Composite Index during 1991–2001 all responded to the introduction of related policies and information. Actually, any policy would have both positive and negative effects and cannot simply be called “bull” or “bear.” However, that investors like following suit would lead to their overreaction. After the introduction of each government policy, there would be reverse adjustment in the form of booms or slumps. Therefore, as long as the government does not release false information maliciously, investors should realize that they must assume full responsibilities for the risks caused by their own behavioral patterns. As a matter of fact, excessive, unnecessary and abnormal market fluctuations produced this way act adversely on both the government and the investors. Government officials should make fewer speeches on whether the introduced policies are “bull” or “bear,” while investors should correctly estimate the introduced policies and not think too much of getting short-term interests from policy speculations. Only in this way could China’s stock market avoid being policy-oriented. Completed in October 2004

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PROSPECTS OF CHINA’S STOCK MARKET I am very glad to come to China Capital Market Forum for the third time and discuss with you the development of China’s capital market, especially at the moment when equity division reform is in smooth progress. I would mainly talk about three questions today: the target pattern of China’s stock market reform; major problems and the acceleration of equity division reform; and that improving listed companies’ overall quality is the permanent cure. Besides, I may say something about supporting the development of securities companies and improving market supervision. The stock market of new China was set up after the reform and opening up under the guidance of Deng Xiaoping. It took great courage to establish such a market at the time. In more than a decade, China’s stock market has greatly improved in terms of its scale and development level and has played an important role. The promulgation and implementation of the Securities Law has also pushed forward the legalization and standardization process of China’s securities market. However, we should see that China’s stock market is still at the initial stage and needs to be developed and improved with arduous long-term efforts. Therefore, we should make practical efforts and keep exploring a development path consistent with the national conditions. Today, I would like to say something based on my personal studies and the studies done by scholars and experts under my tutelage, as well as my experience in the examination of the Securities Law enforcement and the deliberation of the revised Securities Law .

Target Pattern of the China’s Stock Market Reform The target pattern of the Chinese stock market reform is to give full play to the basic role and recover the nature of the stock market as an efficient venue for investment and financing and a venue featured by moderate speculations. An “efficient venue for investment and financing” means that investors should be able to pour their capital into enterprises they think are of investment value and decide whether they want to hold the stocks and wait for bonuses or sell the stocks for cash; on the other hand, enterprises with good profitability yet insufficient capital should be able to absorb, from the market, the capital they need. Only by doing so can the role of the stock market in resource allocation be given full play to. The stock market provides investors with the opportunities to make direct

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investments and enterprises to do direct financing. For investors, since the stock market presents higher risks, they expect a higher rate of returns from corporate

stocks than from securities. Enterprises thus have investment value. Stock returns include not only dividends, but also the appreciation of an enterprise’s value. On the other hand, since enterprises require investors to share the risks, they should also share higher returns with investors. To make the stock

market an efficient venue for investment and financing, we must guarantee that

enterprises have enough investment values and that investors can get rational returns in general. Otherwise, it would be hard for us to maintain the nature of the stock market.

The stock market is also a venue characterized by moderate speculations.

There are two types of investors in the stock market: value-investors who focus

on the value of stocks and hold stocks for a long term waiting for appreciation; and speculators who make money by using the differences of stocks’ market

prices. A mature stock market is a venue featured by moderate speculations, without which there would be no stock market. However, a dynamic

balance between value-investment and speculations should be maintained. Theoretically, the rational value of a corporate stock depends on the current value of the realization of its future returns. If all investors register the same rational value and nobody buys or sells a stock, there would not be a stock

market. In the stock market, some investors may sell the stock, for it has exceed its rational price; while others may buy the same stock, holding that the present

price of the same stock is lower than the rational price. Such buying and selling behavior contribute to the volume of trade on the stock market. Therefore, it

is necessary to maintain a dynamic balance between value-investment and

speculations so as to sustain the vitality of the stock market. However, China’s stock market was once overflowed with speculations for a fairly long term.

In such a market, investors tend to focus on the price fluctuations in the stock market and ignore enterprises’ business performances, greatly weakening the role of the stock market in resource allocation. Moreover, excessive speculations

will also instigate short-term market behaviors and create conditions for dealers to manipulate the market illegally. Enormous risks that come with excessive

speculations will become hidden troubles that may cause severe market

turbulence before harming the economy and the society. Therefore, China should never allow the stock market to become a venue for a minority of people

to speculate for colossal profits like crazy, nor a venue for some enterprises to “expropriate” wantonly and carry out low-cost financing.

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Institutional Deficiency and the Equity Division Reform In its more than a decade of development, China’s stock market has shown three major institutional deficiencies, namely, the financing market focused on the stock market’s financing function while ignoring its investment function, or simply focused on the financing convenience it was capable of bringing to listed companies and its injection of capital into state-owned enterprises to help them in their reforms while ignoring the reasonable returns it was capable of bringing to investors; the semi-circulating market; more than a year ago, twothirds of the stocks on the market were not allowed to circulate; and the onesided market which can only go long instead of short. China’s stock market is stronger in helping enterprises financing for historic reasons. In the early 1990s, China implemented the system of allowing an enterprise to go public only after examination and verification and most enterprises at the time were owned by the state. Such a system enabled a great number of poorly-performed state-owned enterprises to go public wholly or partly before achieving low-cost financing in the securities market. It is the financing support they got from the stock market that makes some wellperforming state-owned enterprises what they are today. Though some of these state-owned enterprises later encountered with problems, they got cheap financing by going public. At the beginning, the examination and approval system used quotas and allocated different quotas to different provinces, forming “shell resources.” That is, it gave the government, the owner, the pre-option. The struggle for quotas was fierce at the time. Each province, federation of industries and commerce, women’s federation and even the Communist Youth League vied for a quota. The government, as the owner of state-owned enterprises, was given the pre-option. All enterprises that went public at the beginning were stateowned enterprises. There were some state-owned enterprises that repackaged themselves and managed to go public. Soon after they had gone public, the parent company would undercut the listed company. I once compared this to cake-cutting. Those with the right to allocate should not be given pre-option, or it will be hard to guarantee justice and fairness. On the other hand, the examination and approval system was backed by government credit. That makes the government, the market supervisor, responsible for investors’ losses caused by the irregularities of listed companies. The role of the government as market supervisor and owner of state-owned enterprises are contradictory. In the event that a listed company has problems, its supervisor wants to treat the problems seriously, while its owner hopes to brush aside the problems.

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The vast general investors have indeed not been rewarded with rational returns over the years. According to an online survey, in the big bull market in 2000, only 39.7% shareholders made some money during January to October, 43.2% shareholders suffered losses, and the rest 17.1% made it even. It is reported that listed companies raised RMB843.1 billion by issuing new and rationed shares during 1992 to June 2004, but the revenue was only RMB78 billion. The static yield was less than 1%, which was even lower than the bank interest rate. Ignoring the investment function of the stock market caused serious consequences. On the one hand, since the general investors could not get rational returns, their confidence was badly hurt. Some swore that they would never buy stocks any more (a pledge which of course, I think, would be forgotten if the stock market keeps going up.) On the other hand, listed companies no longer cared about their performances, making the return on assets even lower than the deposits rate. When investors lost the confidence in getting corporate dividends and appreciation, they had to choose to speculate. Moreover, there was some non-transparent information which affected investors’ confidence. For example, investors might initially be optimistic over Changhong Sichuan, yet suddenly, news came that it had failed to retrieve its payment for goods in the U.S. Such news would definitely affect investors’ confidence. Listed companies normally issue new shares at a 20-time premium of the P/ E ratio. After the funds raised become available, the equity per share and net assets per share of non-tradable shareholders would increase substantially, yet the equity of tradable shareholders is greatly diluted, leading to inconsistent interests for public shareholders, state-owned shareholders and corporate shareholders, the latter of which usually holds a significant speculative attitude toward stock price rises and drops. For example, some major shareholders, to enable their holding listed companies to issue rationed shares at higher prices, tend to disclose more good news on purpose, even use false information to stimulate stock price surges, or adopt all possible means to manipulate the stock prices; at times when the stock market is going down, they still increase the supply by issuing new shares so as to raise more social capital, contributing to the further fall of the stock market. The existence of a great deal of nontradable shares leads to different values for the same shares. That the value of non-tradable shares is far lower than that of tradable shares is essentially same shares with different rights. Since a great number of listed companies have a single dominant stock, the management basically is not supervised by investors and the general meeting of shareholders serves practically no

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function. I once held a small and medium–sized investor seminar, at which I was told by attendants that they all knew general meetings of shareholders did nothing, that they attended them to have a free lunch and take some souvenirs, and that illegal behaviors like releasing false information, disclosing internal information, manipulating the market, etc. happened recurrently even under strict prohibition. It is just too common in the development of China’s stock market in the past decade. One-sided market would weaken the vitality of China’s stock market and encourage investors to engage in excessive speculations and short-term behaviors. Only by pushing stock prices high can investors profit from the behavior of buying low and selling high. Investors would swarm at good news. Meanwhile, to avoid risks, they prefer short-term trades, leading to frequent and substantial fluctuations of China’s stock market. Listed companies wish to see the stock market going up, so do investors and the government. Yet, that is impossible. What’s more, one-sided market cannot eliminate the systematic risks for investors. Once the stock market continues to plunge, a majority of investors would be trapped or rushing to sell off the stocks in their hands, causing a slew of problems. In a bilateral market, margin trading and short selling are allowed, so at times when the stock market trends downward, a large volume of transactions can still be maintained. The above three institutional deficiencies all need to be solved carefully. In the latest revision of the Securities Law , opportunities are created to solve these three historic legacies. The stock equity division reform is now being quickly pushed forward fast. So far, over 400 enterprises in 16 batches have been reformed. Yet some people voiced different opinions over this reform on the Internet; some wrote to me. There are generally two extreme opinions. One opinion holds that the stock equity division reform does not have any legal basis, that it makes no sense to let non-tradable shareholders compensate tradable shareholders, and that it is an infringement of state-owned assets. I hold that the stock equity division reform aims at achieving same rights for same shares, the forms and management basis of which will both be based on the provisions of the Contract Law . Nontradable shareholders promise to not put their shares in circulation when the stocks were initially issued. If their shares were made tradable, and the capacity of the stock market increased greatly, stock price would fall. The change of the initial commitment not to put their shares in circulation will definitely damage the interests of tradable shareholders. Therefore, to obtain the right for their shares to circulate, non-tradable shareholders should pay certain compensation to tradable shareholders. It is allowed under the Contract Law . Both sides will make new decisions through consultation in case of any change to the original

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contract. Initially, after going public, tradable shares and non-tradable shares will have different prices. Now that non-tradable shares are to be traded, certain compensation to tradable shareholders is necessary and understandable. And frankly speaking, the capital supports from tradable shareholders are very important for some state-holding listed companies to develop well and make great achievements today. When going public initially, non-tradable shareholders convert their assets into shares and barely contribute any cash. The pricing of some assets is not right (in most cases, it is done based on the book value), not to mention there are certain problems in asset quality. The assets of non-tradable shareholders are sunk cost, which are hard to be realized based on their pricing, while what tradable shareholders invest is cash. The two are different in their practical value. Over the years, state-holding listed companies have been developing with the cash invested by tradable shareholders. Now that non-tradable shares are to be traded, giving certain compensation to tradable shareholders is legally feasible and reasonable. I am not in favor of the other opinion, either. I do not think the nation should compensate small and medium–sized investors for their losses over the years, because the state-owned shares of listed companies are national properties, instead of the properties of the tradable shareholders. Stocks are being traded all the time. People who initially suffered losses may have already withdrawn from the market. Current holders of the stocks do not have the right to ask for any compensation on their behalf. In the event that tradable shareholders do suffer losses due to the violation of the law by listed companies, a claim may be made according to the Securities Law , instead of asking for compensation in the negotiation of the consideration. One of the above two opinions is from some major shareholders, and the other is from some small and medium–sized shareholders. Both ideas have to be clarified. With the Contract Law as the basis, it should always be one policy for one enterprise. Non-tradable shareholders and tradable shareholders, instead of the government, should formulate unified standards or methods through consultation before making a final decision by voting. Generally, both sides will reach an agreement through consultation. In the plan for the stock equity division reform in listed companies approved by China Securities Regulatory Commission, consideration is paid mainly by presenting shares. For every 10 shares of tradable shares, 1.6 to 5 shares will be presented. However, the stock market cannot be stimulated simply by equity division reforms, it also needs capital injection. IIya Prigogine, winner of the Nobel Prize for physics, put forward the theory of dissipative structures, pointing out that a system far from equilibrium can only maintain a relative stability

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when exchanging energies and substances with the external world. To apply the above theory to the stock market, that is, a system like the stock market can only maintain a relative stability when it exchanges capital and information with the external world. In 2005, China’s stock market turnover shrank; the accumulated market turnover of Shanghai Stock Exchange was nearly RMB5 trillion, down 35%; and that of Shenzhen Stock Exchange was about RMB1.24 trillion, down 21.5%, indicating that China’s stock market was still shrinking. Without capital injection, it would be hard for China’s stock market to go up. The first thing to do in order to increase capital injection into the market is to strengthen investors’ confidence. Investors now can be classified into three types: small and medium–sized public investors, domestic institutional investors and overseas strategic investors. Currently, small and medium–sized public investors are not confident enough. Policies on domestic institutional investors have been loosened and insurance funds are allowed to enter the market. However, because of their lack of confidence, the amount of capital having actually entered the market is negligible. China has approved more than 20 QFIIs. Recently, it has announced to allow overseas strategic investors to enter China’s stock market, but require them to hold at least 10% of the shares for no less than three years, opening another channel for capital inflow. However, overseas strategic investors will be very prudent when entering the market and never buy stocks without any investment value. Therefore, listed companies have to have true investment value so as to improve and maintain investors’ confidence.

Improving the Overall Quality of Listed Companies Improving the overall quality of the listed companies is not only the permanent cure for the stock market, but also a fundamental measure for protecting the general investors’ legal rights and interests. To protect investors’ legal rights and interests does not simply refer to the proper handling of problems existing in listed companies. Most fundamentally, investors should be able to get rational returns from the stock market. Of course, there are risks in the stock market, which will be assumed by the investors themselves. However, to protect investors’ legal rights and interests fundamentally, we must ensure the fairness, equality and justice in the stock market, help it recover its true colors, and enable the investors, as a whole, to get returns (dividends plus enterprise value appreciation) higher than bond interests in the long run. To truly give play to the role of the stock market in optimizing resource allocation, supporting the superior, and eliminating the inferior, we need to carry out dynamic regulations

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and allow a few of eligible quality companies to go public, while forcing some listed companies that perform poorly to delist. I suggest that China force some poorly-performed listed companies to delist so as to improve the overall quality of the entire stock market and make room for those with better performance. Only by doing so is it be possible to enhance the investors’ confidence in the stock market. The overall quality of the listed companies in China is not satisfactory. According to a rough estimation, of the more than 1,300 active companies on the A-share market in China, only 400, about 30%), present a good investment value and are capable of bringing rational returns to investors, while most of the rest more than 900 companies present low or no investment value. If the situation continues, it would be hard to enhance investors’ confidence and achieve the health development of China’s stock market. According to the report for the third quarter of 2005, of the 1,353 active listed companies in Shanghai Stock Exchange and Shenzhen Stock Exchange, 36 had negative net assets and 235 negative net profits. There are three ways to delist listed companies. First, regular delisting, which requires setting-up a trading counter as a channel for the delisted tradable shares to be realized. Second, agreed delisting in which listed companies with poor performances and no investment values will be persuaded to make an offer and repurchase its stocks held by tradable shareholders before being given priority to resume the listing qualifications upon performance recovery. When a foreign stock market is at its low point, it has fewer of listed companies. But in China, when the stock market is at a low point, the number of listed companies is on the rise. NASDAQ has two markets: the national capital market with over 1,000 listed companies now (at most over 3,000 in history); and the small capital market with only 700 listed companies (at most over 1,800 in history). Some enterprises choose to delist by repurchasing their stocks, for delisting will make them unsupervised and able to rectify themselves and wait for right opportunities to get relisted. The third way of delisting is through acquisition. Listed companies with good performances or newly-listed companies may acquire the tradable shares of those listed companies with a poor performance on a voluntary basis. All in all, the three ways of delisting should be adopted to delist some of the listed companies. Many countries and districts have made specific provisions on the delisting of listed companies. For example, in the U.S., it provides that any listed company, as long as it meets one of the following conditions, must be delisted: with fewer than 600 shareholders; with fewer than 400 shareholders, each of whom holding more than 100 shares; with fewer than 200,000 shares of public

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shares; or with a market value under USD1 million; suffered operational losses over the past five years; with the total assets under USD4 million and suffered losses in each of the past four years; with the total assets under USD2 million and suffered losses in each of the past two years; failed to share profits for five consecutive years. According to the trading rules on the NASDAQ market, any company getting listed in NASDAQ will receive a warning of losses if the unit price of its shares is less than USD1 and the situation has lasted 30 trading days. Should the company put on notice fail to take corresponding measures to change the unit price of its shares within 90 days after the warning, it will be banned from trading. The criteria on delisting listed companies in China look simple for the time being and not so financially strict. It has followed the provision in the Contract Law and the Securities Law that listed companies suffering operational losses for consecutively three years must be delisted. It is suggested to develop criteria on delisting listed companies in a scientific way, set time limits for listed companies that meet the delisting criteria to reorganize themselves. In the event that such companies are still unqualified after the rectification, they may be suspended from going public, retain their transaction codes, and be ordered to delist if they still fail to reach the listing standards in two years. Not long ago, the State Council approved and put forward 26 articles in Opinions on the Improvement of the Overall Quality of Listed Companies with the goal of further improving the corporate governance system, encouraging listed companies to improve their transparency, disallowing local government to interfere with market entry, operational process and delisting mechanism of listed companies, trying hard to solve the problem of capital embezzlement and illegal guarantee, and putting an end to the problem of single dominant stock. To improve the overall quality of its listed companies, China must treat the symptoms, strengthen supervision, and give play to the role of independent directors. When the Company Law of the People’s Republic of China was revised and deliberated, some people held that independent directors and the board of supervisors were duplicated and increased the cost of supervision. I do not agree and insist on setting up independent directors. Members of the board of supervisors are usually representatives of major shareholders or of staff and workers, while independent directors should protect the interests of small and medium–sized shareholders. The two play different roles. When it is favorable to major shareholders and staff and workers, the board of supervisors would approve or ignore behaviors that harm small and medium sized shareholders. Independent directors must play their role in protecting the interests of small and medium–sized shareholders. To this end, China Securities Regulatory

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Commission has implemented independent director system in listed companies. Some people are against the system of independent directors, for there are some deficiencies in the system now. For example, in most cases, independent directors are nominated and hired by major shareholders, so they tend to speak for them. Besides, there has not been any job requirement on independent directors. If the requirements are made too low, anyone could serve as an independent director; if it requires too much, few people would be qualified. Today, well-known economists are usually hired to serve as independent directors. When an economist serves as the independent director for a number of companies, he actually does not do his job. By the way, I am not in favor of letting economists serve as independent directors, since they are not specialists in corporate management. They may be able to talk eloquently about something on the surface, but seldom spot the “tricks” in enterprises. Therefore, listed companies should hire people who have corporate management experience to serve as independent directors. It is the same case abroad, where more than 70% of the people serving as independent directors are experienced in corporate management, even top management of other irrelevant companies. Besides, the responsibilities and rights of independent directors should also be taken into consideration. If the pay is too high, independent directors may be bought by the management; if the pay is low, nobody would be willing to serve as an independent director. Independent directors should have the right to exercise their authority. Without timely and intact materials, independent directors may find it hard for them to duly play their role. It is expressly provided in some foreign countries that the chairman of the audit committee and that of wages and salaries committee overseas must be independent directors, and that all materials needed in a meeting of the board of directors be sent to independent directors. The resignation procedures of an independent director shall also be clarified. No independent director is allowed to just leave in case problems happening to the listed company he is working for. What is more, the independent director must bear joint liabilities. I would like to see China Securities Regulatory Commission further improve the independent director system, clarify the rights and responsibilities of independent directors. I would also like to see independent directors truly play their role in protecting the legal rights and interests of small and medium–sized shareholders.

Supporting the Growth of China’s Securities Companies There is also a very significant issue regarding the securities companies in China: They are large in number, quite different in quality, small in size and

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uncompetitive. For example, as of the end of 2002, Morgan Stanley from the U.S. saw its total assets reach RMB6 trillion, its net assets reach RMB335.1 billion, and total revenue reach RMB245.7, being twelve times, three times,ten times, respectively, of that in China; its per capita management assets had reached RMB320 million and per capita profits RMB12 million, being 64 times and 50 times, respectively, of that in China. Compared with international investment banks, securities companies in China have yet to improve in terms of corporate governance, management experience, customer network, incentive mechanism, brands and talents. The above four problems existing among the securities companies in China must be solved. Efforts should be made to develop and strengthen the securities companies in China, resolutely eliminate a group of securities companies that have severely violated laws and regulations, investigate the legal liabilities of their chief management, merge and reorganize a batch of small and less competitive securities companies, and select two to three securities companies with better foundations and stronger capabilities before helping them develop into investment banks with international competitiveness.

The Importance of the Market Supervision The responsibilities of securities regulatory agencies should be clarified in the first place so as to strengthen and improve market supervision. It should be made clear that the prime responsibility of such agencies is to maintain the fairness, openness and equality of China’s securities market and help China’s stock market assume its basic role as a venue for direct investments and financing and a venue featured by moderate speculations. Various illegal behaviors of plundering the wealth of small and medium–sized investors must be rigorously and investigated in a timely manner. Meanwhile, the single dominant shareholder must be stopped institutionally; equal market entry opportunities should be created for enterprises with different ownerships; and excellent enterprises capable of bringing higher returns to investors should be provided with more financing opportunities. The risk-free arbitrage condition on the issuance market should be eliminated to prevent the stock market from becoming a venue for some enterprises to “expropriate money.” Securities regulatory agencies should not be held responsible for the rises and slumps of the stock market, nor prevent stock prices from rising or save the stock market as owners of state-owned assets. Under special and necessary circumstances, securities regulatory agencies may require the government to appropriately interfere with the market through statutory procedures.

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Market supervision should be focused. Effective measures should be taken to prevent fake packages from entering the market, avoid listed companies from changing the investment directions of the fund raised arbitrarily and harming investors’ rights and interests. Efforts should be made to further improve the standards on information disclosure, promote the internationalization process of accounting standards, and guarantee the truthfulness, accuracy, intactness, compliance and timeliness of the information disclosed by listed companies and related intermediary agencies. The information disclosure, analysis, announcement and punishment should be properly carried out. More attention should be paid to strengthening the management over securities companies, listed companies, intermediary agencies, specialized media and stock analysts; and preventing them from colluding with one another or disclosing false information to mislead public opinions and the vast investors. The role of the market should also be highlighted. Although the healthy development of the stock market cannot be achieved without government regulation, certain attention should be given to displaying the self-organizing effect of the market. Means of administrative examination and approval should be lessened when dealing with such matters as issuing stocks, going public and trading stocks. Meanwhile, the role of the stock exchange, securities industry association and other self-discipline organizations in bridging and bonding the government and the market should be given full play to. I used to say that China’s stock market needs not only stock analysts, but also “guards.” Most stock analysts would make a pitch for listed companies, whereas stock market guards focus on spotting the problems in listed companies and disclosing the fake information released by listed companies. I hope that my students would become “guards” and do more analyses for the interests of the vast general investors. Means of supervision should be constantly strengthened. A national network of real-time stock trading system and supervision and pre-warning systems should be established. Legal procedures should be followed to empower China Securities Regulatory Commission to make necessary investigations and take punitive measures. The construction of the securities regulatory agencies should be further strengthened, so should the political and ideological quality, business quality and professional skills of securities regulators. China Securities Regulatory Commission, banks, courts and procuratorates must intensify mutual cooperation, establish a centralized law enforcement coordination mechanism, and increase the strike of major securities irregularities. The NPC is now deliberating on Amendment 6 to the Criminal Law of the People’s Republic of China . Handling of the problems in listed companies and securities companies have never been mentioned in the Criminal Law .

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Whenever a problem appeared, it was dealt with by fines. However, money was never a headache for the top management of listed companies. It will be another issue to jail the top management. The heaviest punishment given by China Securities Regulatory Commission right now is the revocation of qualification. But besides the securities industry, there is venture capital investment or the insurance industry. So this time, China is determined to write the protection of investors’ interests into its Criminal Law . First, where a director or supervisor of a listed company knowingly damage the interests of the listed company or taking advantage of their positions to manipulate, only to cause enormous losses to the listed company, shall be sentenced to imprisonment or detention, together with a fine, or may simply be punished with a fine. Second, where a controlling shareholder or a person in practical control of a listed company instructs a director, supervisor or senior manager of the company to commit the acts mentioned in the preceding paragraph, he shall be punished in accordance with the provisions of the preceding paragraph. Where a controlling shareholder or a person in practical control of a listed company that commits the offences mentioned in the preceding paragraph is a unit, a fine shall be imposed, and, in addition, the person directly in charge of the unit and the other persons directly responsible shall be punished in accordance with the provisions of the first paragraph. Third, failing to disclose other important information in accordance with relevant provisions, which is required to be disclosed according to law, thus causing serious harm to the interests of its shareholders or other persons, or engendering other serious circumstances, the person directly in charge and the other person directly responsible shall be punished in accordance with the provisions of the preceding paragraph. Currently, it has passed the first deliberation of the NPC Standing Committee. After another two deliberations, it will be passed. Generally speaking, China must encourage the development of the stock market by providing corresponding support on the one hand, and carry out strict control and raise the cost of law violations on the other. The system of fictitious economy features complexity, metastability, high risks, parasitism and periodicity. Attention should be paid to enabling the capital market to interact with the monetary market, combining fiscal policies with monetary policies, developing in a systematic and standard manner, and averting risks. China’s stock market is currently at low ebb. Efforts should be made to improve the overall quality of listed companies, push forward equity division reform, and constantly launch institutions that are in consistent with its national conditions. We must insist on carrying out the reform. It cannot be stopped or reversed. Though the reform plan is yet to be improved, without reform or development, problems existing in the stock market would not be

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solved. I hope that everybody present here could adhere to the reform, and constantly push forward the development of China’s capital market under the leadership of the CPCCC. Of course, it has different requirements on scholars and government officials. Government officials should be responsible for implementing the reform, while scholars should show their support for the reform and promote the reform and development by exploring theoretical bases, commenting foreign experience, improving policy framework, and analyzing possible difficulties, and should make greater contributions to further deepen the reform in and widen the opening up of China. I think scholars should make the efforts in the above four aspects to support and push forward the reform. I believe that it is hopeful for China’s stock market to bounce back after the reform of stock equity division. However, most fundamentally, the overall quality of listed companies has to be improved; due support should be given to the development of securities companies; and scientific supervision based on the law has to be further strengthened. I believe that under the leadership of the CPCCC, China’s stock market will bounce back with our common efforts. I hope to see new developments of China’s capital market at next China Capital Market Forum. Thank you. Completed in January 2006

PROMOTING A STEADY AND HEALTHY DEVELOPMENT OF CHINA’S STOCK MARKET After years of being a bear market, China’s stock market rose suddenly and sharply, arousing wide public concern. I have pointed out many times in recent two months that special attention should be paid to the stock market bubble, yet my words were responded with objections and doubts. In this paper, I would briefly explain my main points and basis.

The Stock Market Bubble As I point out in my book Diagnosis and Treatment: Revealing the Chinese Stock Market , “Bubble in financial assets is the deviation of the financial assets price from the reference value. It is the sudden rise of one or a series of assets prices in the process of continuous financial operations. The initial price rise would give rise to the expectation of continuous rise of the forward price, attracting new speculative buyers and giving birth to the phenomenon that assets’ price is far higher than the rational price. What these investors are interested in are the profits they can get from buying and selling assets instead of the usage and

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profitability of the assets. The expansion of the bubble may lead to temporary boom or frenzy. However, it will burst when it is expanded to a certain level, leading to financial price slumps, economic declining, even financial crises.” The influence of China and that of Beijing Olympic Games have of course contributed to the sudden and rapid rise of China’s stock market. Besides, the inflow of a great deal of domestic and foreign capital for short-term speculations also serves as a contributing factor. In a fictitious economy, bubble exists in the stock market intrinsically, the expansion and burst of which will lead to market fluctuations. Without speculations, there would be no stock market. Since bubble is the intrinsic property of the stock market, we must be aware that we cannot wait for them to expand before bursting them, because that will cause losses to a great number of investors. For example, Shanghai Stock Exchange composite index dropped suddenly soon after it climbed to 2,245 points, causing enormous losses to many investors. It is a problem we have to face calmly. I believe that investors should clearly know the boundary when the situation is good and never panic at stock market slumps. I do agree to some over-optimistic opinions. Even if the stock index went to 2,245 points again, it would be different from the previous peak. The stock index is now backed up by a few of the so-called blue chips instead of the improvement of the overall quality of the stock market. Therefore, I think great efforts are needed to improve the overall quality of listed companies. Some people begin to claim that the stock index may reach 4,000 points. However, without a good foundation, even if the stock index is high, it will turn out to be bubbles and cause damaged to investors. There is a famous saying on the stock market, “When you are rapturous, sell your stocks; when you are to cry because of the market, just buy stocks.” I think currently, investors have to be especially prudent and should not be misled by overoptimistic public opinions. I have also mentioned many times the protection of the interests of the general investors. We do not wait for problems to appear in listed companies before solving them. We should primarily guarantee the healthy development of the stock market and enable most investors to get reasonable returns in general. Such rational returns do not simply mean bonus, but bonus plus the appreciation of listed companies. Returns of the two should be higher than bond yields. Only by achieving this could listed companies truly present investment values. Stock price rise due to speculations will form bubbles and the bursting of the bubbles, causing losses to investors’ wealth. On December 29, 2006, at the seminar held jointly by the Sub-committee of Legislative Affairs of the NPC Standing Committee, the Legislative Affairs

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Office of the State Council and China Securities Regulatory Commission on the anniversary of the implementation of the Company Law and the Securities Law (Revised) , I stressed once more that “it is still a long way ahead for the development of the Chinese capital market. A great number of deep-rooted problems call for careful studies and solutions. We should never have this blind optimism or become reckless because of the bull market, but keep cool toward some overly-optimistic opinions on the market, rationally view the wealth function of the capital market, and well handle the relationship between fictitious economy and real economy.”

The Quality of Listed Companies “Internal cause is the basis while external cause is the condition of changes.” I have mentioned many times in recent years that improving the overall quality of listed companies is the permanent cure for the Chinese stock market. When receiving an interview in early December 2006, I pointed out “The problem of high stock index, but low returns is caused by the not-very-high overall quality of the entire stock market. I did a survey last year and made a general analysis of the 1,344 active companies on China’s stock market, only to find that roughly 400 of them truly presented investment values, accounting for about 30%. There is also a circumstantial evidence. Component stocks selected by all funds were roughly 400. How could other listed companies with low or even none investment values, such as those with zero net assets or even zero net profits, bring reasonable returns to investors? Listed companies are the cornerstone of the stock market. Only by improving the overall quality of listed companies could the stock market develop in a healthy way. It is fundamental. Therefore, I hold that greater efforts should be made to improve the overall quality of listed companies and delist those without any investment value. The existence of such companies on the stock market actually affects the quality of the stock market. An objective opinion should also be held toward the stock index, which represents the stock market only to some extent. Rise in the stock index does not mean that prices of most stocks would rise, either. Instead, it may be pulled by those stocks whose upward trend is so strong. Most of the enterprises whose upward trend is so strong are state-owned listed companies, whose performance is mainly affected by the macro-environment and the support of national policies. If supported simply by these state-owned listed companies, China’s stock market cannot develop in a healthy way.” As of April 30, 2006, 1,344 listed companies on the A-share market had submitted their annual financial reports in 2005 to China Securities Regulatory

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Commission. According to an analysis, companies with negative shareholders’ equity, negative adjusted net assets per share, negative net profits, negative net assets upon the deduction of non-recurring items, negative net cash flows from operating activities, negative increase in the amount of cash and cash equivalent and negative net assets rate of returns accounted for 3.9%, 4.6%, 18.2%, 27.2%, 19.3%, 54.9% and 15.1%, respectively, of the total (of which, some listed companies may have several negative indicators). Measured in a comprehensive way using international standards, only about 400 of them met the international standards, accounting for 30% of the total amount of listed companies. As for the assertion that 70% of listed companies in mainland China cannot meet international standards, it is unfounded.

Winners and Losers in the Bull Market In an interview with the Financial Times in Dubai, I pointed out: “…in a bull market, people will invest relatively irrationally. All investors think they can win, yet many will end up losing. But that is their risk and their choice.” Some argue that “irrational investors exist not only in the bull market, but also the bear market. Therefore, we cannot simply say the investment is rational or irrational just because it is made in the bull market or the bear market.” However, it is undeniable that irrational investors in a bull market are far more than those in a bear market, which tends to encourage the expansion of market bubble more easily. It is impossible that there are only winners in the stock market. Since there are a great number of deeply-rooted problems in the Chinese stock market, it is totally possible that more losers appear in the bull market. According to an online survey, in the big bull market in 2000, only 39.7% shareholders made some money during January to October, 43.2% shareholders suffered losses, and the rest 17.1% made it even. In the latest bull market, a great number of small and medium–sized investors “won the stock index instead of money” or, if they ever made any money, the amount was tiny. The stock index was almost tripled, yet few small and medium–sized investors got a 300% return. As far as I know, an overseas investment fund got a 180% return in simply three months. Due to the asymmetric information and weak capital foundation, small and medium– sized investors become the disadvantaged in the stock market. In the game with big investors in a highly-speculative stock market, they have to be keen, clearheaded, rational and quick, or they will lose. Some hold that my point “makes it hard for people to link together China’s vigorous development of the capital market-led direct financing, its basic

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financial policy of advocating people to change their savings into direct investments, and the proposal to establish such confidence or concepts among investors.” I have mentioned over and over again that the government, as the supervisor, shall never be responsible for the rises and falls in the stock market. Instead, it should create a fair, justified and open environment for investors and guarantee the legal rights and interests of the general investors. What China needs is a healthy capital market capable of optimizing resource allocation instead of a capital market overfilled with speculations and breaking away from the overall quality of the listed companies. That China encourages people to convert their savings into direct investments aims at giving play to the investment function of the capital market, guaranteeing that the general public can get reasonable returns in general so as to help them set up their confidence instead of attracting small and medium–sized investors into the stock market by “cheating” them before using their savings to get huge profits for a few big investors. To this end, small and medium–sized investors have to pay special attention to the risks in the stock market in times of violent stock market rises, and never take in the exaggeration of some people or invest in more capital beyond their financial capabilities. In April 2001, I was invited to present the opening ceremony of NASDAQ Stock Market in Times Square, New York, at which I delivered a speech. In my speech, I pointed out, “According to the viewpoints of fictitious economy, there are bubbles in the stock market, the expansion and burst of which will cause stock market fluctuations. As a prudent optimist, I believe that the stock market will move forward in a spiral way.” I believe that as long as we work hard to improve the overall quality of the listed companies in China, we can ensure the steady and healthy development of the Chinese stock market. Completed in February 2007

TOWARD A HEALTHY STOCK MARKET After a four-year bear market, Shanghai Stock Exchange composite index began to climb from the lowest points (1,011.5) on July 11, 2005, the rise of which began to accelerate in the second half of 2006 and exceeded the historic height (2,242.42) on December 14, 2006. As of the end of August 2007, it reached 5,218.83 basis points. Under such circumstances, the development of China’s stock market has begun to attract more and more attention from all walks of life, both at home and abroad. At the press conference held on March 16, 2007, Premier Wen Jiabao pointed out in clear-cut terms: “I am concerned about the development of the Chinese stock

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market, but I am more concerned about its health; our objective is to build a mature capital market.” I always believe that a healthy stock market should be a venue for efficient investments and financing and a venue featured by moderate speculations. In the previous section, I wrote: “Securities are the products of the socialization of interest-bearing capital while the stock market is the product of the marketization of securities. Basically, the stock market creates chances not only for investors to make direct investments, but also for enterprises to make direct financing. For investors, since the stock market presents higher risks, they expect a higher rate of returns from corporate stocks than from securities. Enterprises thus have investment values. On the other hand, since enterprises require investors to share the risks, they should also share higher returns with investors so as to attract investors and their capital.” “As a rule, moderate speculations do not harm the securities market, but contribute to its operation. A mature stock market is a market full of moderate speculations, the one capable of maintaining a dynamic balance between investments and speculations.” In this section, the author gives a few personal opinions and recommendations on how to further promote the healthy development of the Chinese stock market based on scrutinizes in the field and by combining macro-economics and micro-economics, and quantitative and qualitative analytical methods.

Viewing the Stock Market with a Prudent and Optimistic Attitude In my Times Square speech, I pointed out: “According to the viewpoints of fictitious economy, there are bubbles in the stock market, the expansion and burst of which will cause fluctuations in the stock market. As a prudent optimist, I believe that the stock market will move forward in a spiral way.” The establishment of Shanghai Stock Exchange in December 1990 marked the opening of New China’s securities market. The average monthly growth rates of the stock indexes in Shanghai Stock Exchange, China and other major countries and districts from December 1990 to the end of 2006 are shown below in Table 7.1. Table 7.1.

Average monthly growth rates of major stock indexes, late December 1990–late December 2006

Stock indexes Shanghai Stock Exchange Composite

196

Closing price as of the end of December 1990 127.61

Closing price as of the end of December 2006 2,675.47

Average monthly growth rate (%) 1.60

Toward a Healthy Development of China’s Stock Market

(Cont'd) Closing price as of the end of December 1990

Closing price as of the end of December 2006

Average monthly growth rate (%)

Dow Jones Industrial Average

2,633.66

12,463.15

0.81

NASDAQ Composite

373.80

2,415.29

0.98

Standard & Poor’s 500

330.22

1,418.30

0.76

Hang Seng Indexes

3,024

19,964.72

0.99

23,849

17,225.83

–0.17

Singapore Strait Times Index

1,154.80

2,985.83

0.50

Taiwan Stock Exchange Capitalization Weighted Stock Index

4,530.16

7,823.72

0.29

Stock indexes

Nikkei Index

From the data in the table, we can draw two conclusions: First, though all

major stock indexes inevitably went up and down during the period, except for the Nikkei Index which presented a negative growth rate under the influence

of the Japanese economic depression, the rest of the stock indexes were rising

in general: Second, the average monthly growth rate of China’s stock indexes was higher than that of other major stock indexes, mainly thanks to China’s sustained and rapid economic development and the constant progresses made to the institutional construction of China’s stock market.

By understanding this, people should make no fuss about normal rises

and falls in the stock market, nor view them as indicators of the government’s political performance or social stability. Regulatory departments have to focus

on strengthening the institutional construction of the stock market, protect the fairness, equality and justice of the stock market, and safeguard the legal rights

and interests of the general investors. Meanwhile, they should pay certain

attention to the development of the stock market, timely and appropriately guide and regulate the stock market, try hard to prevent booms and slumps in the stock market, and maintain market stability.

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Stock Market Boom Is Hard to Sustain Since the total market value of Shanghai Stock Exchange accounts for over 75% of that of Shanghai Stock Exchange and Shenzhen Stock Exchange. Shanghai Stock Exchange composite index is generally thought to be able to represent the overall development status of the Chinese stock market. According to the trends of Shanghai Stock Exchange Composite Index, it is believed that China’s stock market has entered a boom period as of the end of 2006. The average daily growth rates of major stock indexes in China and those overseas are shown in Table 7.2 below. Table 7.2.

Comparison of the average daily growth rates of China’s stock indexes during the booming period with those of major stock indexes, December 31, 2006–August 31, 2007 Closing price as of the end of 2006

Closing price as of the end of August 2007

Shanghai Stock Exchange Composite

2,675.47

5,218.83

0.41

Shenzhen Stock Exchange Composite

6647.41

17,872.11

0.61

Shanghai Shenzhen CSI 300 Index

2,041.05

5,296.81

0.59

Dow Jones Industrial Average

12,463.15

13,357.74

0.04

NASDAQ Composite

2,415.29

2,596.36

0.04

Standard & Poor’s 500

1,418.3

1,473.99

0.02

Hang Seng Indexes

19,964.72

23,984.14

0.11

Nikkei Index

17,225.83

16,569.09

–0.02

Singapore Strait Times Index

2,985.83

3,392.91

0.08

Taiwan Stock Exchange Capitalization Weighted Stock Index

7,823.72

8,982.16

0.09

Stock indexes

198

Average daily growth rate (%)

Toward a Healthy Development of China’s Stock Market

It can be seen from Table 7.2 that during December 31, 2006 to August 31, 2007, the average daily growth rate of stock indexes in China was far higher than that of their overseas counterparts, making it a boom period for China’s stock market. Seen from the experience of different countries, stock market boom reflects the rapid expansion of bubbles, yet such boom can hardly sustain. I once pointed that “Bubble in financial assets is the deviation of the financial assets’ price from the reference value. It is the sudden rise of one or a series of assets prices in the process of continuous financial operations. The initial price rise would give rise to the expectation of continuous rise of the forward price, attracting new speculative buyers and giving birth to the phenomenon that assets’ price is far higher than the rational price.” I pointed out for many times at the beginning of this year that special attention should be paid to the formation of bubbles in the stock market, which was responded with objections and doubts. Now, more and more people begin to admit that there are bubbles in China’s stock market. However, the rules of the formation and development of the bubbles call for further discussions. It is safe to say that speculations, bubbles and risks are symbiotic. Speculations would bring forth bubbles and bubbles present risks. Since the stock market is a market full of speculations, there will be bubbles, the expansion and eventual bursting of which will cause fluctuations in the stock market and bring risks to investors. Stock market bubbles start with individual stocks. The rational price of a stock should equal the present value of its future profits, which depends on its future returns and the discount rate. However, due to the uncertainties of the objective world and investors’ limited ability to know such uncertainties, it is hard to determine the rational price of a stock correctly. When most investors subjectively think the price of a stock is lower than its rational price, they would buy the stock in large amounts, which would drive its price to over its actual value, giving birth to bubbles. When it is a bull market, people holding one stock will wish more people to buy the same stock by spreading optimism so as to make more profits by selling shares of the same stock at a higher price. Out of following suit or playing the “greater fool,” more people buy the same stock, contributing to the continuous expansion of the bubble. People having already sold their stock and made money will choose to stay, but speculate in other stocks, even trash stocks, theme stocks, concept stocks, etc., leading to the proliferation and expansion of more bubbles. More and more bubbles will finally form the general stock market bubble (which is thought to be structural since some individual stocks

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do not have any bubble). Then, what people are interested in are the profits they can get from buying and selling assets, instead of the usage and profitability of the assets per se. The expansion of the bubble may lead to temporary boom or frenzy. However, when it expands to a certain level, it bursts. The stock market will decline rapidly due to the burst of the bubble after soaring to the critical point, or it will enter into a period of adjustment. In severe cases, a price drop of the financial assets may lead to economic recession, even financial crises. Another reason that violent rise in the stock market cannot be sustained is the restraint of the amount of net capital inflow. I once pointed out that “as a metastable system, the stock market has to maintain a relative balance by exchanging capital with the outside world. Since securities in themselves do not have any value, their prices are determined not by the objective law of value, but by people’s subjective estimation of their future prices and the concurrent demand-supply situation after they can be bought and sold on the market, leading to the derivation of their prices from the performance of real economic activities. When the price of fictitious capital is far from the reasonable expectation, they would create ‘economic bubbles’ and need the outside world to keep injecting capital so as to maintain its stability. However, it is a fictitious stability easy to be broken.” Theoretically speaking, the market value of the stock market will increase and stock index will rise as long as capital inflow into China’s stock market is larger than capital outflow, from which we can see that a prerequisite for the violent rise of China’s stock market is the rapid increase in the amount of net capital inflow into the market. We selected the period from November 2005 (it was then China’s stock market began to go up) to the end of August 2007 and regressed the index of Shanghai Stock Exchange against its market value, the index of Shenzhen Stock Exchange against the market value of Shenzhen Stock Exchange, the Shanghai Shenzhen 300 Stock Index against the total market value of Shanghai Stock Exchange and Shenzhen Stock Exchange, only to find that both the total market value and the tradable market value have shown a significant linear relation with corresponding stock indexes. Trendline equations and the related coefficient are shown below. Table 7.3.

Trendline equations and the related coefficient of the three stock indexes and their corresponding market values Stock index—Aggregate market value

Shanghai Stock Exchange

200

Stock index—Circulation Market value

Trendline equations

R2

Trendline equations

R2

y=39.879x – 27,608

0.9937

y=11.137x – 7,699

0.9798

Toward a Healthy Development of China’s Stock Market

(Cont'd) Stock index—Aggregate market value

Trendline equations

R2

Stock index—Circulation Market value

Trendline equations

R2

Shenzhen Stock Exchange

y=3.0352x – 10.977

0.9912

y=1.5633x – 709.2

0.9933

Shanghai and Shenzhen Stock Exchanges

y=48.017x – 13,442

0.9946

y=15.938x – 4906.9

0.997

All conditions basically unchanged and based on the above table, when the Shanghai Stock Exchange composite index reaches 6,000 points, the corresponding circulation market value will hit RMB5,912.3 billion. Seen from the circulation market value as of the end of August 2007, the circulation market value of Shanghai Stock Exchange accounted for two-thirds of that of the sum of Shanghai Stock Exchange and Shenzhen Stock Exchange. Therefore, seen from Shanghai Stock Exchange and Shenzhen Stock Exchange, under the premise that the stock market structure remains unchanged, the total amount of capital needed will be RMB8,904 billion (59,123/66.4%); since the total market value of Shanghai Stock Exchange and Shenzhen Stock Exchange was RMB7,933.6 billion on August 31, 2007, the amount of net assets needed is RMB967.4 billion. When Shanghai Stock Exchange composite index reaches 10,000 points, the corresponding circulation market value of Shanghai Stock Exchange will be RMB10,367.1 billion; the total amount of capital needed by both stock exchanges will be RMB15,613.1 billion and the net assets inflow needed will be RMB7,679.5 billion. With the reduction of non-tradable shares, IPO and the return of overseas quality stocks taken into consideration, the amount of net assets needed will greatly increase. Once the inflow of net capital is less than needed, stock indexes would fall; when investors sell off out of panic, the inflow of net capital into the stock market would reduce, even become negative, causing a continuous fall, even a slump of stock indexes. Past experience has proven that slump always comes after a violent rise. For example, from October 19, 1999 to March 10, 2000, the NASDAQ composite index was in the rising period, with an average daily increase rate of 0.64% in nearly five months; shortly after it reached the historic high 5,048.62 points on March 10, 2000, it began to drop violently, a period which lasted from March 10, 2000 to May 23, 2000, with an average daily drop range of 0.91%. Two and a half years later, NASDAQ composite index fell to 1,114.1 points, being almost the level in 1996. Another example, before reaching the historical high on February 10, 1990, the

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Taiwan Stock Exchange Capitalization (TSEC) Weighted Stock Index had experienced several phased peaks each being followed by a significant drop. During December 7, 1989 to February 10, 1990, the TSEC Weighted Index rose with the average daily growth rate reaching 1%. After soaring to the highest point, it began to slump. Within eight months, it had dropped from 12,495.34 points to 2,560.47 points at an average daily plunge rate of 0.85%. China’s stock market once went through such a process, too. Starting from December 27, 1999, Shanghai Stock Exchange composite index began to rise, reaching the historic high of 2,242.42 points on June 13, 2001 before dropping to 1,520.67 points on October 22, 2001, a level very close to that prior to the violent rise. Within four months, the increase in the previously one and a half year was almost wiped out. So it is safe to say that during June 13 to October 22, 2001, Shanghai Stock Exchange composite index experienced a slump, making the average daily plunge rate 0.44%. It can be seen that violent surges of the stock market should be avoided so as to prevent market slumps, which mainly needs to relieve the blind optimism among investors and prevent excessive speculations. We should never wait until the bubbles burst by themselves and cause great losses to investors.

Listed Companies Are the Cornerstone Stock trading on the stock market (commonly known as stock speculation) is a fictitious economic activity, which cannot create social wealth in and of itself, but simply result in the redistribution of the wealth on the stock market among investors (after deducting the brokerage fees collected by securities dealers and the stamp duties collected by the government). However, the stock market could play its role in optimizing resource allocation, supporting the superior, eliminating the inferior, and promoting listed companies to improve their performance to create more social wealth. That is why we call listed companies the cornerstone and source of wealth of the stock market. Although the values of listed companies are usually underestimated in a bear market, they are usually overestimated in a bull market. People harboring blind optimism often forget a basic truth: For any listed company, the rise of its stock price cannot always be higher than that of its value. When the stock market rises violently, the rise of most listed companies’ stock prices will be far greater than that of their values, since it is impossible for a listed company to experience a boomlike performance. I have proposed making great efforts to improve the overall quality of listed companies many times in recent years, since it determines the health and development of the stock market to a great extent. The overall quality of listed

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companies is not only dependent on the quality of individual listed companies, but also the overall structure of all listed companies’. In particular, when it is a bull market, optimism would gloss over the problems of some listed companies. There are even listed companies who fake their performances with all means possible for private gains. Investors should calm down and analyze the quality problem of listed companies instead of being dazzled by their “superb” performance growth. Moreover, such “superb” performance growth is sure to end soon. I once mentioned that about 70% of the listed companies in China had yet to meet international standards. Great efforts have to be made effectively to improve their quality and lay a solid foundation for the healthy development of China’s stock market. In most cases, the quality of an individual listed company can be measured by its financial indicators. The several major financial indicators for measuring listed companies’ quality mentioned are as follows: (1) Rate of main business income (Mark 1); (2) Rate of income of adjusted main business (Mark 2); (3) Net profit rate (Mark 3); and (4) Net profit rate after the deduction of current profits and losses (Mark 4). In terms of financial indicators, the minimum criterion for measuring listed companies’ performances is the deposit rate. According to listed companies’ annual financial reports in recent years, most listed companies in China have failed to meet the criterion (See Table 7.4). Table 7.4.

Financial indicators of China’s listed companies below the ratio of deposit rates Mark 1

Mark 2

Mark 3

Mark 4

End of 2004

51.9% (1,294)

69.4% (1,118)

45.7% (1,347)

63.4% (1,351)

End of 2005

50.1% (1,351)

62.3% (1,293)

45.2% (1,348)

70.4% (1,350)

End of 2006

69.1% (1,410)

69.1% (1,339)

46.2% (1,408)

64.7% (1,410)

Note:

Figures in the brackets are the total numbers of listed companies in the sample.

As we can see in Table 7.4, the adjusted rate of main business income (Mark 2) and the rate of net profits after the deduction of non-recurring gains and losses (Mark 4) of most listed companies on the Chinese market are lower than

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the deposit rate. The total number of component shares selected by most funds in China is about 400, accounting for about 30% of the total number of listed companies in China. More and more attention has been given to the corporate governance of listed companies in recent years. Many researchers view corporate governance as an important evaluation criterion for measuring the overall quality of listed companies and have put forward some evaluation index systems. Nankai University’s China Research Center of Corporate Governance has released China Corporate Governance Index (CCGI NK ) based on evaluation index systems and criteria. According to the data released by the Center on April 28, 2007, the mean of the governance index of 1,249 valid sample listed companies’ in 2006 was 56.1. See Table 7.5 for the grade distribution. Table 7.5.

CCGINK grade distribution Distribution

Levels of CCGI

NK

CCGINK I CCGI

NK

CCGI

NK

CCGI

NK

CCGI

NK

CCGI

NK

Total

Number of companies

Proportion (%)

90–100

—

—

II

80–90

—

—

III

70–80

10

0.80

IV

60–70

251

20.10

V

50–60

832

66.61

VI

Below 50

156

12.49

1,249

100

It can be seen that most (79%) listed companies in China were low in corporate governance (with marks below 60). Without effective improvements, it is hard for them to achieve sustained development. Of course, for a few high-growth companies (mainly innovation-oriented companies), the leap of their value in the future is what concerns the vast investors. Additional evaluation criteria are needed. However, this kind of highgrowth companies is mainly in the second board market instead of the main board market.

The Stock Market Structure Has to Be Improved As for the structure of the Chinese stock market, there are three hidden worries concerning its structure that need to be solved.

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First, of the structure of listed companies, the proportion of big and monopolistic state-owned enterprises is too big. Such companies are concentrated mainly in finance, petro-chemistry, power, telecommunication, metallurgical and other industries and weigh much in such indicators as the stock index, total profits of listed companies, etc. As seen from the contribution of listed companies in China to the stock market profit, the net profit of the top 50 most profitable listed companies account for 73.5% of the total amount of net profits; those of the top 300 most profitable listed companies account for 98.7% of all in 2006; According to the bulletin of listed companies for the first half of 2007, though the growth rate of the total net profit was as high as about 70%, the net profit of the top 100 most profitable listed companies and the top 300 most profitable listed companies account for 70.9% and 92.6%, respectively, of the total net profits of the stock market. All these listed companies have played a significant role in driving the boom of the stock market and supporting the stock indexes during stock market plunge. Though they make efforts to better their performance, the extraordinary performance growth of these listed companies are generated mainly by the national supports provided in fiscal, taxation, resources and price policies. Should any problem appear, the government would tolerate and protect them to some extent, making them somewhat different from the overseas blue chips. In the future, with the deepening of the opening up in China, these listed companies will face fierce competition; and on the other hand, with the implementation of the anti-monopoly law in China, they will be forbidden to harm consumers’ interests with their status as controllers or monopolies. Both factors will limit the performance growth of these listed companies. Moreover, extraordinary performance growth (annual growth rate being above 50%) is hard to sustain. Second, too few of the stock investors are engaged in long-term investments. In a healthy stock market, a balance should be maintained between investors engaging in long-term investments (holding shares for more than half a year) and those engaging in short-term investments. The fact in China is that private investors are numerous on the stock market. What is more, most private investors and institutional investors of various funds are engaged in short-term investments. As I pointed out in 2003, due to their large scale, sufficient capital and professionalism, funds are naturally impulsive to manipulate the market. Driven by colossal profits, they tend to engage in short-term investments. The major indicator used to measure the degree of short-term investments is the turnover rate. The turnover rate on China’s stock market during January to August this year is shown in Table 7.6.

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Table 7.6.

China’s stock market turnover rates in 2007 Shanghai Stock Exchange Current-month turnover rate of tradable shares(%)

Average daily turnover rate of tradable shares(%)

Shenzhen Stock Exchange Current-month turnover rate of tradable shares(%)

Average daily turnover rate of tradable shares(%)

A-share B-share A-share B-share A-share B-share A-share B-share January 2007

102.93

37.08

5.15

1.85

101.92

30.97

5.10

1.55

February 2007

64.55

19.26

4.30

1.28

65.60

17.75

4.37

1.18

March 2007

105.07

18.98

4.78

0.86

109.89

18.00

5.00

0.82

April 2007

119.74

26.40

5.70

1.26

127.20

28.06

6.06

1.34

May 2007

112.23

89.10

6.23

4.95

113.60

45.76

6.31

2.54

June 2007

100.54

46.13

4.79

2.20

109.25

31.62

5.20

1.51

July 2007

62.82

30.02

2.86

1.36

67.08

20.87

3.05

0.95

August 2007

88.10

26.84

3.83

1.17

91.73

18.23

3.99

0.79

In Table 7.6, we can see that the monthly turnover rate of A-shares on the Chinese stock market exceeded 100% in most cases (equivalent to changing hands of all tradable shares within one month), being higher than not only that of B-shares, but also the turnover rate of major foreign stock markets. Securities investment funds have been developing fast in China since this year. Such funds should fall into the category of institutional investors managed by financial experts, the investment rationality of which should be higher than that of private investors. Such funds should be the main force to maintain a rational balance between long and medium–term and short-term investments. However, in an atmosphere of excessive speculations during stock market booms, fund managers are faced with frequent stock redemptions and under the pressure of pursuing performance, which motivate most of them to engage in short-term speculations and help expand stock market bubbles and increase risks for private investors. Third, the mode of relying mainly on the professional supervision of China Securities Regulatory Commission is not forceful enough. Forceful supervision is an important condition for maintaining the health of the stock market. Stock market supervision in China now is mainly carried out by China Securities Regulatory Commission. Although the revised Securities Law has endowed

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China Securities Regulatory Commission with more regulatory powers and means, it is still hard to analyze the information disclosed by over 1,000 listed companies, carry out follow-up investigations, and handle the problems discovered in terms of the member composition and quality of China Securities Regulatory Commission, let alone the disturbances and obstacles coming from all aspects. Generally speaking, when it is a bull market, cases on illegal behaviors will increase. To intensify market supervision, it needs not only the cooperation and supports of people’s courts, procuratorates, State-owned Assets Supervision and Administration Commission of the State Council, State Administration for Industry and Commerce, China Banking Regulatory Commission, China Insurance Regulatory Commission and other authorities, but also the participation of social forces. For example, the Enron case in the U.S. and Lantian Share in China were first disclosed by non-government figures.

System Management Needs to Be Improved How to treat China’s stock market under the market economic system is a problem that calls for the Chinese government to make profound studies and accumulate practical experience. Personally, I think that, on the one hand, means of the social market economy should be adopted to give play to the role of the stock market in promoting economic development, supporting the superior, eliminating the inferior, and optimizing resource allocation. Related government departments should not interfere with the stock market or the normal rises and falls of individual stocks. On the other hand, socialism principles should be abided by to protect the lawful rights and interests of the general investors, prevent the stock market from becoming a venue for a few people to profiteer from violent market rises and plunges. To manage the stock market in a systematic way, efforts should be made in the following several aspects: Guidance of public opinions Although an investor makes decisions on buying and selling stocks at his own discretion, he will be affected by public opinions to a large extent. Investors on the stock market will form a strong force at the macro-level and within a relatively long period through the effect of self-organization, then drive the stock market to go up or drop and form a bull market or a bear market. In a bear market, public opinions should focus on boosting investors’ confidence; while in a bull market, they should focus on preventing the growth of blind optimism among investors, warn investors of the risks on the stock market and their own risk tolerance. It is suggested that mainstream media publicize less the unlikely events, such as “million points

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can be expected” or “the biggest bull market in the past decade,” or examples of quick fortunes of a tiny number of “super shareholders.” Adjustment of supply and demand. The rises and falls of the stock market are greatly influenced by the supply-demand relationship, and when a great deal of capital enters the market to chase after a small amount of stocks, it easily leads to violent rises on the stock market. Therefore, the listing of quality enterprises in mainland China should be accelerated; and quality enterprises going public overseas should be encouraged to return to China’s stock market so as to increase the supply of stocks and improve the overall quality of the listed companies in China. On the other hand, illegal capital inflow into the stock market should be limited; state-owned and state-holding enterprises must be forbidden to speculate in stocks; legal provisions on the proportions of investments by social security funds and other institutional investors involving public interests should be made; banks should prohibit individuals from mortgaging their residential housing for loans to speculate in stocks. Also, lowincome families and students enjoying various grants and financial aids should not be allowed to open accounts and speculate in stocks. The rule of the stock market by law. China Securities Regulatory Commission, the Supreme People’s Procuratorate and the Supreme People’s Court have to strengthen market supervision based on related laws. It is suggested that China Securities Regulatory Commission start by intensifying market supervision with information disclosure, establish incentive funds, and encourage investors and related personnel to analyze and report the illegal behaviors of listed companies before announcing and dealing with such behaviors upon verification. Securities companies and related intermediary agencies having irregularities must be severely punished. Efforts should be made to cultivate a group of prosecutors and judges familiar with securities operations in the Supreme People’s Procuratorate and the Supreme People’s Court. China should encourage the legal circles to provide legal aids to general investors and improve the securities cases common litigation system. Besides, a strict delisting system should be established to force some unqualified listed companies to withdraw from the market. Policy regulation. Policies are the external cause which can function only through the internal cause. Changes in the policy environment should be able to influence people’s behaviors, change their decision-making criteria and even the direction of the self-function effect on the stock market. The monetary policy (raising the interest rate and the bank reserve ratio) and fiscal policy (raising the rate on the stamp duty) adopted by China in the previous several months have played a certain role in curbing violent rises in the stock market. However,

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other supporting measures to reduce excessive liquidity and the guidance of public opinions are needed. Some countries prohibit profiteering in the stock market by levying capital gains tax. China should carefully study the pros and cons of the above approach, pay attention to protecting small and medium– sized investors (e.g. implementing higher threshold and a progressive tax rate), and encourage long-term shareholding (e.g. exempting taxes from shareholders who sell the shares after holding them for more than one year). The system of fictitious economy is generated by and attached to the system of real economy. Therefore, when developing the real economy, we should give play to the role of fictitious economy in promoting the real economy while pay special attention to safeguarding against its internal risks. I firmly believe that as long as we work hard following the instructions of the 17th NPC, we will sure be able to promote the steady and healthy development of China’s stock market, and enable it to become more and more mature and play its role in thoroughly implementing the scientific thought of development, building a harmonious socialist society, and constructing a well-off society in an all-round manner. Completed in September 2007

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Chapter

Reform of the RMB Exchange Rate Regime

ECONOMIC REFORMS AND DEVELOPMENT IN CHINA VOL. 3

In recent years, with the rapid economic development and the increasingly improved international status of China, RMB exchange rate has become an issue that attracts close attention both at home and abroad. Since the reform and opening up, the export-oriented economy in China has been developing fast and China’s dependence on foreign trade (the ratio of import and export volume against GDP) has been increasing from 9.7% in 1978 to 58.2% in 2008. Changes in the exchange rate will significantly influence the prices of the imported and exported goods in China, affecting the performance and structure of the foreign trade, even the economic growth in China. Besides, because of its abundant human resources, low commodity prices and other comparative advantages, China has seen a growing foreign trade surplus, increasing from USD1.14 billion in 1978 to USD295.5 billion in 2008. Such an import and export unbalance will lead to the increase of trade frictions and pressuring on the RMB appreciation in a prolonged period. Moreover, the rapid economic growth, enormous market potential, quality and cheap human resources, good infrastructures and the increasingly improved investment environment have all made China increasingly attractive to foreign capital. The annual amount of foreign investment introduced has increased from USD1.96 billion in 1985 to USD92.4 billion in 2008. A host of world-renowned multinational companies have entered China. It is obvious that RMB exchange rate will influence their investment decision-making. Still, foreign trade surplus coupled with the net inflow of foreign capital have led to the ongoing capital and current accounts surplus and the rapid increase of foreign exchange reserves, which has increased from USD167 million at the close of 1978 to USD194.6 million as of the end of 2008. Though the considerable foreign exchange reserves are capable of strengthening China’s economic power, they will bring risks to China due to changes in the exchange rate. Finally, as the income of urban and rural residents continues to grow and China’s residents are buying more imported commodities or increasingly traveling abroad, changes in the exchange rate will influence the international purchasing power of the RMB and consequently influencing the domestic consumption behaviors and structure. Attention should also be given to the influence of RMB exchange rate on China’s fictitious economy, including cross-border short-term capital flows, price variations of financial assets, inflation or deflation and other factors that may influence China’s economic stability and security. It can be seen that the RMB exchange rate is an important issue that involves the national economy and people’s livelihood and deserves deliberate and prudent study. Since 2003, China has been pressured by the U.S., Japan and other Western countries on RMB appreciation. At the G7 Economic Summit held in the spring

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of 2003, the Japanese government accused China of seriously undervaluing the RMB, dumping cheap products on the international market which led to a global deflation. U.S. senators blamed China for exporting a great amount of cheap goods, which not only worsened its employment, but also resulted in huge trade deficits and economic depression. Some U.S. Congress members even threatened that if China did not appreciate RMB by 30%–40%, the U.S. would pass legislation to collect a 27.5% tariff over the Chinese imports. Coupled with the reports and coverage of overseas media, RMB exchange rate expectations were greatly influenced, generating certain pressures over the RMB exchange rate and international balance of payments. On July 21, 2005, China launched the exchange rate regime reform, aiming at strengthening the RMB exchange rate flexibility and giving greater play to the role of the market mechanism in regulating foreign exchange supply and demand. Since then, the exchange rate of RMB against the dollar has been appreciating all the way. As of July 20, 2008, the cumulative appreciation of the exchange rate of RMB against the dollar has reached 20%. Though a slight depreciation of the exchange rate of RMB against the dollar was later seen, the expectation of RMB appreciation remained strong. Moreover, since the second quarter of 2008, the exchange rate of RMB against euro and the yen has appreciated (the exchange rate of RMB against euro appreciated to RMB10 for less than 1 euro as of September 2, 2008). It is expected that Europe and Japan will also exert pressure on RMB appreciation. Due to the rapid economic development and the long standing surplus of the international current and capital accounts in China, the development of the highly-dependent foreign trade and the export-oriented economic structure set up due to large-scale foreign direct investments in China will not change very soon. The RMB exchange rate will also have to bear pressure from some other countries. Though the issue of exchange rate involves a nation’s monetary sovereignty and the international community does not have the right to require China to change its exchange rate, exchange rate regime and related policies, the externalities of exchange rate will become what Western countries are most concerned about. Judging from the development trend, the pressure on RMB exchange rate will be prolonged, thus requiring China to study the issue carefully and push forward its reform of the RMB exchange rate regime in an active and prudent manner. The author once used complexity science to analyze the regime issue, believing that a regime should include two aspects: system and mechanism. System refers to the state and structure of the regime at a specific time, while mechanism refers to the process of and driving force for the evolution of the regime. System and mechanism are mutually dependent. System is the starting

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point and result, while mechanism is the evolutionary path. And the RMB exchange rate regime should also involve these two aspects. China should study not only the selection of the RMB exchange rate regime, the determination of the exchange rate level at the present stage and the history and causes of the evolution of the RMB exchange rate regime, but also the ways of guiding and strengthening the administration of RMB exchange rate regime with proper policies. The author has been studying the issue of RMB exchange rate since 1997 and has expressed personal opinions concerning RMB exchange rate both at home and abroad many times. When serving as the director of the Department of Management Sciences, National Natural Science Foundation of China during 1996–2004, the author organized related studies on RMB exchange rate. In this paper, the author studies the RMB exchange rate regime, including its arrangement, level, related policies and management, and points out the direction of further studies using theories of fictitious economy, complexity science and international finance.

ANALYSING THE EXCHANGE RATE FROM THE PERSPECTIVE OF FICTITIOUS ECONOMY Compared with the real economy, the fictitious economy is another economic pattern in the economic system. It refers to all activities of fictitious capital mainly based on the financial platform and all relationships thus generated. As a special commodity of a universal equivalent, currency serves as the measure of value, means of circulation, means of payment, means of storage and world currency in the commodity economy, playing an important role in both the real economy and the fictitious economy. Regarding the theories of fictitious economy, the RMB exchange rate issue may be observed from the following perspectives.

The Currency Virtualization Tracing back to 1821, when Britain took the initiative in forging the gold standard, gold had been guarding the widely-issued paper currency, and the gold standard system began to won its popularity in Europe and the U.S. before finally becoming the foundation of the world currency in 1870. After WWI ended, the gold standard gradually degraded into gold exchange standard system. After WWII, as the U.S. set the minimum price for foreign central banks to purchase or sell gold, major European countries provided, in 1958, that their

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currencies may be freely converted into gold or the dollar in international payments. However, in 1971, the U. S. stopped the free convertibility from the dollar to gold at the fixed price (USD35 an ounce), since when the foundation of the international currency system became the dollar and other paper currencies, and the official role of gold in international currency exchange was thus ended. The “decoupling” with gold also terminated the free convertibility of gold at the fixed price. From then on, the currency should issue in line with the total credit of a country, thus make that currency become an irredeemable paper money (fiat money, aka the legal tender). As a universal equivalent, currency in and of itself is a special commodity that may function as a measure of value. It can be compared with another commodity in terms of quantity and convert the value of commodity into a price expressed in the monetary form before enabling the commodity to exchange with other commodities. It makes direct barter between commodities the exchange with currency as the media, endowing the currency with the function as a means of circulation (currency in circulation). Once “decoupled” from gold, a currency directly manifested the social labor embodied in gold. As soon as a currency “decoupled” from gold, it was virtualized to a certain extent. That is to say, currency in itself was merely a piece of paper which could have a value only with the credit support of the government that issued it. At this moment, it became impossible for people to determine the value of the currency with a fixed-value “reference,” but measuring the value of the currency indirectly through its purchasing power. Since the mechanism that currency would exit automatically from the entire economic system due to the limitations of the gold standard, the purchasing power of the currency was then determined by the quantity of money and the volume of real economic output (mainly commodities and services). The purchasing power of a currency then might be conceptualized and expressed as follows: Pi = (Ci + Si) / Mi Where i is country i; Pi is the currency purchasing power; Ci is the total volume of its commodities; S i is the total volume of its services; and M i is the total amount of its currency. The reciprocal of Pi would be its overall price level. After currency decoupled from gold, the issuance volume of currency was no longer restrained by its gold reserves or gold-equivalent currency reserves, but relied on government decisions. Besides, the common measure for valuing each currency was abandoned, resulting in uncertainties of the exchange rate. It was also a manifestation of currency virtualization.

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Distinguishing between the Domestic and International Currency Purchasing Power Since currencies were virtualized and no longer had any fixed value, the value used to measure their purchasing power would vary with time and place. In recent years, many foreign scholars have been using the PPP theory to push for RMB appreciation. When discussing with Fred Bergsten and other scholars from the Institute for International Economics on the issue of RMB exchange rate on June 15, 2004 in Washington, the author proposed that the two types of purchasing powers—international purchasing power and domestic purchasing power—should be differentiated and that the PPP should not be simply taken as the basis of determining the RMB exchange rate. The PPP theory originated in the mid-16th century’s Spain. The term PPP was summarized and proposed in 1916 by Swedish economist Gustav Cassel. Briefly, the theory may be expressed as follows: The exchange rate of two currencies mainly depends on their relative purchasing powers. That is to say, people’s demand for the local currency and foreign currencies is mainly generated by their needs to buy local and foreign commodities and services. So the swap of the local currency and foreign currencies is actually an exchange between local purchasing power and foreign purchasing power. Since the exchange rate is the price of the foreign currency expressed in local currency, it depends on the ratio of their respective purchasing powers, or that of the price levels between the two countries, which is the concept of absolute purchasing power parity (Absolute PPP). Considering the difficulty to obtain data on the commodity price levels, people introduced the concept of relative purchasing power parity (Relative PPP), i.e. the inflation rate of the ratio between the inflation rates of the two countries multiplied by the base period. Later, researchers further relaxed related conditions, no longer requiring proportionate domestic and foreign relative prices and changes in the exchange rate, nor requiring symmetric domestic and foreign price indexes. Since the invention of the PPP theory, it has been regarded as a good way to predict the long-term exchange rate behaviors. However, empirical research conducted after the decoupling from gold demonstrated that the PPP did not apply to most currencies. Therefore, Western economists constantly studied and improved on the theory, trying to make it applicable to new situations. Unit root test, co-integration techniques (including Engle Granger ’s two-step method, Johansen’s maximum likelihood estimation, etc.), variance ratio test, fractional co-integration and other relatively advanced tools for statistical analyses have been widely applied to test the PPP theory. Meanwhile, more and

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more economists have begun to notice the application of PPP in developing countries. Some economists pointed out that it was necessary to find a mediumand long-term equilibrium exchange rate theory from among the Fundamental Equilibrium Exchange Rates (FEER) theory, the Behavioral Equilibrium Exchange Rates (BEER) theory and the Equilibrium Real Exchange Rates (ERER) theory gradually were developed and established since the 1980s, capable of effectively explaining the RMB exchange rate fluctuations, guiding policies on exchange rate adjustments, and reducing the economic costs of related policies. The author believes that the PPP theory does not apply to the RMB exchange rate mainly due to the difference between the international purchasing power and the domestic purchasing power of RMB under the current circumstances that RMB is yet to be freely convertible. Determined by the government, the exchange rate, though having referred to the supply-demand relationship to some extent, simply represents the international purchasing power of the RMB, mainly the value of RMB when used to purchase foreign products and services. PPP is based on the domestic purchasing power of the currency. However, due to the differences between China and Western countries in such areas as the degree of marketization, price index composition, structure of foreign trade and labor productivity, coupled with the influence of some non-economic factors, even the exchange rate calculated at PPP cannot fully represent the value of currencies of Western countries in purchasing Chinese commodities and services after being converted into RMB. Besides, the relationship between the exchange rate and the domestic purchasing power of a currency is related to the degree of the country’s dependence on foreign trade and its foreign trade structure. Generally speaking, they are positively correlated with the degree of dependence on foreign trade. If a country’s dependence on foreign trade is zero, its exchange rate has nothing to do with the purchasing power of its currency. It may also be inferred that such relevance is positively correlated with the proportion of the country’s consumer goods in its foreign trade structure. Though China is a trading power, its consumer goods account for a small proportion in its foreign trade structure and the correlation between its exchange rate and domestic purchasing power is small. It is also one of the reasons that PPP theory does not apply to the RMB exchange rate. In addition, changes in the exchange rate also depend on the mutual influence between people, the influence of the environment over people’s behaviors and people’s confidence in the local currency. For example, the expectations about RMB appreciating will literally push up the RMB, after which a positive feedback will further consolidate people’s expectations about RMB appreciation.

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It should also be aware that purchasing power falls into the category of commodity exchange in the real economy. To calculate the exchange rate with the PPP theory is actually the static and balanced factor analysis that takes into account such factors as the national incomes, price levels, and interest rates of both countries. Even taking into consideration people’s behaviors (mainly of the expectation of the exchange rate), the method is still applicable for predicting the trend of the exchange rate in the long run. In addition, it fails to take into full consideration of the influence of transnational flows of real and fictitious capital on the exchange rate. All in all, the author does not mean to completely negate the role of the PPP theory in predicting the long-term trend of RMB exchange rate, but simply holds that the PPP theory should be corrected based on various political and economic factors so as to determine the reasonable level of RMB exchange rate.

Augmented Scale and Accelerated Speed of Transnational Capital Flows According to the definition made by the International Monetary Fund (IMF), international capital flows may be divided into three types: foreign direct investment (FDI, including equity capital, reinvested earnings, other capital, etc.), foreign portfolio investment (FPI, including stocks, securities and financial derivative products) and foreign other investment (FOI, including long-term and short-term trade credits, loans, currency, deposits, equity and bonds that are not traded, insurance and pension reserves). Besides, international capital flows can also be divided into foreign long-term investment (with terms longer than one year) and foreign short-term investment (with terms of one year or shorter). With the development of the world’s financial markets, the deregulation of capital flows and the advances of the information technology sector, financial transactions can be carried out 24 hours a day and large amounts of capital can be sent thousands of kms away within seconds. All these factors have contributed to the constant expansion of the scale of transnational capital flows and consolidated the tendency of short-term capital flows. During 1986–2003, the average annual growth rate of world economy (real GDP) was about 3.5%; and that of international trade (including the trade in commodities and services) was about 6.1%; international capital flows were growing more rapidly. The growth of global capital flows (net input of global capital) was slow in the early 1990s, but accelerated during 1998–2000 to an annual rate of 20% before falling suddenly in 2001 due to the synchronized global economic downturn, then rode on the growth momentum in 2002, and showed a rapid

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growth in 2003 and 2004. In 2004, the volume of global capital flows reached USD960 billion, up 29.4% year-on-year. The number continued to soar to USD1,356.2 billion in 2006. According to the IMF’s estimate in 2007, the size of global capital flows may reach USD1,448 billion. Since the 1990s, the FDI has been growing rapidly, of which the proportion of cross-border M&A became increasingly greater. The global amount of FDI flow reached USD1.83 trillion in 2007, of which the total amount of M&A was as high as USD1.64 trillion, accounting for 89.6% of all. Cross-border M&A involves cross-border mergers and cross-border acquisitions. It refers to the behavior of an enterprise or investment fund (in a country) to purchase all of the assets or part of the shares of another enterprise (in a foreign country) through certain means including paying in cash, exchanging listings or swapping assets with stocks, etc. Through mergers and acquisitions, an enterprise aims at either dominating the market or expanding businesses; whereas an investment fund, by merging and acquiring another enterprise, aims at raising its value and selling it for a profit. Cross-border M&A has a very complicated influence on the exchange rate. Theoretically, the inflow of a great deal of foreign capital into the home country (host country) of the enterprise to be merged or acquired will promote local currency appreciation, which will further increase the M&A cost and reduce the inflow of foreign capital. Actually, if the increase in the M&A cost triggered by local currency appreciation does not weaken the host country’s advantage in attracting foreign capital, the inflow of foreign capital will not drop. Greenfield investment falls into the category of the real economy. In M&As, if capital is invested and used in scale expansion, such activities also belong to the real economy, but listings exchange or stock-for-assets are fictitious economic activities. The M&A activities launched by investment funds are, in most cases, fictitious economic activities. One party of the investment funds would appreciate its fictitious capital using its management and financial expertise. Judging from the term structure of global capital flows, the proportion of short-term capital has been ever increasing, of which foreign securities investment and other foreign investment can be regarded as fictitious economic activities, accounting for the highest portion.

The Ever-swelling Fictitious Economy With the continuous growth of the world economy and the rapid advance of the information technology industry, the world’s financial markets, especially in developed countries, have been expanding sharply. Driven in particular by the

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swelling of the network economic bubble in the U.S. during 1997–2000, the scale of fictitious economy—relying mainly on the trading of such fictitious capital as stocks, securities and financial derivatives products—expanded rapidly, too. The global market value of stocks, the balance of bonds and the balance of global over-the-counter (OTC) trading have collectively reached about USD50 billion, approximately 10-fold greater than the world’s total GDP. The nominal average daily trading volume in the global foreign exchange markets has exceeded USD2 trillion, about 50-fold greater than the world’s real average daily trading volume. In other words, of the world’s total daily floating capital, only 2% is literally used in international trading. Current transnational financial activities are the process of selecting investors and financiers around the world following the same “game rules” and using the same financial tools. Financial markets of all types in all regions have been mutually connected, enabling capital to not only achieve transnational flow in a certain kind of markets, but also transfer among different types of markets, greatly obscuring the boundaries between long-term capital and shortterm capital and that between international finance and domestic finance. Since the connections between all financial markets become increasingly intimate, the spread of risks thus become faster. One small risk might trigger the world financial market chaos. With the development of financial innovations, financial derivatives market emerged in the U.S., UK and other countries after the 1970s. This kind of markets may go into two categories. First, the market composed of financial products issued by banks, called OTC trading. However, market transactions are mostly completed through the telephone network. With the launch of a great number of financial derivative products, the operational pattern of the entire banking industry has been changed, enabling transnational banks to develop into “all-round” banks and their off-balance sheet activities to grow rapidly. Second, the tangible market composed of financial futures exchange. Currency derivatives on the derivatives market include forward contracts, currency and interest rate swaps, perpetual interest rate agreements, financial futures and options, etc. Financial derivative products related to the exchange rate also develop fast. According to statistics released by the Bank for International Settlements (BIS), the total value of open contracts on exchange rate derivatives by the end of 2007 was USD29.1 billion, of which swaps and options accounted for half-and-half. All these financial derivatives aim at hedging their funds, but they are also served as the high-risk speculation vehicle. The U.S. subprime crisis–led global financial crisis is mainly caused by the over-expansion of financial derivatives related to residential mortgage loans.

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Exchange Rates among Various Currencies Have Become Tools for Policy Gaming Since the exchange rate can only reflect the international purchase power of a currency, the rise and fall of national economic power will trigger exchange rate fluctuations of a variety of currencies. Meanwhile, governments of different countries may also use exchange rates for their own policy purposes to reap greater benefits in current accounts or capital accounts based on their national interests, thereby turning exchange rate adjustments into inter-governmental gaming. To put it in the theoretical perspective, if the governments concerned can adjust and coordinate on the international exchange rate in line with the overall interests, it may generate the Pareto effect to satisfy all parties involved. Unfortunately, those countries often begin with their respective national benefits, thus making it hard to get the expected coordination, which could be clearly seen in the process of coordinating the international exchange rates by and among developed countries during the 1980s. During 1981–1985, driven by the decline of the yen’s exchange rate and the ascent of the dollar ’s exchange rate, there was a rapid increase in Japanese exports, of which those to the U.S. increased by 74%. Japan’s trade surplus against the U.S. grew tremendously. In this context, initiated by the U.S., a conference was held at the Plaza Hotel, New York, on September 22, 1985 and attended by the finance ministers and central bank governors of the U.S., Japan, Germany, France and UK (G5), aiming at coordinating the exchange rates of the participating countries so as to truly reflect economic development, and balancing the book under the current account. Through consultation, the five parties reached the Plaza Accord , deciding to take joint actions to reduce the exchange rate of the dollar against major currencies in an orderly manner. The Plaza Accord , the world’s first large-scale exchange-rate coordination, achieved the desired results in a short term. Since the central banks of all countries began to sell the dollar and buy the yen and the mark, the exchange rate of the dollar fell 8% against the yen and 6% against the mark within only a week after the Plaza Hotel Conference. By the end of February 1986, the dollar had depreciated about 20% against both the yen and the mark. Then all countries concerned believed that if let the dollar continue to depreciate, it would produce adverse effects on their respective economic development. To this end, the finance ministers of the U.S., Japan, Germany, France, UK, Canada and Italy (G7) held another conference at Louvre, Paris, during February 21-22, 1987, to forge strategies to maintain a relatively stable international exchange rate. Apart from Italy, which withdrew later, finance ministers of the six

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countries signed the Louvre Accord , agreeing to limit the range of exchange rate fluctuations of each country within a reasonable range. Any exchange fluctuation beyond the reasonable scope would be interfered with by all of the countries through joint actions. However, the U.S. failed to seriously implement its plan on reducing the deficits as promised. In particular, after the U.S. stock market plunged on October 19, 1987, the U.S. government followed closely its domestic economic problems and allow the dollar continue to depreciate, rendering the Louvre Accord useless. The continuous appreciation of the yen became a major factor for the birth of the bubble economy in Japan. Since the economic bubble in Japan burst in 1991, the Japanese economy has been stuck in a long-term recession. Historical experience revealed that the exchange rates must not be merely viewed as an economic or financial issue, but also a political issue. For example, after the East Asia financial crisis broke out in 1997, under the pressure that many Western countries asked China to depreciate the RMB, China asserted its exchange rate sovereignty, resolutely maintained the stability of RMB exchange rate, and helped East Asian countries weather the storm. However, since 2003, China has begun to again face the pressure from Western countries to appreciate the RMB, it has to study and weigh the situation and the pros and cons of adhering to its exchange rates sovereignty before making reasonable decisions. The game of the exchange rates has enabled some insightful people to realize that it is hard to get reasonable coordinative results when participating countries are great in number yet far weaker in economic power than the U.S. Therefore, it is better to coordinate all countries in the same area to form a united front capable of contending with the U.S. while conducive to stabilizing local finances. It was the main motivation force behind the birth of the euro. It is predicted with the development of regional integration, the trend of financial integration among all countries in the same area will continue to be enhanced. The conceptual Asian Currency Unit (ACU) planned to be launched by the Asian Development Bank (ADB) will be a new example.

The Dilemma of Selecting an Exchange Rate Regime Close links exist between the system of the fictitious economy and that of the real economy. The system of fictitious economy is generated by and attached to the system of real economy. Due to such close links, any risk generated by the system of the real economy, such as product overstock, rapid decline in foreign trade, enterprise bankruptcy, etc., will all be transmitted to the system of fictitious economy, upsetting its stability. On the other hand, risks in the system

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of fictitious economy, including a drop in the stock index, the plunge of real estate prices, a sharp increase in bad bank loans and a significant depreciation of the currency, will all severely affect the real economy. Today, when finance has become the core of the economy, the real economy cannot survive without the fictitious economy. Therefore, if the system of real economy is regarded as the hardware of the economic system, then the fictitious economy is the software. As early as during the 1950s when the dollar-dominated gold exchange standard was prevailing, the debate over the selection of the fixed exchange rate or the floating exchange rate started. Scholars represented by Kindleberger strongly praised the fixed exchange rate regime, believing that the floating exchange rate would lead to an unstable exchange rate, while another group of scholars led by Friedman strongly advocated the floating exchange rate regime, claiming that “the floating exchange rate is arguably stable. Even if the exchange rate is unstable, it is mainly because of the economic foundation that guides international trade has proved unstable. Although “fixed” exchange rate is stable literally, it may prolong and strengthen the instability of other economic factors.” The debate touched upon the objective of the exchange rate regime. In an open economy, if the prime objective is to maintain a stable exchange rate, the independence of the monetary policy should be abandoned and the fixed exchange rate adopted; otherwise, if the priority is to cushion the shock brought by the exchange rate adjustment, the floating exchange rate should be the chosen strategy. Some economists tried to find an exchange-rate regime applying to both worlds, yet only proven by Mundell et al to be impracticable. During the 1960s, Mundell and Fleming set forth the Mundell-Fleming model (M-F model). With the adoption of the analysis of short-term demands in an open economy, the model introduced foreign trade, capital flow and other factors to analyze different roles played in the monetary policy and the fiscal policy under the fixed exchange rate regime and the floating exchange rate regime. The hypothetical prerequisites of the model include: 1) completely open finance, namely, completely open current accounts and the capital accounts; 2) free capital flow, namely, substitution of all domestic and foreign currencies and securities assets; 3) demand-oriented output, and the flexible output and supply; 4) a small-scale domestic economy which wields almost no influence on foreign interest rate and the price level; 5) interest rate remains unchanged within the prescribed period; and 6) local currency depreciation, which is capable of improving the balance of current accounts. Under the above prerequisites, selecting the fixed exchange rate regime would make the

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monetary policy useless over economic stability (that is, it does not have any influence on income and employment), whereas selecting the floating exchange rate system would make the fiscal policy useless over economic stability. It can be seen that the M-F model actually has embodied the “trilemma,” namely, only two of the three—the free capital flow (or the opening of the financial market), the fixed exchange rate and the independent monetary policy (or adjusting the supply of currency to enable the interest rate to reach the expected level)—can be changed. The M-F model laid the foundation for the exchange rate determination theory. A great number of related studies since then have focused on loosening or revising the prerequisites of the model, and on extending the model. Krugman and Frankel further formalized the M-F model into the “impossible triangle” model, putting forward the “semi-detached & semistable” combination. Yi Gang and Tang Xian extended the impossible triangle model before setting forth the extended triangle hypothesis and describing the influence of the intermediate regimes. Shen Guobing and Shi Jinchuan introduced the impossible triangle model into the variable of local currency international debt capacities, trying to extend the impossible triangle model into a “tetrahedral hypothesis” and to prove that the former was simply an exception of the latter. Based on that, they believed that selecting the exchange rate regime was a dynamic conversion process and that, according to the multivariate difference and variability in the selection of the exchange rate regimes by different countries, selecting the exchange rate regime would be the co-existence and mutual conversion of multiple exchange rate regimes.

THE RMB EXCHANGE RATE ARRANGEMENT The exchange-rate regime refers to a series of arrangements or provisions on the principles, modes and institutional framework followed and adopted by a country’s monetary authorities in order to regulate and manage its exchange-rate level. To avoid the fuzzy definition and generalization of the word “regime,” the author herein uses the phrase “exchange rate arrangement” and defines it as the relationship between local currency and the foreign currency. It can be seen that the exchange rate arrangement falls into the category of “system” (or structure). It is relatively stable in a short period, but evolving gradually in the long run.

An Overview of the Evolution of the Exchange-Rate Arrangement From 1880 to 1914, most countries around the world adopted the fixed

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exchange-rate regime under the gold exchange standard. The exchange rate between two currencies was determined by the gold parity—the ratio of their monetary units calculated on the basis of their legally fixed gold content. After WWI broke out, the gold exchange standard gradually disintegrated and the exchange rate arrangements of all countries involved fell into chaos. It was not until July 1944 that 45 member states reached the Bretton Woods Agreement and set up the dollar-based gold exchange standard (under which the U.S. pledged that USD35 could be converted into 1 ounce of gold, thus reserving the dollar was equivalent to reserving gold), and began to implement the fixed exchange rate regime under the Bretton Woods System. The exchange rate of all currencies against the dollar can fluctuate within 1% of the dollar parity. In August 1971, the U.S. announced the depreciation of the dollar and ended the conversion from the dollar into gold. Subsequently, the Bretton Woods system began to collapse, triggering a widespread exchange rate arrangement chaos. In January 1976, the IMF member countries reached an agreement in Jamaica, acknowledging the co-existence of the fixed exchange rate and the floating exchange rate and empowering all member countries to select their own portfolios. Since then, all member countries have been making their respective exchange rate arrangement and a uniform arrangement has yet to be established. After more than three decades of evolution, there are mainly 10 exchange rate arrangements in the world today. In a descending order of their flexibility, these exchange rate arrangements are: 1) The floating exchange-rate regime (float), in which the exchange rate is determined by the supply-demand relationship of the market, and the central banks do not interfere with the foreign exchange market nor timely respond to the external and internal shocks on the nominal exchange rates, so large amounts of foreign exchange reserves prove to be unnecessary. However, this lassez-faire approach may allow violent fluctuations of the exchange rates, thus distorting resource allocation and making it difficult to tackle inflation. As a matter of fact, all governments, when formulating and implementing monetary policies, will more or less consider their exchange rate targets. Therefore, it is safe to say that no country in the world would audaciously and completely adopt the floating exchange rate regime. 2) The managed floating exchange-rate regime (managed float), where the central banks interfere with the foreign exchange market based on the exchange rate targets, but do not preset the exchange rate parity. The central banks may actively intervene by employing both hedging and non-hedging approaches, which cause changes to its foreign exchange reserves; or carry out intervene

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indirectly by changing the interest rate and liquidity, or using other financial tools, which will not cause any changes to the foreign exchange reserves. Although helping avoid violent fluctuations of the exchange rate, the managed floating exchange-rate regime will risk black-box operations by the central banks, thus it might bring only a short-term benefit, or even produce adverse effects. 3) Target zone exchange-rate regime (target zone), where the government, after setting the basis of the equilibrium exchange rate of local currency (central parity), allows the free floating of the central parity-centered nominal exchange rate within a certain interval, and where the equilibrium exchange rate could peg to one currency or a basket of currencies. The monetary authorities should limit the fluctuation range of the central parity-centered spot exchange rate within the upper and lower limits of the set target zone. However, practically speaking, the monetary authorities do not have the absolute obligation to make immediate interventions at the moment when the spot exchange rate hits the upper or lower limits of the target zone. For example, the European exchange rate mechanism (ERM), established in 1979, allows the exchange rate fluctuation range of its members to be within ±2.25%. Such a regime is good because disclosing the exchange rate fluctuation range and the central parity helps improve the transparency of the exchange rate and guide the public expectations, and the monetary authorities do not necessarily have to frequently intervene in the foreign exchange markets. 4) Crawling zone exchange-rate regime (crawling zone), where the exchange rate is allowed to fluctuate within a zone, yet the central rate fluctuates with time. The crawling of the central rate may be “retrospective,” i.e. the central rate is adjusted in accordance with the past inflation rate; or “forward-looking,” i.e. the central rate is adjusted in line with the expected or target inflation. Such an exchange-rate regime enables high-inflation countries to adjust their respective central rate according to the inflation situation without adjusting the exchange rate zone. However, retrospective crawling may introduce inflation inertia while forward-looking crawling may lead to overestimating the exchange rates, thus breeding the currency speculations. 5) Basket peg exchange-rate regime (basket peg), where a country’s currency is not pegged to another certain currency, but to its major trading partners’ currency-weighted outcome. Weights of the currencies mainly depend on its foreign trade structure. That is, the weight of a certain currency in the basket is usually the trade volume of the two countries divided by the total volume of foreign trade of local country. However, when the two countries adopt a third currency to settle their accounts, the weighting of the third currency should also

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be increased accordingly. Sometimes, the currency’s structure of external debts and the foreign capital introduced also need to be taken into consideration. 6) Crawling peg exchange-rate regime (crawling peg). Such a regime is applicable for high-inflation countries. Small-scale depreciation of local currency at the pegged exchange rates is allowed based on the country’s inflationary situation so as to maintain the stability of the real exchange rate. Sometimes, the crawling rate is set lower than the expected inflation rate in attempt to slacken the pace of inflation. Under such a regime, without support of the fiscal or income policies, it will be difficult to maintain the stability of the real exchange rate. Adjusting the exchange rate based on the inflation rate will create the inflation inertia, thus weakening the role of the exchange rate as the nominal anchor. 7) Adjustable peg exchange-rate regime (adjustable peg). Even if the monetary authorities promise to adopt a fixed exchange rate, and the nominal exchange rate is fixed over a certain period, the monetary authorities may adjust the exchange rate parity based on the operations of the real economy. Since the collapse of the Bretton Woods System, most developing countries have adopted such a regime, under which there are always sudden announcements of exchange rate adjustments, thus bringing uncertainties to the exchange rate and risking a more aggravating inflation. 8) “Truly fixed” exchange-rate regime (“truly fixed” exchange rate), where a country’s monetary authorities promise to maintain a fixed exchange rate over another currency or a few other currencies. However, since the promise does not have a solid foundation, thus it is rarely kept in face of difficult situations. 9) The currency board regime (currency board). The monetary authorities issue the local currency at a fixed exchange rate based on the foreign exchange reserves of a certain pegged currency, and require the cash portion of the local currency be fully supported by the pegged currency so as to secure the conversion of the two currencies at a fixed exchange rate at any time. The monetary authorities maintain the stability of the exchange rate by buying or selling the local currency in the foreign exchange market. Such a regime is conducive to maintaining the stability of the exchange rate since the market is confident in the monetary authorities’ ability to maintain a fixed exchange rate. However, it is not conducive to the regulating the exchange rate. External shocks can only be cushioned by domestic economic activities and thus the central bank may lose its function as the lender of last resort. 10) Currency union, where more than one sovereign state use the same currency issued by the central bank of a currency union set up by the member states. For example, the European Monetary Union (EMU) issues the euro through

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the European Central Bank and makes it the uniform currency of its member countries. Another method is to use an existing currency, which in most cases is the dollar. For example, Panama and some eastern Caribbean countries adopt the dollar-based monetary system. That is, they use the dollar as the local currency. These countries therefore give up the seigniorage and lose their monetary policy sovereignty. It is arguably an extreme form of the fixed exchange rate regime. In recent years, with the expansion of the economic globalization and international capital flows, as well as the enhanced integration of the international financial market, the exchange rate has begun to play an increasingly significant role in the national economy. The national financial systems of Mexico, Thailand, Indonesia, Korea, Russia, Brazil, Turkey and Argentina, countries that used to swing between the fixed exchange-rate arrangement and the floating one (or, intermediate exchange rate regime), were stricken to different degrees, thus forcing them to adopt either the floating exchange-rate regime or the fixed one. For this reason, Obstfeld and Rogoff claimed that all intermediate exchange-rate arrangements between the floating exchange rates and the monetary union were flawed. Summers also held that with free capital flow, those countries adopting the intermediate exchange rate arrangement would face a gradually dwindling number of choices, making it hard for them to maintain their exchange rate stability. However, Frankel believed that most countries currently adopt the intermediate exchange rate arrangement in which local governments intervene, more or less, in the foreign-exchange market. Wolf divided exchange rate arrangements into six classes, and studied the frequency of conversion of different exchange rate arrangements and the duration of each class during 1975–1999, only to find that the traditional single currency peg was exited 147 times, yet was entered into only 39 times. While other classes of exchange rate arrangements were exited more frequently than they were entered into. The strict peg exchange rate arrangement was entered into 30 times without any withdrawal. The duration of the strict-peg exchange regime was the longest, 14.9 years on the average; the average duration of single currency peg and currency basket peg regimes was somewhere between 9.5 and 9.9 years; while the duration of floating exchange rate regime was relatively shorter, somewhere between 4.5 and 6.2 years, indicating that the exchange rate arrangements in any country will not always persist, but should be adjusted in line with the changes of domestic and foreign conditions.

Evolution of China’s Exchange Rate Arrangement After the modern China was founded, it adopted the RMB (its legal tender)

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floating exchange rate regime following the principle of “promoting exports, guaranteeing imports, accumulating sources of foreign exchange, and encouraging overseas remittances.” However, since most countries around the world adopted the fixed exchange rate regime under the Bretton Woods System and the world exchange rate maintained relatively stable, the RMB exchange rate was also stable. In reality, what China adopted was the informal fixed exchange rate regime coupled with the dollar. In view of its losses of export proceeds due to the depreciation of the pound in 1967, China began to use the RMB for valuation and settlement in the spring of 1968. With the collapse of the Bretton Woods System in 1971, it turned to the exchange rate regime pegged to a basket of currencies, converting the fixed exchange rate regime into the managed floating one. Starting from 1979, China started trying out different pricing methods over foreign exchange earnings through trading and non-trading channels, and began to implement the foreign exchange retention system, allowing foreign trade companies to retain a small portion of their export proceeds and turn the rest over to the state at the official exchange quotations, thus forging a dual-layered exchange rate arrangement. The official exchange rate was the managed floating exchange rate regime pegged to a basket of currencies, while the adjustment price at swap center among enterprises floated according to the supply-demand relationship on the market. In April 1980, the Bank of China began to issue foreign exchange certificate (FEC), mandating that all foreign currencies held by both domestic and non-native residents had to be converted into RMB-equivalent FEC at the official foreign exchange quotations before being used in the designated areas in China. In 1994, China cancelled the dual-layered exchange rate regime, terminated the foreign exchange retention system and the issue of the FEC, and adopted the single and managed floating exchange rate regime based on market supply and demand. However, due to its undeveloped marketization, the exchange rate of RMB against the dollar could only fluctuate within ±0.3% of the reference rate. Therefore, the RMB exchange rate arrangement was actually the fixed exchange rate regime pegged to the U.S. dollar. On July 21, 2005, China began to implement the managed floating exchange rate regime which is based on market supply and demand and regulated with reference to a basket of currencies. The PBOC would adjust the exchange rate bands in line with China’s market development and its economic and financial situation, manage and adjust the RMB exchange rate in order to shield it from violent fluctuations and keep its exchange rate in a reasonable and equilibrium state. Besides, the PBOC is struggling to promote the fundamental balance

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of international payments, thus safeguarding the stability of China’s macroeconomy and the financial market. Such an exchange rate arrangement seemingly gives further flexibility to the RMB exchange rate and promoted RMB appreciation. However, the arrangement is somewhat flawed. First, the currency basket exchange rate regime presents low transparency. The currencies and their proportions in the basket are obscure, thus empowering the PBOC with great discretionary power. Therefore, the RMB exchange rate is not truly based on the market supply-demand relationship. Such an approach relying on the subjective decision-making of the PBOC easily leads to the exchange rate misalignment. Both overestimating and underestimating will do harm to China’s economic development. If the RMB exchange rate is undervalued in the long run, it would result in enterprises’ overdependence on their price competitiveness, influence structural adjustment and industrial upgrading, and consequently weaken the China’s international competitiveness. Second, the RMB exchange rate is now controlled, to a large extent, by the PBOC, regulated through trading in the foreign exchange market, and completely adjusted by changes in the reserve assets. A large number of foreign exchange resources concentrated in the hands of the central government are extremely unfavorable for risk dispersion. The prime objective of the China’s exchange rate policy should not be stabilizing the value of RMB, but maintaining the balance of international payments and economic growth. The equilibrium exchange rate of an economy subject to structural changes will inevitably fluctuate with constant changes in labor productivity, level of economic development, trade and capital flows and other factors. The RMB exchange rate arrangement should be conducive to mitigating the imbalance in foreign trade, improving China’s trade conditions, optimizing its resource allocation, expanding its domestic demand, enhancing the international competitiveness of its domestic enterprises, rationalizing the utilization of foreign investment, strengthening the independence of the monetary policy, improving the initiative and effectiveness of financial regulations, taking full advantage of both internal and external resources and both domestic and overseas markets, and further opening China’s market to the world. China has come to its golden age for exchange rate regime reform. Against the background of the global economic deceleration due to the financial crisis, China still boasts a burgeoning micro-economic environment, a sound balance of international payments, a sustained foreign trade momentum, and a great potential to maintain the growth of the FDI. More importantly, China has

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favorable economic fundamentals and the aspirations of a healthy and relatively fast economic growth. Therefore, the Chinese government should set the full convertibility of the RMB as the ultimate goal of the reform.

Direction of the Reform Since McKinnon proposed the “financial repression phenomenon,” in 1973, which, as he pointed out, was the main obstacle for the economic upsurge of developing countries, they have been focusing on studying the exchange rate arrangements and putting forward a variety of theories. Black proposed using the trade-weighted index to check developing countries’ selection of the exchange rate regime and believed that no matter which exchange rate regime to adopt, both its costs and benefits must be leveraged. Given that theories of exchange rate regimes in developing countries have their own complexities and influenced the decision-making of their monetary authorities on the exchange rate regimes, it proved necessary to analyze and generalize them in a systematic way. American economist H. R. Heller believed that the selection of the regime mainly depended on various economic factors. For those countries with a relatively high level of economic openness, less developed domestic financial market, relatively strict capital control, and a small economic scale or highlyconcentrated varieties of imported and exported commodities from and to highly-concentrated target partners, it was better for them to adopt the fixed exchange rate regime or the pegged exchange rate regime. Otherwise, the flexible exchange rate regime would be the best choice. Economists from developing countries believed that their countries were economically backward, so they needed to bring in advanced technologies and capital. Thus the developing countries generally presented a high degree of dependence on foreign trade and lack the objective requisites for practicing the floating exchange rate regime. Therefore, they had no other choice but the pegged exchange rate regime. In terms of the anchor currency, it usually depends on the concentration of the country’s foreign economic and political relations. On the basis of that, Bird G. proposed 10 measurements as the reference for whether a developing country should adopt the floating exchange rate regime. Specifically, the 10 factors included: 1) foreign countryled economic fluctuations; 2) low degree of economic openness; 3) high level of commodity diversification; 4) wide geographical distribution of trade; 5) high level of integration of the domestic and international capital markets; 6) large disparities in relative inflation rates; 7) high degree of elasticity of the import

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and export commodity prices; 8) fewer international reserves; 9) a society preferring income growth rather than income stability; 10) the establishment of a full-fledged forward foreign exchange market. As long as a country features most of these factors, the floating exchange rate regime was suggested; otherwise, the fixed exchange rate regime would the best fit. Yoshitomi and Shirai held that if the interferences that shocked the economy were monetary factors such as changes in the demand for money, it was desirable to adopt the fixed exchange rate regime; in case of substantial factors such as changes in preferences or changes in prices, it was desirable to adopt the floating exchange rate regime. If the interferences feature external shocks, the floating exchange rate was desirable to isolate the domestic economy and offset the negative impact; otherwise, in case of some unstable fiscal and monetary policies and other domestic interferences, it was desirable to adopt the fixed exchange rate regime. Since the 1990s, due to frequent international currency crises, the selection of the exchange rate regime of developing countries has become a hot topic. Some scholars claimed that employing the intermediate rate arrangement in the developing countries is not feasible; while some believed that developing countries should adopt an exchange rate regime pegged to the dollar or follow the example of the euro regime due to its backward financial system, which may trigger currency misalignment or due date misalignment; other scholars held that some fluctuation-aversion developing countries usually chose to stabilize the exchange rates of their currencies against a certain currency (the dollar in most cases) within a narrow band. Factors that influence the selection of the exchange rate arrangement are complicated and diversified. Countries with different levels of economic development consider different factors. Therefore, it is inevitable that the exchange rates regime determined by these quite different factors will are diverse. Thus, a paradox occurs when trying to draw a uniform conclusion on the selection of the exchange rate regime. Most economists study the selection of the exchange rate arrangements from static, regional and equilibrium perspectives, thus their conclusions may withstand the scrutiny merely from the static angle. However, since influential factors vary and would change with the development of political, economic and financial factors, hence the multivariate difference and variability have made their conclusions one-sided. Therefore, the selection of the exchange rate arrangement is not permanent. All countries will be willing to or forced to change their respective exchange rate regime. Special exchange rate arrangements may be applicable for certain countries in certain periods.

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As has been noted, from the RMB exchange rate arrangement pegged to the dollar to that with reference to a basket of currencies, the transition from the fixed exchange rate regime to the floating one was realized with the rapid development of China’s export-oriented economy and enhancement of its financial strength. However, China is still faced with many difficulties and adverse conditions in the reform of the RMB exchange rate regime, such as the influx of hot money due to expectations about RMB appreciation, the weak adaptability of the domestic institutions to exchange rate fluctuations, and their lack of experience in risk management. In particular, China has to prevent the possible shocks on the market brought by the exchange rate policy adjustment under high expectations about RMB appreciation. In addition, the market mechanism in China is yet to be established; there are still restrictions regulating trade and investment; the interest rate has not been totally marketized. All prices formed under such circumstances cannot represent the true market supply and demand. Obviously, China is not ready to adopt outright a complete floating exchange rate regime. Therefore, it should follow a proactive and controllable process, dedicated to full convertibility of the RMB. Regarding the domestic and foreign circumstances, and after comparing various exchange rate arrangements, the author suggests adopting a “flexible RMB exchange rate target zone regime” at the present stage. The exchange rate target zone is the expected band of exchange rate fluctuations set up by the monetary authorities. The monetary authorities are responsible for maintaining the exchange rate within the target zone by properly intervening in the foreign exchange market. The exchange rate target zone regime involves the selection of the equilibrium exchange rate of the target zone, the selection of the width of the target zone, the transparency of the target zone, the pattern and intensity of the monetary authorities to intervene in the exchange rates, and related intervening policies, etc. Since China’s capital projects has yet to be fully opened, the RMB exchange rate target zone regime is more active than making adjustment based on a basket of currencies, thus not only stabilizing the RMB exchange rate, but also energizing a more effective exchange rate mechanism. It combines the advantages of the fixed exchange rate regime and the floating exchange rate regime. Expectations about RMB appreciation will no longer be influenced merely by the words from the monetary authorities, and the RMB exchange rate will not be determined by the amount of foreign exchange assets purchased by the monetary authorities, but by market supply and demand. The monetary authorities may set the central rate of the target zone using the equilibrium exchange rate. When the market exchange rate touches the upper and lower

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limits of the target zone, the PBOC will intervene immediately. The “honeymoon effect” created by the exchange rate target zone management mechanism (i.e. when the exchange rate is close to the upper or lower limit of the target zone, it is in reality lower or higher than the anticipation estimated under the floating exchange rate regime due to the expectations of depreciation and appreciation) will also dampen the changes in the exchange rate, and give full play to the market in discovering price, guiding effective resource allocation, stabilizing the exchange rate, and averting speculations and doubts on the basket of currencies. The Chinese government also has reasonable explanations on regulating the RMB exchange rate, thus effectively preventing or reducing frictions with external partners. The author advocates a “flexible RMB exchange rate target zone regime” which involves the following three meanings. First, the target zone is dual-layered. When determining the exchange rate target zone, the monetary authorities should divide it into “soft” target zone and “hard” target zone. “Hard” target zone refers to the exchange rate target zone which is open and transparent, narrow yet not subject to frequent revisions in the form of the monetary authorities’ interventions; while the “soft” target zone is not open, with a wide band, and determined and revised by the monetary authorities based on the balance of international payments and the domestic and foreign economic situations. Second, the target zone is extendable. Boundaries of the target zone are not fixed, and can be extended constantly with the deepening of China’s financial reform and the internationalization of the RMB. The ultimate goal is to eliminate the boundaries and realize a fully convertible RMB. Third, the central rate of the target zone is movable. The central rate of the target zone is relatively fixed and can be moved or adjusted, when necessary, in accordance with international financial stability and domestic inflation.

Definition and Extension of the Exchange Rate Target Zone Exchange rate target zone was initially put forward by Fleming in 1974 before being included in the administrative provisions on the exchange rate fluctuations of the IMF’s Executive Board. It denoted that exchange rate fluctuations should be confined within a certain “target zone.” In 1976, the then-Dutch finance minister Duisenberg drew a blueprint to devise an exchange rate target zone of the six member states of European Economic Community (EEC). On March 13, 1979, the European Exchange Rate Mechanism adopting the exchange rate target zone regime was officially set up.

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Williamson set forth the idea of “exchange rate target zone” in 1985, believing that the spot exchange rate should adjust itself within a certain zone, while basically centering on the FEER which is backed up by the monetary policy. He suggested that the United States, Japan and the Federal Republic of Germany (G3), the then world’s top three largest economies, set a common central rate and a target zone and adopted coordinative monetary policies in order to stabilize the international exchange rate. Frenkel and Goldstein recommended that the exchange rate target zone should be as stable as the fixed exchange rate regime and as flexible as the floating exchange rate. Krugman posited in 1991 a restrictive theoretical model of the standard target zone, assuming that the exchange rate depending on the integration of money supply and other basic economic variables, as well as the expected value of the future exchange rates. Key assumptions of this model include: 1) the exchange rate target zone is totally reliable and fixed; 2) the target zone in itself has an internal stability mechanism and intervention of the monetary authorities prove unnecessary; and 3) aggregate variables of other basic economic variables are random variables subject to the Brownian motion. Flood et al statistically proved Krugman’s “the exchange rate target zone is totally reliable and fixed” yet “…the intervention of the monetary authority is not necessary within the target zone” were questionable. The target zone may be abandoned and converted into a floating exchange rate regime or, in all likelihood, the target zone may be reorganized into a new type. In addition, Obstfeld and Rogoff believed that when the exchange rate touched the boundary of the target zone, it would encounter the same problems faced by the fixed exchange rate regime. It was also suggested to replace the Brownian motion in Krugman’s target zone model with an autoregressive Omstein-Uhlenbeck process. Based on the basic framework of Dornbusch model, Miller and Weller introduced a random variable in the price formation process, and devised the sticky-price target zone model. Sutherland resorted to the power series method to solve the rate function of the sticky-price target zone model, proving that the model was capable of explaining the peak distribution of the exchange rate statistics and the uncertainty of the relationship between the exchange rate and the interest rate. Bartolini and Prati proposed the soft target zone model, featuring the extension of the reference criteria of the exchange rate intervention from time point to a relatively lengthy period. Different from the current exchange rate fluctuation band in the above models, that band in the soft target zone featured the moving average of the current exchange rate and past exchange rates, which

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denoted that the monetary authorities may tolerate current exchange rate to go beyond the set fluctuation band, yet promised to confine the average exchange rate to the set target zone in the long run. The soft target zone is usually more capable of resisting speculative attacks than the hard target zone. To set up the RMB exchange rate target zone regime, first clarify the upper and lower limits. An over-narrow target zone is hard to reflect the exchange rate flexibility; while an overly-wide target zone will influence the import and export trade and the stability of the capital flow. As Yang Ming and Wang Shuai suggested, given that the European Monetary System (EMS) once widely adopted the band of ±2.25% and ±6% (for some nations), and China was still a developing country with relatively more unknown variables in its financial system, the amplitude of its target zone should be appropriately broadened to about ±5%. However, the figure is yet to be scrutinized in a rigorous way. According to the analytical results of previous statistics, Wang Qinghao proposed that the upper and lower limits should be the equilibrium exchange rate, plus twice of its variance, i.e. the width of the target zone should be the equilibrium exchange rate variance multiplied by four. Yet Wang Qinghao failed to give a specific number. Guo Juanjuan regressed related data of China during 1990–2005 using the method of least squares, and found that the value of the nominal exchange rate fluctuates within 15% around that of the equilibrium exchange rate. She then suggested that the above range be set as the fluctuation range of the RMB exchange rate target zone. The flexible RMB exchange rate target zone regime recommended by the author covers the dual-layered zone. Besides, within the hard target zone, the exchange rate should be determined basically by market supply and demand but intervention of the monetary authorities; while outside the hard target zone, yet within the soft target zone, the monetary authorities may make proper interventions. With the marketization of its exchange rate, China may gradually extend both its hard and soft exchange rate target zones in three steps, before finally achieving the full convertibility of RMB. At the initial stage, both target zones should be controlled within a narrow range, partly because the Chinese enterprises need a gradual process of adaptation, and partly because the monetary authorities need a process to change its management style. At this stage, the PBOC should gradually limit its interventions in the exchange rate and weaken its role as the market subject, and serve as a guidance of the behaviors of all subjects in the foreign exchange market by wielding three major tools—reserve rate, discount rate and open market operations. Only when it is very necessary should it enter and intervene

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in the market by directly investing in foreign currencies or local currency. The author suggests that the width of the hard target zone should fluctuate within ±1% of the central rate at this stage. Given that the standard deviation of RMB against U.S. dollar, euro and the Japanese yen was 0.5, 0.6 and 0.33, respectively, during July 2005 (after the exchange rate reform) to May 2009, 1% proves safe and sound. While the width of the soft target zone at this stage may be set at ±3% of the central rate in order to bring the unstable and relatively abnormal exchange rate fluctuations under control. At the adjustment stage, as the capital accounts in China are opened gradually and the exchange rate continues its marketization, the width of the hard target zone should be slightly extended to ±5% of the central rate, while that of the soft target zone should be extended to ±15% of the central rate. At the integration stage, both target zones need substantial extensions. The pace of extension of the hard target zone should be faster than that of the soft one before the two finally get integrated into a single exchange rate target zone with ±30% fluctuation amplitude and transiting the RMB into a fully convertible currency.

DETERMINATION OF THE CENTRAL EXCHANGE RATE OF THE RMB The determination of the central exchange rate of the RMB paves the road for setting up the exchange rate target zone regime in China, which needs to choose the central currency first before determining the central exchange rate of the local currency against the central currency.

Selection of the Central Currency When selecting the central currency, a country needs some knowledge about its own foreign trade situation. The central currency may be one or more (a basket of) currencies. With the progress of economic globalization, more and more countries favor a basket of currencies as the central currency. Varieties of foreign currencies and their weights in the basket should be based on the country’s foreign trade, foreign capital and foreign debts. In most cases, the basket of currencies would include the dollar, the euro and the yen (G-3).

Determination of the Central Exchange Rate We believe that the equilibrium exchange rate is the real exchange rate when

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the balance of international payments and full employment are both achieved at the same time, or when the internal and external equilibriums are achieved at the same time. Swan systematically expounded on the relationship between the equilibrium real exchange rate and the macro-economy, laying down the theoretical foundation for later studies. Based on Swan’s studies, Williamson put forward the FEER that can be used in empirical analyses and measured the equilibrium real exchange rate of major currencies in the West, including U.S. dollar, Japanese yen, Deutsche mark, British pound, French franc, Italian lira and Canadian dollar. The so-called FEER is actually a real, effective exchange rate consistent with the macro-economy, namely an ideal situation when the macro-economy is featured by full employment and low inflation (internal equilibrium) and current items reflect the sustained flow of net assets (external equilibrium). To explain reasons for the misalignment of the dollar exchange rate and the U.S. current account deficits, Stein came up with the natural real exchange rate (NATREX) theory in 1994 and employed it to measure the equilibrium real exchange rate of the dollar, the mark, the French franc, and the Canadian dollar. Such equilibrium exchange rate referred to the mid-term real exchange rate that was depended on major real economic factors and was capable of helping achieve the balance of international payments. Clark and MacDonald put forward the BEER theory in 1998, which aimed at analyzing the changes in the exchange rate of U.S. dollar, Japanese yen and Deutsche mark. Such an equilibrium exchange rate was defined as the estimated value obtained by using econometric methods to devise the behavioral formula between the real effective exchange and related economic fundamentals. The theory used the co-integration technique of the econometric field developed in recent years to discover the statistically-significant co-integration relationship between the real exchange rate and various long- and medium-term exchange rate determinants identified in previous S&T literatures, and took such relationship as the basis of determining the equilibrium real exchange rate and judging whether or not the exchange rate was misaligned. It has been widely used in the measurement of the equilibrium real exchange rate and the empirical studies of the problem of exchange rate misalignment in recent years. Since the late 1980s, some scholars have been studying the equilibrium exchange rate of developing countries. Edwards was the first who put forward an ERER theory for developing countries, in which he took into full consideration the significant macro-economic characteristics of developing countries, such as the implementation of foreign exchange control, the existence of trade barriers and that of the parallel exchange rate (black market

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exchange rate in most cases). Within the theoretical framework, he conducted empirical studies in the currencies of some developing countries, such as Brazil, Colombia, India, the Philippines, Malaysia and Thailand. Based on integrating the existing theoretical literatures on the ERER of developing countries, Montiel set up the determinants of the long-run ERER and found that the BEER theory was more advantageous in the study of the exchange rate misalignment in developing countries. See the paper written by Jiang Boke and Li Huaiding for more detailed comments on the equilibrium exchange rate theory.

Determination of the RMB Equilibrium Exchange Rate Foreign scholars have also done research over the RMB equilibrium exchange rate. Most concluded that the RMB was extremely undervalued. For example, after calculating the RMB equilibrium exchange rate using the absolute PPP and the relative PPP, Bosworth and Overholt found that regardless of the income level disparities in related countries, the USD/RMB equilibrium exchange rate was two; taking into consideration the per capita income difference, RMB was undervalued by about 40%. By introducing the adjusted PPP, Frankel found that RMB was undervalued by 35% in 2000 and more than 35% in 2004. Domestic scholars’ studies on the RMB equilibrium exchange rate mostly learn from Western equilibrium exchange rate theories, based on which they adjust the structures and parameters of related models in accordance with China’s reality. Those studies can be classified as follows: 1) Based on the PPP theory, such as studies done by Yu Qiao, Li Yaxin and Yu Ming, Wu Jun and Zhou Yongwu. The common conclusion is that RMB is not or only slightly undervalued. 2) Based on the ERER theory, such as books and papers written by Jin Zhongxia, Ma Gang, Chu Youyang, Zhang Bin, Lin Boqiang, Bu Yongxiang and Qin Wanshun, Zhang Xiaopu, etc. 3) Based on the BEER theory, such as books and papers written by Zhang Xiaopu, Liu Yang, Shi Jianhuai and Yu Haifeng, Qin Wanshun et al, Zhang Zhichao, etc. Liu Liya and Ren Ruoen introduced Edwards’ ERER model to measure the equilibrium effective exchange rate of the RMB and set up the theoretical model of RMB equilibrium exchange rate by choosing the factors of trade terms, government expenditures on non-tradable goods, trade restrictions and the degree of transaction control, technical progress, and the debt service ratio as the fundamentals influencing the ERER. Besides, they built up the RMB

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equilibrium exchange rate model through analyzing factors such as the overdue supply of domestic credit, and the ratio of fiscal deficit to high-powered money (DEH). After a mathematic analysis, they drew the conclusion that since the 1980s, RMB went through two significant periods each of overvaluation and undervaluation: in 1986–1988 and 1991–1995, RMB was significantly undervalued; while in it was significantly overvalued 1983–1985 and 1989–1990. Despite substantial research conducted by domestic and foreign scholars, they all learned from one or more of the aforementioned Western theories, thus making their conclusions quite different, even mutually contradictory. To this end, more studies and innovations are needed in order to set up RMB equilibrium exchange rate model that is fully consistent with the Chinese characteristics.

Determination of the Central Exchange Rate of RMB Exchange Rate Target Zone The author claims that when establishing the RMB exchange rate target zone, the basket of central currencies should be adopted in order to truly reflect China’s foreign trade capacity, its status in international payments, and RMB’s international purchasing power. China must deliberate its foreign trade, foreign capital and foreign debt structures when selecting foreign currencies and deciding their weightings. At the initial stage, it is not appropriate to adopt the equilibrium exchange rate as the central rate. On the one hand, China has not realized the conditions for a widely-recognized RMB equilibrium exchange rate; on the other hand, China has to maintain the relative stability of the RMB exchange rate and achieve the smooth transition from the current exchange rate regime with reference to a basket of currencies to a flexible exchange rate target zone regime. At the adjustment stage, the central exchange rate may shift toward equilibrium exchange rate while achieving the extension of the target zone, thus promoting the movement of the target zone. At the integration stage, the central exchange rate should get increasingly close to the equilibrium exchange rate. With the ongoing reform, and the constantly enhanced social market economy, China will gradually cast off the traditional single-structured, central bank-monopolized foreign exchange market. Only under the premise that enterprises and banks have truly become market subjects could it be possible to determine the exchange rate of RMB based on market supply and demand and the equilibrium exchange rate will become the central rate of the RMB exchange rate target zone.

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ADJUSTMENT OF THE RMB EXCHANGE RATE POLICY Any policy involves two aspects—goals and measures. Through policy measures, the government guides the market and other systems to evolve in the direction that is conducive to achieving policy goals. The author has pointed out that no policy is flawless, and all policies are the results after weighing the pros and cons. It is worth noticing that the internal causes of system evolution are the interaction between all subjects within the system and the external environment. The self-organization thus produced effect will push the system forward in a desired direction. Only when it is capable of changing the behaviors of market subjects and consequently changing the direction of the self-organization effect can the policy, the external causes, serve its role. The exchange rate policy, as the macro-economic policy that touches upon domestic and foreign affairs, plays an important role in developing the country’s national economy. Since July 2005, China has set its exchange rate policy so as to keep the RMB exchange rate at a reasonable and equilibrium level, and to maintain the basic balance of international payments, and ultimately safeguard the stability of its national economy and financial market. Practices in recent years saw a stable and healthy progress. However, we should also be aware that China is still transitioning from the traditional planned economy to the socialist market economy, and the transformation of government functions has not yet been completed, thus making it hard to give full play to the essential role of the market in resource allocation. Besides, the international financial crises have had various adverse effects on the Chinese economy, so it is necessary for China to re-examine and adjust its existing exchange rate policy. The author once pointed out that, under the market economic system, the objective of the macro-economic control in China was no longer limited to maintaining the balance of international payments, promoting economic growth, creating more job opportunities, and stabilizing the commodity price, but also pushing forward the synchronous growth of people’s income and social wealth, narrowing the wealth gap between the rich and poor, advancing the economic, social, political and cultural development, and achieving sustainable development. In order to realize that, China should handle the following several balances well.

Balance between Storage and Use Productivity has been increased continuously since the reform and opening up, and the output of the real economy has far exceeded domestic demand,

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leading to an rapid expansion of its foreign trade and a sharp increase in its foreign exchange reserves. As of June 2009, China’s foreign exchange reserves reached USD2.13 trillion, No. 1 around the world. The sharp increase in foreign exchange reserves has made the monetary policy operations tougher, requiring PBOC to pay more in order to maintain exchange rate stability. Thus the independence of the Chinese monetary policy faces immense challenges. China’s enormous amount of foreign exchange reserves has used a great deal of the base currency. In the absence of corresponding hedging tools, faced with an influx of foreign exchange capital, the PBOC has to pump more RMB into circulation in order to stabilize the exchange rate. According to PBOC’s Summary of Sources and Uses of Credit Funds of Financial Institutions , as of June 2009, China’s funds outstanding for foreign exchange reached RMB17.79 trillion and currency demand fell short of the supply, aggravating the RMB appreciation pressure. Dollar assets account for the largest share in China’s foreign exchange reserves. In particular, China has bought a considerable amount of U.S. bonds. By the end of June 2009, the U.S. bonds held by China had exceeded USD800 billion, posing great threats to China’s finances. The substantial depreciation of the dollar has increased the cost of risk to China’s foreign exchange reserves as the depreciation of the dollar will inevitably lead to the shrinking of value of China’s foreign exchange reserves. The USD2.13 trillion of foreign exchange reserves means the equivalent value of China’s commodity-purchasing right amounts to RMB16 trillion. This immense idling right is literally providing USD2.13 trillion to China’s trade-deficit partners at a lower price. According to the author ’s calculation, the rational amount of foreign exchange reserves should be USD650 billion, of which USD450 billion should be strategic reserves (including reserves for repaying foreign debts, those for temporary imports, apportionment of reserves for foreign aids and emergencies) and the rest USD200 billion should be tactical reserves (including foreign exchange reserves needed by the PBOC to intervene in the exchange rate, profit repatriation of FDI, and residence reserves). To this end, China should rationalize the use of its foreign exchange reserves, including importing the needed equipment, products, technologies, establishing strategic resource reserves, and increasing the amount of dollar loans to enterprises with good operational performance, while providing policy support, setting up overseas investment credit allocation mechanism, encouraging competitive domestic enterprises to “Going out” and invest abroad, operating multi-currency securities investment, and opening free-on-board (FOB) financial business under certain conditions, etc.

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Balance between Domestic and Foreign Demands Due to insufficient domestic demand, China has to propel its domestic economic growth with exports. Therefore, China has long been formulating exportoriented policies, thus rendering the consumption-to-GDP ratio to reduce from 67% during the 1990s to about 40%. In the wake of the global financial crisis, China’s exports declined substantially due to the sharp decline in foreign demands. Its total volume of imports and exports in the first half of 2009 dropped by 24.5% year-on-year and the net exports presented a negative effect on its economic growth (-2.9%). Therefore, what China should do is to expand its domestic demand, and promote consumption to improve the consumptionGDP ratio, all of which require it to improve the purchasing power of its people by taking such measures as increasing salaries and property income, improving the social security and credit systems, reducing taxes, etc. In particular, China has to struggle to achieve the synchronous growth of its people’s income and the national economy, narrow the economic disparities and income distribution among regions, and forge the pattern that domestic demands fuel the economic growth. To this end, a diversion from the export-oriented exchange rate policy proves necessary.

Balance between Supervision and Innovation Over the years, China’s foreign exchange authorities have been to focus on averting exchange rate risks and maintain the exchange rate stability, but seldom encourage financial innovations. However, being risk-free often leads to low efficiency. Both risks and opportunities are created in the exchange rate fluctuations. When the exchange rate fluctuates with market supply and demand, it is more conducive to empowering the market with full authority in foreign and domestic resource allocation, thus to promote the balance of the domestic and foreign demands. Therefore, China should develop, with a positive and prudent attitude, exchange rate–related financial derivative products, including swaps (switch), futures, options, etc., while carrying out legal and effective supervision.

Balance between Corporate Interests and Public Interests China’s foreign exchange policy overemphasizes exchange rate stability mainly out of the fear that exchange rate fluctuations might undermine the interests of the enterprises (especially large state-owned enterprises). The Chinese enterprises have long been doted on by the government. Therefore, in case of

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losses caused by exchange rate fluctuations, they will resort to the government, demanding price rise, subsidies, etc. rather than improve their competitiveness and lower the production cost. To achieve the objectives of its exchange rate policy, China should first improve its exchange rate formation mechanism, transition from the current exchange rate regime with reference to a basket of currencies to the flexible exchange rate target zone regime, take multiple measures to promote the balance of its international payments, strictly control the inflow and outflow of hot money, and push forward the reform and opening up of China’s financial system.

IMPROVEMENT OF THE RMB EXCHANGE RATE MANAGEMENT When adopting the flexible RMB exchange rate target zone regime, China should follow the requirement of being “proactive, controllable and progressive,” rationalize the relationship between the foreign exchange rate markets, improve the exchange rate fluctuation mechanism, and mature the RMB exchange rate management.

Guard the Massive Inflow and Outflow of Hot Money Since China’s entry into the WTO, the rapid development of its foreign trade and the sustained inflow of enormous amounts of foreign capital have opened the doors for speculative capitals (aka “hot money”) without a practical trading background. According to the author ’s analysis on China’s 2004 foreign exchange receipts and disbursements, the increase of China’s foreign exchange reserves exceeded the sum of its trade surplus and the revenue of the FDI and foreign exchange investment, which indicated an inflow of hot money. Due to the great differences amid various foreign trade and foreign assets statistical criteria, and substantial missed or error items, it is hard to correctly estimate the volume of hot money. By a rough guess, the amount should be somewhere between USD40 billion and USD80 billion. Although a small amount of hot money flowed out of China in 2008 due to the financial crisis, the surplus inflow of hot money will overwhelm in the future thanks to its favorable economic outlook. The net inflow of hot money will further drive the expectations about RMB appreciation, restrict the independence of China’s monetary policy,

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consequently impact the effectiveness of its macro-economic control, and increase the volatility of the foreign assets and the exchange rates. Thus it seems rational to strengthen China’s oversight over the cross-border flow of hot money and prevent it from shocking China’s economy and finance. China should also keep a vigilant eye over: 1) the capital afflux by domestic and foreign parentsubsidiary companies through affiliated transactions or fake contracts, or by increasing the amount of advances; 2) the afflux of a great deal of foreign exchange capital under individual items (since statistics under individual items do not distinguish non-residents from residents, or investment from trade, it is easy for speculative capital to hide thereunder); 3) abnormal phenomena such as undue loans, real estate speculations and penetration to the collectibles market. Underground banks that serve as secret channels for the inflow and outflow of speculative capital must be outlawed. Domestically-funded enterprises must be forbidden to buy and sell foreign exchanges via the black market.

Preventing the Speculative Attempts of the Idle Capital in China’s Foreign Exchange Market If the nominal exchange rate diverges from the equilibrium exchange rate over a long period of time, it would lead to the expectation of currency appreciation or depreciation, which will be further strengthened by the margin income gained from local and foreign interest rate spread, and the relatively high premium of local currency, making it easy to induce speculative capital to launch speculative attacks. It would lead to violent fluctuations of the exchange rate and force the monetary authority to put local currency or foreign currencies into circulation. Today when speculative capital is capable of controlling trillions of dollars of hot money, it is totally possible that a country’s foreign exchange reserves would be greatly depleted or hyper-inflation would be generated, forcing the government to abandon the exchange rate target zone and adopt the floating exchange rate regime. Therefore, the government should maintain the narrow width of the hard target zone at the beginning, and be highly-vigilant after the exchange rate enters the soft target zone before taking immediate actions.

Maintaining the Government’s Credibility over Its Target Zone Commitment The credibility of the exchange rate policy arguably reflects the government’s trustworthiness, with which the general public may be persuaded that the government will not pursue short-term interests or diverge from the exchange

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rate objectives by abandoning its exchange rate policy commitment. Exchange rate policy credibility is conducive to achieving the objective of stabilizing government policies. In particular, only when the public fully trusts the government’s commitment on the hard target zone can the exchange rate target zone regime succeed. Therefore, any government should deliberately and prudently determine and announce its commitment on the hard target zone, and win the public trust that its monetary authority will not take any measure to intervene in the exchange rate within the hard target zone so as to make better use of the “honeymoon effect” produced by market forces to maintain the stability of the exchange rate target zone. To improve China’s international competitiveness and influence, the RMB internationalization proves to be imperative. Under the current difficulties and uncertainties in the path of internationalizing RMB, China’s scholars have to delve into the reform of the RMB exchange rate regime in order to support the decision-making process toward full RMB convertibility. The author suggests carrying out in-depth studies over the flexible RMB exchange rate target zone regime in the following several aspects: 1) theoretical overview and the status quo of domestic and foreign studies on it; 2) historic changes in the reform of the RMB exchange rate formation mechanism and existing problems; 3) empirical analysis of the RMB exchange rate and the influences of exchange rate misalignment on the Chinese economy; 4) objectives and basic rules of the reform of the RMB exchange rate formation mechanism; 5) RMB exchange rate target zone management mechanism and the measurement of RMB equilibrium exchange rate; 6) policies on the management of the RMB exchange rate target zone and supporting measures; 7) other supporting policies and suggestions on the reform of the RMB exchange rate formation mechanism; and 8) directions of follow-up studies. Based on in-depth studies, China may transit from the exchange rate regime with reference of a basket of currencies to the flexible exchange rate target zone regime in due time. Completed on August 1, 2009

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Chapter

Toward the Reform of China’s Housing System

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The housing system refers to the collection of standards, including laws, regulations and policies related to the construction, allocation, transaction and management of housing, which are designed to regulate the relations among relevant parties and their conducts. The establishment and improvement of housing system is vitally important as it wields direct influences on people’s livelihood, as well as on social stability and economic progress. As denoted in the Athens Charter , there were three primary functions of city, namely, dwelling, work and recreation, with the dwelling function being fundamental. The population boom in WWII’s wake triggered a more urgent and problematic housing system. In October 1978, the UN established the UN Center for Human Settlements (Habitat), or UNCHS as an administrative body within the UN framework responsible for coordinating the development of human settlement. The UNCHS supports and cooperates with central and local governments of various countries, as well as NGOs and private sectors in this cause. The 1982 resolution of the UN General Assembly designated 1987 as the “International Year of Shelter for the Homeless,” aimed at “by 2000, eliminating all homeless people by providing them residences, which are equipped with tap water, drainage and public transportation, while city should be supported by infrastructure and protected from rapid expansion…” In 1987, more than 130 nations, including China, registered and took part in the events. In June 1996, the Second UN Conference on Human Settlements (Habitat II) convened in Istanbul, in which, “adequate housing for all” and “sustainable development of human settlements in an urbanizing world” were recognized. The Istanbul Declaration stressed that as the challenge we faced in human settlement was global, in order to tackle the world’s housing problem and improve the habitat for human, cooperation among international communities, states and local governments should be established, and aid in the form of funding and technology transfer among international communities should be intensified as well. The 16th Session of the UN Commission on Human Settlements in 1997 passed a resolution that urged governments to accelerate the process of establishing and implementing their respective housing strategies and policies. The resolution also required governments to maximize their coordination and collaboration by cooperating with different parties in providing housing so as to promote, guarantee and increase the joint contribution to the provision of housing by public, private and NGO sectors. It also stressed a balanced housing development between rural and urban areas, citing that ignoring rural housing construction may result in tremendous rural to urban migration, which

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would aggravate the already grim housing problems in cities. Reportedly, in developing nations, more than 600 million urban residents lived in dwellings of very low quality. They suffered bad or imperfect drinking water, sanitation, drainage and garbage collection, posing a constant threat to their lives and health. Every year, several million residents are driven out of their homes by force, swelling the rank of homeless, to an estimated 100 million. It was also estimated that half of the global population (3.3 billion) will be living in urban area by 2008, over 1 billion of which in slums or shacks. In December 2001, the UN General Assembly passed its 56/206 resolution, which upgraded the UNCHS to the UN Human Settlements Program (UNHABITAT). The UN-HABITAT was devoted to facilitate the realization of the goals of “adequate housing for all” and “sustainable human settlements developments in an urbanizing world.” Its main functions were to implement the Habitat Agenda passed in the Habitat II convened in Istanbul in June 1996, and facilitate UN’s effort to eliminate poverty and promote sustainable development. One of UN-HABITAT’s primary approaches of in realizing its goals was to facilitate the establishment of policies, strategies and supply systems concerning housing and social service, and encourage full-on or phasein realization of the right to housing. The housing problem in China is very severe. China has long been implementing a planned economic system that promoted high saving and low consumption and offered high employment and low wages, in which housing construction was under a unified guidance of a basic construction and investment plan by the state. From 1958 to 1977, under the influence of leftwing thoughts embodied in a string of policies such as “life after production” and “housing construction after environment transformation,” investment in housing was slashed to a very low level. As a result, by 1978, the national living floor area per capita in urban area lowered from 4.5 square meters upon the founding of China to 3.6. The insufficient housing supply became a serious social problem at the time, with a large number of households suffering from housing difficulties. As early as in September 1978, Deng Xiaoping said, “Can we broaden the approach of solving housing problem? We can, for example, allow private constructors. We can even subsidize them or give loan to them which they can return in installment, so that we can raise money from the public. The state can supply them with construction materials. This is doable.” On April 4, 1980, during a conversation between him and some other central government officials, Deng said, “On the urban housing problem, we must take into consideration a whole set of policies ranging from construction to allocation. Urban residents

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should be allowed to both buy their dwellings, and to build their own ones. Not only should new dwellings be allowed to put on sale, second-hand ones should be allowed too. In terms of payment, both one-time payment and installment payment should be allowed, and the length of payment should be extended to as long as 10 or 15 years. After allowing the sale in housing, the rent should also be adjusted. We should regulate the rent based on real estate price, so that people may realize buying their own dwellings is more economic an option than renting them. A gradually increasing rent should be designed, because if the rent of dwelling stays too low, people would not consider buying one. Rent should be different for dwellings in downtown and outskirt, areas with high traffic flow and low traffic flow, and urban areas and rural areas. After the rise of rent, there should be subsidy in place for low income groups. All these policies should be comprehensively considered. On the construction of housing, we should encourage construction projects jointly run by private constructors and government, private construction projects with governmental aid, as well as wholly private owned projects. Construction in rural area should use new designs rather than building quadrangle courtyards all the time. Multi-story buildings should replace single-story ones. This can save more land for farming. And the style of buildings should be in line with the actual demand of residents in each specific area.” Deng’s far-sighted remarks set the basic framework for housing reform, which since then began its explorations both in theoretical and practical aspects. Starting from 1978, through 30 years of painstaking work, housing reform in China has made significant achievements. By the end of 2008, the urban per capita floor area reached 27 square meters (calculated on the basis of population with hukou ). The housing reform has been recognized by international community, and in November 2005, China has received 12 UN Habitat Scroll of Honor Awards. However, the overall progress is still not satisfactory. Admittedly, the guiding thoughts of the reform were basically correct, but the reform itself has been stumbled by many obstacles in practice. The major problems are: slow progress in the construction of low-rent housing, a lack of regulation in affordable commodity housing, and chaos in regular commodity housing market. In the 5th Session of the 10th NPC, Premier Wen Jiabao said, “Real estate industry plays a major role in developing economy and enhancing people’s housing conditions. It therefore needs to develop in a sustainable and healthy way. That is to say, first, in its development, we should take into consideration the fact that China has a large population but limited land resources, and that China is still a developing country, which requires us to make plan rationally,

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construct buildings in a scientific way, moderate our consumption and develop energy-saving, land-saving and environmental real estate, so as to eventually form a housing construction and consumption pattern with Chinese characteristics. Second, the real estate industry should focus on providing average-level commodity housing for the general public. The state should pay special attention and care for low income groups with housing difficulties. Moreover, the state should intensify its policy support such as tax regulation, build a sound low rent housing system, and improve its affordable commodity housing system. Third, the state should utilize correctly both governmental regulation and market mechanism, keep the scale of real estate investment on a reasonable level, optimize the supply structure of commodity housing, intensify the supervision and regulation of property price, curb the undue rise of property price, and retain the price at a reasonable level. Fourth, the state should regulate and rectify the real estate market order, and intensify its supervision on the market. It should punish illegal conducts in real estate circulation processes such as construction, transaction and agent. Similarly, local government should take the responsibility to adjust and regulate real estate market.” The author has paid continuous attention to problems of China’s housing reform, and has conducted researches with other experts and scholars over this issue. I will discuss how to further promote China’s housing reform and facilitate healthy development of its real estate market, and eventually provide some suggestions over the issues.

CHINA’S HOUSING PROBLEMS Historical problems and the diversity of interest parties have complicated China’s housing problems. Since the very start of China’s housing reform, property prices have become the focus of all walks of life, and the property prices and real estate industry have been subjects of constant debates. I personally believe these all are signs that the Chinese society is becoming more open and democratic, and should thus be encouraged and supported. However, there are also views on the internet that distort facts and go to extreme, with some of them overly politicalizing the debate. There are also a few scholars that put forth unpractical claptrap, and some media pointlessly sensationalizing these views. All this has placed an irrational interference to the housing reform of China. In order to further improve the housing reform, a well-rounded, systematic and in-depth analysis is needed. For this reason, the author makes the following eight points about China’s real estate market, with which he

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hopes to clarify the status quo. To begin with, housing is a special commodity with four characteristics: First, housing is a necessity. As housing is essential for the survival of human, the rise in population and income are accompanied by a housing demand that expands constantly. When excluding demands other than that for residence, the price elasticity of demand can be considered low, which means the effect of changes in property prices on property demand is insignificant. Second, housing is a durable commodity. At present, the durability of regular dwellings is about 50 years, while the annual natural housing turnover rate is 2%. Therefore, consumers who buy and move into new dwellings are not driven by the fact that their old dwellings have been used for more than 50 years; instead, they are driven by changes in their income, the number of household members, job, the environment and aesthetic need. This will create new housing demand and simultaneously facilitate the development of the second-hand property market. Third, housing is a high-value commodity, which often amounts to over four times of a household’s annual income of. In developed nations, for households either buying property with mortgage or renting property, the cost, inclusive of water bills, electricity bills and property management fees, normally takes up 20% to 35% of the total household income. The state should therefore pay special attention to low income groups with housing difficulties and enhance its housing welfare. Fourth, housing is an immovable asset. People are often left no choice but move into new places when their working locations change. In addition, the value of property depends on its location and surroundings, such as the quality of adjacent schools and shops, or the state of pollution and security of the neighborhood, etc. normally speaking, property prices in big cities are higher than in small cities, and downtown than in the outskirts. That is why it requires a differentiated policy making for different regions. In other words setting a universal standard for the whole nation would be inappropriate. Besides, real estate industry is one of the pillar industries of national economy. It has been proved both home and abroad that the residence construction industry has immense market potential and a high industrial linkage, but is seldom obstructed by technological barrier. Residence construction can spur growth in dozens of industries, such as construction, construction material, light manufacturing and electronics, which all together create a considerable employment and evidently stimulate economic growth. It is estimated that currently in China, every RMB100 of investment in residence construction will yield RMB170 to RMB220 of demands in related industries; every ten percent growth in residence construction will hopefully spur one percent of growth in GNP; every 10,000 m 2 increase in floor area constructed

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as residence can provide employment for 100 people; every 100 more people employed in the residence construction industry will create 200 more employment in related industries. The prosperity in the residential construction industry provides stimuli in intermediate product manufacturing such as steel and cement, final product or consumer product manufacturing such as home appliances and furniture, and service industry such as housing moving services and property management services. For these reasons, in many nations, real estate industry is made one of the pillars of the national economy and is given great attention. Also, real estate serves both as residence and investment. The function of a property as a residence lies mainly in providing a safe, comfortable, eyepleasing and convenient dwelling for its owner. Its price, therefore, depends on its buyer’s judgment on whether or not the pricing of the property is reasonable. The investment function of property mainly lies in its ability to hedge against depreciation of assets and the ability to increase the value of assets. Therefore, its price is mainly determined by the buyer’s anticipation on the appreciation of the value of the property. Investing in commodity housing is one of the main approaches people have in hand to hedge against depreciation and increase their property income. Both renting and buying property are ways to achieve the goal of adequate housing for everyone. The ownership of urban housing of China is 72%, among the highest in the world. However, there still exist demands and supply of property renting. Furthermore, retaining a certain number of properties for rent is good for the circulation of property, which will in turn benefit the development of the housing market. The key to keep the balance between renting and buying property is to set a reasonable rent for property. That is to say, we need to maintain a basic balance between the actual rent and the virtual rent of self-owned properties. The so-called virtual rent means the sum of the deposit interests of the down-payment of properties, interests of mortgages and property management fees. Virtual rent is key in determining whether or not the renting and purchase of properties is balanced and an important approach of market regulation. The government should strengthen its macro regulation over the property renting market, which comprises measures to keep the balance between renting and buying properties, such as taxation and subsidy, and protect the rightful interests of tenants and property owners. Welfare housing and commodity housing should be differentiated. In the market economic environment, the government should on one hand, provide low-income group with proper housing subsidies; on the other hand, it should satisfy the reasonable housing demands of the majority based on market disci-

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pline. The main responsibility of the government is to construct welfare housing and make sure all low income people who have difficulties in housing are protected, while those who are not eligible are refused to share any benefits from the program. Commodity housing, on the other hand, is a commodity rather than a public product, which means its price is determined by many market factors and will therefore change as these factors change. The housing market will fluctuate continuously like the stock market. The macro-regulations by the government can affect the price of commodity housing to a certain degree and prevent huge changes. However, the government should not and is incapable of controlling the price; instead, consumers should decide on their own the time of purchase, location, area, decoration, financing pattern, etc. Resolving the housing problem needs the cooperation of the invisible hand of the market and the visible hand of the government. The evolution of housing policies of most nations in the world provides the conclusion that market regulation should take the primary position, while government support should only be a supplement. This is the pattern China should follow. On one hand, the fundamental effect of the market in allocating resources should function, and the force of the market should be used to allow commodity properties to adapt to the varying demands for them, so as to retain an instantaneous equilibrium. On the other hand, the government should establish a housing market system, i.e. the market should be divided and categorized based on the order in which properties enter the market, the types of properties, location of properties, types of transactions, purposes of purchases, etc. Meanwhile, the government should shoulder the responsibility to guarantee housing for low income groups. The cooperation between the two hands should be as such: The government focuses more on maintaining social equity, while the market operates based on the law of value, the supply-demand principle and the competition principle. There are voices that the government should render a housing guarantee for all citizens. Such claims are actually seeking a return to the “welfare allocation of housing” system back in the socialist economic era. This is not only opposite to the direction of socialist market economic reform, but also too big a burden for state finance. Welfare housing programs can only cover low income households without allotted housing from the government and low income households with housing difficulties. According to the fact that China will be in the preliminary state of socialism for a long time, in which GDP per capita and fiscal income will remain in a relatively low level, the government housing guarantee will only be able to cover about 30% of urban residents who are low-income but without allotted housing from the government (including migrant worker households

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that have stayed in the urban area for more than two years) and low income households with housing difficulties (the residential area per head is lower than 40% of the average level of the region), whose number is estimated to be around 20 million. The area of welfare housing should not exceed 60% of the local average area, and there should be a unified standard for both low-rent housing and affordable commodity housing. If carefully planned and implemented step by step, it is expected to provide housing guarantee within three to five years for everyone in need. The function of market regulations should be brought into play in the commodity housing market. As the majority of the housing demands of urban residents will be met in commodity housing market, the state should, based on careful analysis over the effective demand for housing of urban residents, strive to construct and constantly improve a commodity housing market system that fits China’s status quo. It should also increase effective supply, improve agency system and provide financial support. The government should exert proper and effective macro-regulations over the commodity housing market, and pay extra attention to middle income households without residence. It should not, however, intervene too much in demands such as buying a second residence to meet higher housing requirements, and buying residence as investment. Instead, it should hand such matters over to market regulation. The government need not provide special preferential policies for developers of commodity residence. It should leave it in the developers’ own hands to make decisions, shoulder responsibilities and risks, or profit.

FINE-TUNING CHINA’S LOW-RENT HOUSING SYSTEM Low-rent housing is a public product provided by the government to low income groups with housing difficulties as a means to achieve the goal of “adequate housing for all.” The distribution of low-rent housing relies primarily on rent subsidies, and is supplemented by the provision of furniture and in some cases, rent exemption. The property right of low-rent housing belongs to the state. They are, normally speaking, for renting only. Although the idea of building a low-rent housing system dates back to the housing system reform of 1998, the construction of the system made slow progress. The Report on the Construction and Implementation of China’s Urban Low-rent Housing System by the Ministry of Construction reveals that by the end of 2005, the accumulated amount of money used for providing housing for the lowest income households was RMB4.74 billion and the coverage had extended to 329 such thousand households. However, there are still 70 prefectural-level cities or higher

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administrative units that have not established such system, and in Fujian, Henan, Yunnan, Jilin, Gansu and Inner Mongolia, there are still more than half of cities without such a system. The author suggested accelerating the construction of the low-rent housing system in the 2005 NPC and CPPCC. Later the author headed researches conducted by his doctoral students on relevant aspects, and meanwhile, with the results of the overseas survey organized by the China Democratic National Construction Association on low-rent housing regimes in the U.S. and Europe, the author discussed low-rent housing policies with leaders in the Ministry of Construction. Based on his above experience and thinking, the author makes the following six suggestions. First, integrate the low-rent housing system in the scope of social security, and make clear the respective responsibilities of governments at different levels to provide such social security. Research shows that by the first half of 2006, China put in only RMB6 billion in low-rent housing, which only covered less than 15% of eligible population. China should thus intensify its efforts in this aspect. Furthermore, China should integrate existing policies concerning the provision of housing security, accelerate its legislation, establish mid-term, long-term and annual plans, and make the outcomes in the aspect an important indicator in the evaluation of administrative performance of local governments. Second, make it clear that the coverage of the low-rent housing program should include low income households without residence or with housing difficulties, i.e. the state should provide housing security for low income households without a residence or low income households with a residence far lower than the standard of security provision. According to the survey conducted by the Ministry of Construction, households eligible according to the standards amount to 8.2 million, among which, about half are receiving the basic living allowance. The system should also cover migrant worker households who have stayed more than two years in the same city, as they have created wealth for the city and live in the city and should be entitled to the provision of housing security. Third, establish basic eligible standards for housing security based on China’s status quo. Under the precondition of guaranteeing the basic function of residence, the area of each low-rent residence should not exceed the average area of local residences. Based on the differences in income, these households should receive subsidies of different amounts. Households already receiving a basic living allowance should be given full rent exemption, while the rest should be given margin subsidies. Fourth, increase low-rent housing supply housing. The housing supply can be fulfilled in the following two ways. The government should manage construction

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of small-sized low-rent residence. In construction, the government should take into consideration some social factors, such as avoiding concentrating the low-rent residence in a certain area, which may lead to the separation of wealthy and less

wealthy communities. Another way is renting second-hand residence. For property

owners who own extra properties, but are not allowed to sell them or unwilling to sell them, their old apartments can be used to supplement the housing supply. The low income households pay the rent according to market standards, and the government would cover the margin.

Fifth, increase the low-rent housing guarantee fund. Guarantee funds of national

and provincial levels should be founded, and transferred payments should be made to help poorer regions such as western China. According to research, households

with housing difficulties in western China are twice in number of those in the east, but the housing fund of western China is much less than that of the east. Based

on the current requirement of using 5% of the land transferring fees on low-rent

housing, the percentage should gradually rise. In richer areas, the percentage can be raised to 15%.

Sixth, intensify the inspection and management of policies concerning low-

rent housing, build and improve an organizing body over low-rent housing. There are 179 million urban households nationwide. The 8.2 million eligible households

account for only less than 5% of the total. In view of the current economic status and fiscal income of China, it should not be too difficult to cover all these households before 2010.

After the abovementioned suggestions being approved by the State Council, the

author further studied with leaders in the Ministry of Construction on measures in the implementation of the proposal. The Ministry of Construction had made

clear requirements that all cities and counties in China should establish low-rent

housing systems prior to 2008. The leaders in the Ministry of Housing and Urban-

Rural Development made a statement on November 12, 2008 that, in the following three years China would see an increase of 2 million low-rent residences, 4 million affordable commodity residences, and over 1 million reconstructed residences

in forestry industrial regions, agricultural regions and mining regions. The total investment would amount to RMB900 billion, which would be divided and used in

the following three years. The author believes that it is possible to build a relatively sound low-rent housing regime in China before 2011. But the author suggests establishing special entities in charge of the various aspects of the program such

as the investigation of eligibility, subsidy approval, the collection and payment of rents, the allocation of residences and the extension of housing supply.

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STRICT REGULATIONS OVER THE AFFORDABLE HOUSING SYSTEM Affordable commodity housing refers to commodity residences that are part of the social security program constructed by developers or construction units collectively funded by the organization of local governments according to national plans, and then sold with very small profits to low income urban households. The program, previously known as “comfortable housing program,” was renamed in 1998 as affordable commodity housing program. In the following years, it developed relatively fast, as the investment in it, the areas under construction, the sale volume, and the area sold were all on the rise. However, the shares of the area newly put under construction and the area sold of affordable commodity housing have decreased in the total area newly put under construction and the total area sold since 2000. As some unreasonable institutional problems emerged, the program was under constant criticism and question, which can be summarized into the following aspects: The first is insufficient supply. Since 2000, the annual area newly put under construction was kept around 50 million m2 and area sold 40 m 2, which only met the demands of about 400 households. The main reason for the problem is the inactive attitude of local governments. The land for affordable commodity housing is allocated by the local administration, in which all relevant taxes are halved and the price of the land is determined by pricing authorities. These procedures mean a much less fiscal income for the local governments compared with regular commodity housing. In addition, the construction, allocation and management of the program bring much work and troubles to the local governments. Furthermore, as the profit margin stipulated by the government is too low (3%), some developers are less driven to participate in these projects, and some even jerry-build such projects; some developers collude with local governments and used the governments’ authority to allocate the apartments, resulting in the illegal sale of the eligibility to buy apartments, which could be sold at prices as high as more than several hundred thousand RMB, and those who are truly eligible are kept away from the program. Second, the price of affordable commodity housing is relatively high, making it difficult for middle to and low income households to buy them. The main reason for the problem is due to the tendency of local governments to increase fiscal income and the ubiquitous “rent seeking” phenomenon; developers are somehow allowed to dominate the development and sale of affordable commodity housing. They reduce green area at will and increase the floor

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area, leading to a large number of big residences whose areas exceed 100 m 2. Meanwhile, the rise of construction standards also raises the price. In addition, it is common place that developers claim false and higher cost of construction and illegally lift prices, which again make it almost impossible for low income households to afford the residences. Third, due to loopholes in the regulations for the eligibility for affordable commodity housing, a great number of such residences were obtained by higher income people. This problem is caused in part by the difficulties in obtaining accurate information on applicants, and in part by cheating in applications and even bribery to government officials. As a result, in the affordable housing district, we can see luxury sedans all over. There are also people making profits out of the program by renting or reselling these specially priced properties. As a survey by a real estate agency in Beijing shows, the volume of renting transactions in two affordable housing communities in Huilongguan and Tiantongyuan of Changping District has accounted for 78.8% of the total volume of the district, and sale transactions of the two communities is also on the rise. Some people, after managing to buy several affordable commodity residences, combine them into one luxury mansion. The last problem is the locations of affordable commodity residences in many cities are too remote. In addition, as they are often badly planned and arranged in unreasonable structures and lack necessary facilities, the high living cost of these residences put extra financial pressure on their owners despite lower prices. Furthermore, as in some cities, affordable commodity properties make not much difference from regular commodity properties, but require much more complex procedures in application, transfer and resale, many eligible households do not apply for them. As the affordable commodity housing is neither economic nor affordable, the program has long been under criticism. Some scholars even suggested cancelling the program. In order to regulate and improve the affordable commodity housing regime, governments at different levels put forth various regulations. On November 30, 2007, seven ministries, including the Ministry of Construction promulgated the Regulations on Affordable Commodity Housing , which clearly states that the owners of affordable commodity residences have only partial ownership of the residences. Local governments, such as the Shanghai municipality, also promulgated local regulations over affordable commodity housing. The author holds that, despite the many problems emerged in the past decade, the affordable commodity housing program has indeed solved the housing difficulties for some low income households and thus played a certain role in

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housing security. With improvement in its regime and a stricter implementation, the program can still be an indispensable part of China’s housing supply system. According to the theories of complex science, a system should comprise both institution and mechanism. Institution refers to the status and structure of the system at a certain time, while mechanism refers to the process and drives of the evolvement of the system. The two aspects are mutually dependent, as institution is the beginning point and result of evolution, while mechanism is the route of the evolution. The mutual effects of the agents within the system and the mutual effects between the system and external environment will lead to a self-organizing effect of the system, which will in turn form the multi-level structure and functional structure of the system and push the system to evolve in a certain direction. Policies from the government are only external cause. Only when it changes people’s code of conduct of can it truly function. Therefore, in designing regulations concerning affordable commodity housing, the following points should be taken into consideration to eliminate the possibility of ineligible people getting these properties or any people profiteering from these properties: 1) Moderate standards. As affordable commodity housing is a kind of welfare housing to meet the demands of medium and low income households, its standards should be the same as low-rent housing. By doing so, governments would have an easier time managing construction and receiving the finished construction, and higher income households would find it less attractive to live in or invest in such properties. In addition, complaints from middle- income households disqualified for the program (they complain that the sum of the income of eligible households and governmental subsidies exceeds their income) would be less. When low income households earn a better income, they would be allowed to buy the low-rent properties they are living in. 2) Partial ownership. Affordable commodity housing is welfare properties sold at prices lower than market prices. The margin of the two prices are subsidized by public finance, therefore this part of ownership should belong to the government. Affordable commodity properties are not allowed to be rented, to be sold directly or be transferred in unofficial procedures. When low income households have a better income and want to live in better residences, governments can buy the part of ownership held by the households at prices of second-hand properties. 3) Severely punish cheating. To people or households that cheat by hiding evidence of their existing properties, reporting lower income or reporting more household members, their eligibility to apply and their ownership of affordable commodity properties should be revoked and they should be gravely punished. 4) Severely punish corruption. Land allocation for affordable commodity

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housing should be more transparent. And any collusion between government officials and developers should be gravely punished. These are a factor that determines the success or failure of the program. A recent scenario of one household getting six consecutive opportunities to buy affordable commodity properties in a lottery was a typical case in which real estate agency colluded with government officials and cheated in the allocation of affordable commodity housing.

ANALYSIS ON THE MAIN PROBLEMS OF CHINA’S COMMODITY HOUSING SYSTEM Since the welfare housing distribution system was called to an end and was replaced by commodity housing in 1998, the property market of China has seen rapid development. From 1997 to 2008, the area newly put under construction, area completed and area sold have risen by respective 240%, 140% and 860%. The housing condition of most urban residents has improved, with over 80% of households qualified with registered permanent residence (hukou ). In the decade-long development of China’s commodity housing market, debates never ceased as there have been many different opinions in both the understanding and the practice of the market. Such a situation presents a lot difficulties in the construction, sale, management and regulations of the market, and to some degree, even misleads government decisions and the behavior of consumers, resulting in the still-chaotic status of the housing market. To facilitate the healthy development of China’s housing market, careful analysis on the following aspects should be conducted.

Distinguishing the Welfare Housing and the Commodity Housing Welfare housing, or social security housing and commodity housing are two completely different concepts, as the former is a type of public products offered by the government whose prices are determined by the government according to certain welfare standards, while the later are a type of goods that are traded freely in the market, whose prices are mainly determined by the supply-demand relation. However, many people make their comments on the issue mixing the two concepts consciously or unconsciously. For instance, some say that there are 70% of people who cannot afford their homes in China, so to guarantee social equity, the government is responsible to suppress property price. But as a matter of fact, for those 30% of low income households, even if the property prices plummet by 50%, they still cannot afford buying their own homes. Therefore,

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such seemingly just claims are made on behalf of medium or higher income households, among which, many want to improve their housing condition or want to buy their second properties by obtaining commodity properties at a lower price. If property price does drop by 50%, not only both the commodity housing market and China’s economic development would be greatly impeded, 70% of urban residents who own properties would find their homes greatly depreciated.

Huge Demands in China’s Commodity Housing Market As housing is a living necessity, and as people always have the desire to improve their living conditions (from simply desiring a bigger space to desiring better functions, better environment, better services and better feelings), the increase in the demands for commodity housing will accompany the increase in population, resident income, and the development of the social economy. However, such demands become effective only when the buyers are capable of buying. Many people take the property price-income ratio as an effective standard for calculating effective demands. The ratio, as it is much higher than the international average of 3:6, has led to the conclusion that most of the Chinese population is incapable of commodity housing purchase, and thus a further conclusion that only by greatly suppressing property prices can China lift its effective demands and facilitate the development of commodity housing market. But in fact over the past decade, despite fluctuations, property prices have been on quite a rapid rise overall, which has also been accompanied by rises in the area newly put under construction, area completed and area sold. Therefore, the above argument is not in line with the facts on the ground in China. First, the property price-income ratio should not be calculated using national average property price and the average income of all citizens, as the demands of low income households, which accounted for 30% of China’s total urban population, are impossible to be satisfied through commodity housing market. For this reason, it is more appropriate to adopt the definition provided by the UN Urban Governance Index, which is “the ratio between the free market prices of residential units and the annual income of middle income households.” Moreover, the UN-HABITAT pointed out that comparison of the property priceincome ratio among nations should be extra prudent, rather than introducing any “international norm” that the ratio should be between 4:1 and 6:1. Some scholars use the average income of Beijing residents and the price of a 100 m2

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apartment (RMB3,000 per m2) in the calculations, which leads to a ridiculous ratio of around 20:1. The author and his students (hereinafter referred to as “we”) built a model of property purchasing ability based on the consumption structure of urban residents and their financing pattern in property purchase. We used the 2004 statistics in Beijing in an empirical study on the property purchasing ability of high, relatively high, middle, relatively low, and low income households, and then obtained the affordable property prices and the property-price-to-income ratios of households with different incomes form the matrix of household expenses. The result shows that the acceptable property price-income ratio for middle income group is 7.6. In analysis on effective demands, the following situations should be considered. First, the elasticity of demands is very low for middle income households without homes. For some of them, with help from their parents or relatives to make the down payment, their ability to buy homes is significantly increased; for some others, by renting their residences till increases in their income and savings enable them to buy their homes, their effective demands will be observed in the future. Second, as those who want to improve living conditions or purchase their second homes may opt to sell the properties they currently own, their purchasing ability will greatly exceeds that of those whose income comes mainly from salaries, thus resulting in great differences in the calculation of property price-income ratio. Third, the property price-income ratio is only a static data. If the increase in income is faster than the increase in property prices, the effective demands for commodity housing will keep rising. Fourth, under the current circumstances where real estate mortgages are not yet securitized, whenever stock market falls, investment demands for commodity housing will rise, resulting in a capital influx into the housing market; with the anticipation of a rising RMB and inflation, both demands for investment and speculation in housing market will surge. The influx of domestic and foreign capital into the commodity housing markets of Beijing, Shanghai, Shenzhen, Hangzhou, etc., boosted the property prices in these cities.

The Structural Supply-Demand Imbalance in China’s Commodity Housing Market Based on the relatively large empty commodity property area, some scholars asserted that supply has surpassed demand in China’s commodity housing market and foresaw a decrease in property prices and the area newly put under construction. But in fact both the property prices and the area newly put under

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construction are still rising despite short-term fluctuations. Therefore, we need to conduct a further study on where the above argument is wrong. The supply of commodity housing market comprises two parts, namely, the reserve and the increase. Reserve refers to the sum of commodity properties that buyers can instantly move in at a given time, while the increase refers to the number of properties completed during a certain length of time (normally one year). As the increase in the current circle will become the reserve in the next circle, and the reserve will decrease due to reasons such as natural losses and urban redevelopment, a certain ratio should be maintained between the two. The volume of empty commodity properties refers to the floor area of commodity properties ready to for sale or leasing but not yet sold or rented out, which include properties completed in the previous and current circles. The fact that the increase can only be converted into reserves after a certain period of time (normally one year), and that fact that the current reserve will reduce lead to the requirement that the empty property area should be bigger than the sum of area sold and area rented in the next circle. Therefore, keeping a certain volume of empty property area is necessary and reasonable. The main reason for the big volume of empty property area in the commodity property market is a structural supply-demand imbalance, which can lead to the oversupply of high-end properties and under-supply of average properties. Moreover, the average area of high-end properties is way larger than that of average properties, thus producing a seemingly large volume of empty area. The supply-demand balance of commodity housing is dynamic and subject to influences by various factors. Commodity housing market is closely linked to the financial system, as both homebuyers and developers need to borrow money from banks, thus making property price and loan interest rate the main factors in housing market. According to economic principles, when property price rises, developers should increase housing supply and the demand of buyers will in turn decrease, and vice versa; when interest rate lowers, both supply and demand will increase, and vice versa. Under certain combination of property prices and loan interest rates, the balance between supply and demand can be reached, the result of the fundamental function of allocating resources by the invisible hand of market. The supply-demand balance also depends on the anticipation of future prices by both buyers and sellers. If property prices are expected to fall, developers will hope to sell faster, while buyers will want to wait for the fall, thus leading to an oversupply, and vice versa.

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According to dialectic principles, everything is constantly undergoing changes, therefore resulting in a relative balance and an absolute imbalance. According to the emerging complex science, despite the fact that every homebuyer decides by himself when and which to buy in the process of real estate purchase, his decision, however, is inevitably subject to the influence of decisions made by other people and the external environment. Property buyers, developers, banks, government and other factors exert influences on each other, which add up to a self-organizing effect that pushes the market to develop in a certain direction. Therefore, although the market seems to be in disorder from a micro and short-term perspective, it demonstrates a certain direction in its longterm and macro development. As such, the market shows a periodic upward trend despite short-term fluctuations.

Four Major Constituents of China’s Property Prices As mentioned earlier, the effective demand in commodity housing market is relatively high and the main reason for the rises in price is insufficient effective supply. Such a supply-demand relationship precludes the possibility of a bigscaled fall in prices. Overall, property prices can be divided into four major parts: land price; construction and installation fees, which include preliminary engineering fees, infrastructure construction fees, construction and installation project fees, public facility fees, indirect development fees, sundry fees, unexpected expenses, accounting fees, management fees, sale fees, etc.; taxes, which mainly include operational tax, additional urban construction tax, additional educational tax, incremental tax on land value, income tax, etc.; and net profits of projects. There are heated debates over the disclosure of the cost of commodity housing. Many developers object to the idea and stress that the cost is commercial secret and contains a “gray cost” that is inappropriate to be disclosed. In view of this, we propose a concept of reference cost, which can be used to estimate cost with an uncertain objective environment and incomplete information. In 2005, we applied the reference cost in three case studies. The first case was a project in Beijing. The market price was RMB8,211 per m2, within which, the land cost was RMB1,411 (17.2%), the construction and installation fees was RMB2,583.9 (31.5%), taxes was RMB1,693.9 (20.6%) and net profits were RMB2,522.2 (30.7%). The second case was a project in Shanghai. The market price was RMB17,059 per m 2 , within which, the land cost was RMB4,900

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(28.7%), the construction and installation fees was RMB3,683.4 (21.6%), taxes was RMB3,425.6 (20.1%) and net profits were RMB5,050 (29.6%). The third case was a project in Fuzhou. The market price was RMB3,900 per m2, within which, the land cost was RMB4,742.9 (19.0%), the construction and installation fees was RMB1,317.6 (33.8%), taxes was RMB750.7 (19.2%) and net profits were RMB1,088.7 (27.9%). In the three cases we can see that in the four components of market prices, the overall cost of projects (land costs and construction and installation fees) accounted for round half of the prices, while the rest were gross profits (net profits and taxes). Despite the many changes after 2005 in the commodity housing market of China, the above constitutions of property prices can still be used for reference and further study. First, land cost approximated 40% to 60% of the overall project cost, and 20% to 30% of the property price, which is basically a credible proportion. For instance, a survey by the Real Estate Association under the Association of Industry and Commerce shows revealed a land cost proportion of 58.2% in the total direct development cost; another example was the statement made by the vice minister of the Ministry of Land and Resources at a June 23, 2009 press conference that, as shown in a survey by the ministry, the land price accounted for 15% to 30% of the property price in China, with the average being 23.2%. Due to the scarcity of land resources, land prices are expected to continue to rise in the future. Second, the construction and installation fees accounted for only around a quarter of the total property price. This “real” cost as the sum of material cost and labor cost takes up a lower share compared with the international level, therefore it is inappropriate to make direct comparison between the share of land price in the total property price in China and that in foreign countries. It is foreseeable that, as the prices of construction materials and labor rise, this part of the cost will also rise. Third, taxes accounted for about 20% of property prices. Technically, as the tax rate dropped from 33% to 25% after the modified Law of the People’s Republic of China on Enterprise Income Tax became effective since January 1, 2007, the share of taxes in the total property price should reduce. But due to the looser tax levying of the incremental taxes on land value in 2005, the above three cases did not incorporate this tax item. If the incremental taxes on land value of the three cases were paid after the account resettlement of real estate enterprises by the National Administration of Taxation on February 1, 2007, the shares taken up by taxes in the three cases would became 26% to 33% of their respective total property prices. This increased volume of taxes offset the decreased volume of taxes under the new tax law. As a result, the taxes accounted for around 25% of the property price in the above three cases.

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Fourth, the net profits of developers accounted for about 30%, which is lowered to 25% after repaying the incremental taxes on land value. This part of money comprises some “gray costs,” i.e., the expenses for rent seeking. As the development of commodity housing needs to go through many governmental procedures, this part of expenses can amount to a large number but is also the most difficult to be checked. In conclusion, among four major components of property price, land price and construction and installation fees, or the overall cost, would gradually rise rather than fall. To lower the property price, therefore, means to lower the taxes collected by governments and net profits obtained by developers. Property price will not fall unless the government and developers give up some of their interests. Taxation is a major part of fiscal income and is therefore unlikely to be reduced. Investing in commodity housing is a relatively risky investment, as it is subject to market risks. Moreover, as investors often make large investment in property market and are subject to financial risks, the profit margin of property investment should most appropriately remain above 15%. In view of this, under normal circumstances, the price of China’s commodity housing market will not decrease by large scale. Instead, it will rise in the long run.

Bubbles in the Real Estate Market Since 2003, the property market in Shanghai, Hangzhou and other cities have seen tremendous and continued increase in property prices, thus generating the heated debate on whether or not China has real estate bubbles in some areas. Historically, although bubble burst in real estate market was very rare, once the bubble burst occurred, it would bring long-term damage to the economy and society of the nations involved. Although China remained basically intact in the crisis due to its underdeveloped financial system and financial innovations and stricter control over mortgages, the property bubbles in China should raise our attention. Asset bubble refers to the deviation in price from the basic value of the asset. It refers to the scenario in which a sudden increase in the price of a certain asset or a group of assets in consecutive operations. The preliminary rise in asset prices generates the expectation that the price will continue to rise in the long term, thus attracting new speculative investors, which in turn triggers a new round of deviations from the rational price of the asset. What these speculative buyers are interested in is the returns in the trading of the assets, rather than the use and profitability of the assets themselves. The expansion of bubble may lead to temporary prosperity and craze, but the burst after the bubble expands

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to a certain degree can cause plummeting of the asset prices and trigger an economic recession, even financial crisis. It can therefore be said that speculation, bubbles and risks coexist. Whenever there are speculations, there are bubbles, and thus risks. Currently, China has an abundant liquidity but few direct investment instruments, and the securitization of mortgages is still not allowed. People often purchase commodity properties as an investment or speculation, so as to hedge against inflation and increase property income. This naturally brings some speculative elements and therefore bubbles into the commodity housing market. Bubble burst of the market, once happens, will bring turbulence to the market and risks to investors. Bubbles in an appropriate amount, like proper speculations, are beneficial to the property market. Proper amount of bubbles will help boost confidence in profiting through speculation in the market and attracts more capital, which will in turn further invigorate the market. However, the continued expansion of bubbles will lead to excessive speculation, which may subsequently cause bubble burst and panic. In such cases, the ensuing dumping of properties may result in property prices lower than the rational prices, producing negative bubbles. The author suggests categorizing property bubbles into objective bubbles and subjective bubbles, according to the theory of uncertainty decision-making science. While the former originates from the objective uncertainties of the fundamentals of economy, the later is caused by the subjective misjudgment on the prospect of the real estate market. The price of commodity properties is under the influences of supply-demand relation, land price, construction and installation fees, taxes, interest rate and other factors, i.e., it is closely linked to the fundamentals of economy, and therefore requires past and present statistics to make predictions. Although the rapid progress of information technology greatly facilitates prediction techniques such as data mining, knowledge finding in database, analysis on code data, intelligent mining, etc., which greatly improves the accuracy of predictions. The changes in the property market and interest rates can be predicted to some degree, according to which, investors may make relative adjustment to their investment strategies. However, due the uncertainties of the objective world and limitation of the mankind in understanding such uncertainties, there are unavoidable deviations between predictions and actual outcomes. In this sense, bubbles existing objectively in the property market can be referred to as objective bubbles. According to the principles of complex science, in a complex system where men are involved, the expectations of different people about the future are

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always varied. However, mutual influences among people and the guiding effect of the external environment on people will create a self-organizing effect and push the system to develop in a certain direction. The subjective bubbles in the property market is caused by this self-organizing effect, which will also cause positive feedbacks (“Greater Fools”), and eventually create a big gap between the actual price and the rational price of properties. The rational price of commodity properties is an abstract concept very difficult to determine and can only be substituted with the reasonable price. According to the results of the above reference cost analyses and the actual situation of China’s commodity housing market, the author suggests using the sum of the construction and installation costs and a reasonable floor price of developed land as the reasonable price of a property. When price exceeds value, it can be concluded that bubbles exist. The price of developed land is determined by the city where the land is located, its location in the city (for instance, the basis land price of Beijing in 2002 was divided into 10 levels), and other fees such as compensation for removal and preliminary development charges. A reasonable price of developed land can be obtained by adding the reasonable increases of land price and other fees to the 2005 price of developed land. The price thus obtained can be deemed as similar to the base price of land for sale or auction. Land price is a main factor affecting property price. Land price bubbles will cause property price bubbles. Since the nationwide promotion of the land transfer mechanism of auctioning, land prices have seen surges in many cities. Lands auctioned with excessively high prices have also become common place since then. Reportedly, in the afternoon of June 30, 2009, after near 100 rounds of bidding, Franshion Properties won its bid with RMB4.1 billion in the auction of the fifteenth land of Guangqu Road (its base price is RMB1.8 billion). The floor price of the land was as high as RMB15,321 per m2. We conducted a study under the “Myopic REE” theoretical mode, in which we introduced the concept “negative dividend,” and proved that under the actual discount rate the land price is a discount Martingale. Using the land price data excluding inflation rate of eight Japanese cities, we built a land bubble early warning model, with which we conducted further empirical studies on the states of property bubbles of 16 major Chinese cities from 2003 to 2004. The result of the empirical studies shows that serious bubbles existed in Hangzhou, Shanghai and Shenyang in 2004, while signs of overheated property markets are observed in Chengdu and Chongqing. More recently, we used the model to conduct a preliminary study with indexes of property markets in 35 major Chinese cities from 2005 to 2008. The result shows the property price

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of China has entered a bubble danger zone. Among these cities, the state of Hangzhou and Ningbo is very severe, while those of Beijing, Tianjin, Shanghai, Dalian, Fuzhou, Xiamen, Changsha, Hohhot, Chengdu, and Haikou relatively severe. When property price exceeds one time of its overall reasonable cost, the part of excessive revenue, excluding land bubbles, are all gross profit bubbles, which are shared between the developer and the government. As the incremental tax on land value is calculated under a four-layer accumulative system, the more the gross profit bubbles, the more the government earns. As the scope of real estate industry is often large and the value of properties is relatively high, bubble burst in the industry can have major effects on the national economy through credit and loan, investment and consumption. For this reason, excessive speculations should be strictly prevented by setting regulations in its institution and making timely adjustment in policies over the industry. Legislation should be applied to regulate the conduct of developers and government officials. Moreover, the bubbles in real estate market should be reduced by increasing the supply of commodity housing that meets the market demand.

SUGGESTIONS TO FACILITATE THE SOUND DEVELOPMENT OF CHINA’S COMMODITY HOUSING MARKET As housing is a living necessity and concerns the interests of every households, the government is both responsible to provide security housing for low income households based on the principle of social equity, and to eliminate various chaotic phenomena in the market, suppress excessive speculation and facilitate the development of a healthy commodity housing market by means of legislation, macro regulations and guiding the media, under the precondition of allowing the market to function as the fundamental force in allocating resources.

Formulating Laws and Regulations for Commodity Housing Market The laws and regulations of real estate form the legal foundation for establishing the institution of properties, implementing policies on properties, resolving disputes in the property industry, establishing and maintaining property rights, and guaranteeing the managerial functions of administrative bodies over the industry. Since the reform and opening-up, China has formulated a great number of laws and regulations concerning real estate, forming a legal framework

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anchored by the Land Management Law and the Law on the Administration of the Urban Real Estate and supplemented by parallel separate regulations and a variety of other regulations. However, the quality of legislation still needs to be improved, especially the systemization of legislation. Real estate laws are a legal system that encompasses civil law, economic law and legal administrative bodies. It concerns the six major links in the property market, which are, respectively, capital operation, designing and planning, land acquisition and removal of former residents, construction, sale and renting, and property management and services. It is used to legally regulate relations among aspects concerning land, such as land transfer and land leasing, as well as relations among aspects concerning properties, such as the development, assessment, transfer, renting, registration, pledging, agency, property management, etc. All laws and regulations concerning real estate should be further regulated in the following aspects: first, regulate the conducts of market subjects, including property buyers, tenants, developers, banks, government, agencies, etc.; second, regulate the basic relations in the market, such as contracts, trust, agency, etc.; and third, regulate the order of market competition, such as anti-trust, anti-illicit competition, etc. Only when laws in place in the three aspects can a sound property market be built. A complete legal system should comprise three layers of laws, which are, respectively, basic laws, separate laws, and departmental and local regulations. Despite the existence of the Land Management Law and the Law on the Administration of the Urban Real Estate , they both cannot be used as the basic laws of real estate. Moreover, the relations between them are very chaotic, as some of their items overlap or contradict each other in some cases. In terms of separate laws, some items are too abstract to be put into practice, and there are still voids to be filled. For instance, the establishment of residence law and property transfer law are still pending. In terms of departmental and local regulations, due to the dispersed management of real estate, different departments tend to expand their own authorities out of self interests, which result in repeated legislations in some aspects, and even contradicting items of the regulations from different departments. Some local regulations overly stress their own uniqueness, resulting in items in local regulations that contradict departmental regulations, sometimes even laws. Due to the bad systemization of real estate legislation, more detailed items or judicial explanations are often required, thus creating many potential troubles for the enforcement and jurisdiction of real estate laws, and in turn impeding the justice of law and the effect of legislation. For instance, in judging cases of real estate disputes, the court made its jurisdiction based only on the reference

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to departmental regulations or local regulations, resulting in a large number of cases being handled differently. The author suggests that the NPC Standing Committee clean up the real estate laws of China, establish real estate basic laws and other relevant laws based on the spirits of the Property Law , establish important absent separate legislations and correct the items in departmental and local regulations that are not in line with current laws.

Strengthening the Macro-regulations over Commodity Housing Market Speculation in the property market are mostly aimless, while excessive speculations in the property market would lead to great fluctuations in the market, and impede economic development, the interests of people and social equity, the state should therefore strengthen its control over the industry and facilitate its healthy development by macro regulations. Where the real estate legal system is still not complete, policies to some degree play an important supplementary role. In the course of China’s housing reform, governments at different levels put forth a great number of policies, exerting great positive influence on property industry. However, there were also policies that did not yield expected effects, which were later adjusted. For instance, the Provisional Regulations on the Payment of Income of the Sale of State-Owned Residences jointly promulgated by the Ministry of Finance, the Leading Group of Housing Reform of the State Council, Ministry of Construction on November 23, 1994 stipulated the following proportion of income that needs to be handed in to higher authorities: Property management departments and administrative organs, and institutions implementing full budget control should hand in 85% of the income obtained in the sale of stateowned residence; institutions implementing margin budget control should hand in 60%; institutions implementing independent budget control, 30%; enterprises, 10%. Furthermore, in the Circulation on the Collection and Payment of the Income of the Sale of State-Owned Residences jointly promulgated by the Ministry of Finance and the PBOC on June 14, 1996, emphasis were put on the timely payment of the required amount. Such policies dampened the initiative of property right administrative organizations, which led to a standstill of the sale of state-owned properties. Nothing changed until the National Conference on the Housing Reform convened in Shanghai in December 1995 pointed out that the sale revenue of properties was a special fund for the housing construction and housing reform, which enterprises and institutions were thereinafter allowed to retain. As a result of a clear allocation policy, the sale of

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state-owned properties was largely facilitated as property right administrative organizations became very motivated to sell. The author holds that there is no such thing as a perfect policy, or such a policy that can remain unchanged through time. Any policy should be evaluated based on its advantages and disadvantages, and when the former outweighs the later, it should be carried out. Any policy is made under a specific circumstance, and when things change, the policy should change as well. A good policy today might become an obstacle for development later. In view of this, the establishment of macro regulatory policies should be legal, reasonable, timely and effective. The function of policy is to guide the conduct and change people’s rules in decision-making. When a policy fails to guide people’s behavior, it will not yield the expected outcome. The view that policy guides conducts or behaviors is in line with dialectics, i.e., intrinsic causes are the foundation of changes, while extrinsic causes are the conditions for changes; extrinsic causes rely on intrinsic ones to function. Policies are extrinsic causes, whose effects can only be seen through the behaviors of market subjects such as buyers and developers. Only when they accept the policies can the expected effects of the policies be realized. Since 2006, in view of the surging property prices, related government departments hoped to establish certain policies to lower the prices. They promulgated a string of policies, which ranged from controlling the supply of land, increasing the supply of small sized apartments, increasing taxes, intensifying supervision on tax collection, tightening credit, lifting downpayment, restricting the purchase of the second property by a household, to intensifying management on the property purchase by foreign entities and individuals, none of which led to desired outcomes. Due to the rise in cost and undersupply in the market, property prices kept rising all the way until the impact of financial crisis was felt in October 2007. Amid voices and expectations that the prices would keep falling, the volume of trade in the commodity housing market started to shrink. In some major cities, scenarios of mortgage defaults and returning properties started to occur. The property market shrinkage led to declining demand for many products, such as steel and cement, and a rise in unemployment rate (a large proportion of migrant workers work in construction), which posed difficulties to the government’s efforts to fight the financial crisis by spurring demand. Facing such a grim prospect, some of the big and medium–sized cities put forth their rescue measures, while the General Office of the State Council promulgated the Several Opinions of the General Office of the State Council on Promoting the Healthy Development of the Real Estate Market on November 21,

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2008 on the central government’s website, pledging to intensify the construction of security housing, further improve the living standards of the public and promote the healthy development of the property market. In its later policies, the government reiterated that real estate was a pillar industry for the national economy, stressed the importance of expanding final consumption such as housing consumption, pledged to accelerate the construction and investment in security housing, exempted some properties from transaction taxes, lowered the minimum principal capital requirement for real estate investment, increase its loaning support, accelerated financial innovations, broadened financing approaches for real estate, etc. When making macro regulations, the government should take into consideration the basic economic principles (law of value, principle of supply and demand, competition principle), conduct careful analysis on the basic stances and behavioral tendencies of property buyers, developers, agencies, banks and other aspects, and properly balance the interests of all these sides, so as to have a better timing in putting forth its new policies with well-measured strength. In terms of commodity housing policies, the middle-income group that is without homes demands special attention. The author suggests lowering the down-payment to 10% if the buyers of this group purchase commodity properties less than 60 m2 and the monthly payment staying lower than half of their salaries.

Guiding the Public Opinion to a Correct Direction In recent years, due to the surge in property price, grumbling can be heard everywhere on the internet. Some scholars and media make it their claim to fame and make sensational remarks on the topic, with some even demonizing the real estate industry. In view of this, we should carefully analyze the voices on the internet and keep public opinion in the correct direction, so as to further implement the housing reform and facilitate the healthy growth of the commodity housing market. First, we should note that China is still currently in the preliminary state of socialism, which determines that the housing security system of China should be moderate, fair and effective. According to the fiscal strength of the government, simply making sure low income households with housing difficulties are given housing protection in three to five years is already a formidable task, not to mention covering also middle income households. Second, the price of commodity housing is primarily determined by

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market supply and demand. The government can guide the market by macro regulations but cannot directly intervene in property prices. The government should, however, try its best to help solve the housing difficulties of some middle income households with preferential policies. For those middle income households that want to buy a better residence, they should make their own decision based on the state of the housing market. Third, it is very necessary to fight corruption in the commodity housing market. The “gray cost” in the net profits of developers as mentioned earlier is, to put it in a candid way, bribes to government officials. Furthermore, the author recommends heavier punishment for government officials involved in bribery so that the environment of real estate industry can be sanitized. However, as the cost analysis of property prices shows, fighting corruption would not have a major effect on lowering property price as the “grey cost” only accounts for 5% to 10% of price. It is unrealistic to try to lower property price by simply fighting corruption. However, we should be vigilant about opinions that attribute high property prices to official corrupted. Fourth, advocate moderate consumption. China has a large population but limited land resources. Moreover, it is also saddled with environmental problems, and other aspects such as the underdeveloped urban construction and public services. Therefore, moderate consumption in housing should be advocated. The desire to live in better places will always exist, but we should base our aspiration on China’s status quo. An estimate by the author based on foreign statistics shows that the ratio of the living area (m 2 ) to the per capita GDP (USD10,000) in developed nations is between 10 and 20. In 2008 the GDP per capita of China was USD3,267, while the average floor area was 26.7 m 2 (equals to 18.7 m2 of lodging area). Even calculated by PPP, the ratio between the average living area and GDP per capita still approximates 30. As property prices in China are still relatively low but on a rapid rise, a higher ratio is understandable, which, however, still shows that the average living conditions is basically in line with the developmental level of the nation. The living area of middle income households in Beijing, Shanghai, Shenzhen and Guangzhou is similar to that of regular white collar households in New York, Tokyo, Singapore, Hong Kong and Taipei. Therefore, consumers should think carefully about their own financial capacities and the opportunities to purchase properties, so as to make wise decisions in aspects like the size and location of properties. When suitable properties are hard to find, renting is a good alternative. People should be warmed against the consequences of excessive consumption. Fifth, the investment function of commodity housing should not be

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ignored. Currently, public opinions pose a sharp contrast in its attitudes towards speculation in the property market and in the stock market, with the former described as some unforgivable crime and the later heaped with compliments. As a matter of fact, speculating in both the two markets are speculations and means of increasing property income. We should note that capital always seesaws between the two markets, i.e., when the stock market falls the capital flows to property market, and vice versa. Sixth, strengthen legal awareness. The author does not approve of the title “property slave,” given to a person who starts to make mortgage payments. Mortgage is a progress, in the sense that it allows people to enjoy the living in the new residences in advance before they have enough savings, which was usually the case before. Making monthly mortgage payments is the obligation stipulated in the Contract Law . It is clear that government or banks are not to blame for this.

Developing Second-hand Housing Market The second-hand housing market (secondary commodity housing market) is an integral part of commodity housing market. The secondary and primary housing markets boost and supplement each other. In many developed nations, the secondary market is the main part of commodity housing market. Developing secondary market can both invigorate the commodity housing reserve and ease the pressure on primary market, therefore facilitating the healthy development of commodity housing market as a whole. In recent years, the second-hand housing market developed rapidly, with the trade volume increasing year after year. In the first half of 2009, the trade volume of second-hand housing in Beijing exceeded that of first-hand housing. However, problems also exist in the course of development of China’s second-hand housing. These problems require careful study and solution, so as to better foster and develop China’s second-hand housing market. First, an information system should be built for second-hand housing as part of the effort to eliminate asymmetric information in the process of purchasing and leasing second-hand properties. Currently there are a number of agencies that collect information of clients and properties in illegal approaches. They assist in speculating properties, lift property price, and disturb market order. The author suggests choosing a few big or medium–sized cities as trial cities of such an information system. In these cities, an information system aimed at rendering services for people who are interested in buying second properties would be jointly built by the information department, construction department, taxation department, department of industry and commerce, etc.

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Second, the taxes in the second-hand housing transaction should be lowered. The buyers of second-hand properties are required to pay taxes greater both in volume and in types than first-hand buyers. Taxes levied from secondhand housing transaction include evaluation fees, agency fees, operational tax, income tax, deed tax, stamp tax, transfer fees, property repairing fund, etc, which amount to 14.1% of the total cost of the properties. In contrast, buyers of first-hand properties are only required to pay deed tax, stamp tax and property repairing fund, amounting to only 3.51% of the total property price. This means that in a transaction involved RMB1 million, the second-hand property buyer would have to pay one hundred thousand more than the first-hand property buyer. Third, supervision over real estate agencies needs to be intensified. As information in second-hand housing market is less accessible when compared to the first-hand housing market, around 80% of second-hand housing transactions take place through agencies. These agencies are often where the trouble lies. Often with ill-cultivated personnel, these agencies overcharge their customers, evade taxes, engage in disorder competition, etc. For this reason, it is proposed that supervision over these agencies be intensified and requirements should also be imposed on them for their self-discipline.

Promoting Financial Innovations in the Property Market The development of real estate is closely linked to financial system. The financial services in the real estate market are currently mainly serviced by commercial banks, such as homebuyers getting mortgages and developers getting loans from banks. Such a traditional pattern put banks in a dangerous position as they bear default risks on both ends. Furthermore, their liquidity is lowered as they hold a great number of long-term mortgages. For developers, such indirect financing often has a repayment term shorter than the development term of their projects, which imposes greater pressure for repayment and a higher cost of financing on the developers. For social investors who often do not have a large enough sum of money for real estate investment, they have very little chance to invest in real estate as a means of increasing their property income. For this reason, we should learn from developed nations their experience in developing financial derivatives and spur financial innovations in the real estate industry. Financial derivatives are the main content of financial innovations, which are aimed for lifting financial efficiency and hedging against risks. However, they can also be used as speculative instruments. China should prudently promote

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financial innovations and enhance its financial efficiency and its financial international competitiveness. In financial innovation, China should avoid excessive speculation and all possible risks, but it should not stop advancing out of fear for the two. There is one famous saying in institutional economics, “transactions before institutions.” It is impossible to delay transactions till the day when a perfect institution is in place. The only feasible way is to conduct transactions first with a basic institution, and constantly improve the institution based on problems spotted during transactions. Based on the status quo in China, the author suggests trials programs for real estate investment trusts and mortgage-backed securities. Real estate investment trusts, or REITs are securitized industrial investment funds. It collects the capital from investors by giving them trust certificates. It then entrusts professional fund custodian organizations with the fund, which will be invested in the real estate market by prof essional investment organizations. By doing so, risks are effectively lowered, while the comprehensive income of investments such as property renting, will be distributed to the investors pro rata. The Several Opinions of the General Office of the State Council on Providing Financial Support for Economic Development promulgated on December 8, 2008 clearly points out that China should “start trial programs of REIT, so as to broaden the financing approaches of real estate enterprises.” Soon after this, banks, securities, local governments and real estate enterprises all actively prepared for the trial program. The author suggests that China should be quick in establishing relevant laws and regulations, as well as the administrative regime. It should also be quick in introducing and cultivating professional talents. After initial experience is obtained in different types of trial programs, the positioning and types of REITs of China should be established. With the tight control over the quality of mortgages and the upward trend of China’s housing market, MBS presents low risks yet yields high returns. It is an investment vehicle in line with the demand of the general public. Furthermore, it is mutually supplementary with REITs, as the later focus mainly on commercial real estate and property renting. The author suggests carrying out MBS trial programs as soon as possible. The housing reform of China is a complicated, arduous and systematic project. We have learnt a lot precious experience both in the success and failures of the reform. The decision-making body of the reform should follow Deng’s guiding thoughts Xiaoping, prioritize the need of people, coordinate the sustainable scientific outlook of development, get a in-depth understanding of China, make calm and long-sighted decisions, establish the target pattern of the reform, keep the equilibrium of different interest parties, carry out different

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measures with a good control of the strength and timing, be practical and hardworking, so as to continuously promote the reform of the housing system of urban and rural areas, and build a relatively sound housing system in line with the situation of China. Completed on July 8, 2009

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The Global Financial Crisis and China’s Countermeasures

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The subprime real estate mortgage crisis (hereinafter referred to as subprime crisis) that originates from the U.S. in the spring of 2007 has morphed from a debt crisis into a liquidity crisis, and then into a credit crisis. It is a financial crisis triggered by insolvency of subprime mortgage entities, investment banks and funds, and great fluctuations in the stock market. First sweeping the U.S and then the rest of the world, the crisis has created turbulences and panic in the international financial market; spreading from fictitious economy to real economy, it has also brought a downturn to the world economy and to that of many nations. No one has ever anticipated a crisis of such a scope and intensity. It is believed to be the worst and most profound global financial crisis since the second half of the 21st century. In Das Kapital , Marx wrote: “financial products like negotiable securities, which are produced based on loan capital and bank credit system, are fictitious capital.” Over the recent decade, advocated and managed by investment banks and credit rating agencies, MBS, CDO, CDS and other forms of fictitious capital experienced a rapid expansion. Along with this excessive expansion, a leverage ratio as high as 25:1 of U.S. investment banks and the absence of essential and effective supervision eventually led to the outburst of the financial crisis. In the 30 years of reform and opening up, China’s economy has been kept on a healthy track, which has enabled the country to make an increasing contribution to the prosperity and sustainability of the world economy. In view of China’s immense and rapidly developing economy, and its reserve of foreign exchanges that tops the world, great anticipation is placed over China amid this financial crisis. However, as a developing nation, and with a GDP accounting for only 6% of the world’s total and a GDP per capita ranking outside the top 100, China can only shoulder responsibilities according to its own strength and level of development. President Hu has made a clear statement that, nations around the globe should have a greater confidence and should rely on mutual coordination and cooperation to fight the financial crisis. China is willing to continue its responsible stance and join the world’s effort to maintain the stability of financial sector and spur the growth of global economy. However, keeping a steady and relatively fast development of its own economy is already itself a great contribution from China to the maintenance of global financial stability. Thus, we need to first focus on the domestic issues. The author has been closely following the development of subprime crisis since 2007 and has made his personal points and suggestions in various occasions home and abroad over the formation and development of the crisis, as well as over strategies to counter the crisis. Based on the author ’s study and thoughts, the article will analyze the causes of the crisis with the fictitious

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economy theory. This chapter will also discuss the crisis’ implications to China, the strategies China should adopt in the face of the crisis and the direction of its financial reform in the future.

FROM THE SUBPRIME CRISIS TO THE WALL STREET’S TURMOIL Subprime crisis refers to the financial crisis triggered by the increase of defaults in the U.S. mortgage market and the ensuing credit crunch. Subprime lending are loans provided by banks and other loan providers to real estate buyers who have a relatively low income or bad credit history. Encouraged by the government and congress, commercial banks in the U.S. loosened their standards for mortgage loans, and thus generated the development of subprime mortgage market. This kind of loan requires a very low, sometimes zero down payment (in 2005, the median of down payment made by buyers of their first homes in the U.S. was 2% of the total payment, and among them, 43% buyers made zero down payment), and usually adopts a repayment schedule that combines fixed rates and floating rates, namely, buyers make payments based on favored fixed rates in the first several years (in some loans, buyers are even allowed to not repay the principles of the loans, but only the interests in these years) and then based on floating rates. However, the rates of subprime loans are mostly higher than prime loans, and their monthly repayments often increase rapidly as time goes on. The U.S. commercial banks did not shoulder the responsibility to recover the loans. Instead, they sold the loans in parcel to obtain liquidity. Home loans were converted into and sold in the form of mortgage-backed securities, or MBS by relevant agencies. Based on such procedures sometimes referred to as securitization of the mortgage loans, a secondary subprime mortgage market took shape. From 2002 to 2006, the continued boom of U.S. home market and a relatively low interest rate lowered the risks at every link of the above process, facilitating the rapid development of subprime mortgage market in the U.S. From 2001 to 2006, subprime mortgage loans increased in an annual rate of 38% in volume. Being optimistic about the home market, lenders were willing to grant loans because even if default in repayment occurred, they would not lose money after repossessing and auctioning the property. Borrowers, by the same token, pinned their hope on the rises in the home price, which would allow them to pledge their homes to banks for refinancing or even resell their homes when they have

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difficulties in repayment or to gain profits in the transaction. In the prime of the U.S. real estate market, due to the low default ratio, MBS, CDO, CDS and other financial derivatives yielded considerable profits yet posted low risks. Credit rating agencies gave these financial derivatives and their relevant organizations AA+ ratings, directing at them investment from both crazed individual investors and institutional investors such as investment banks, investment funds and insurance companies. Unfortunately, before long, as the home market in the U.S. started to cool down since the second half of 2006, both resale and refinancing through pledging homes became difficult; the continued rise of interest rate (Federal Reserve raised interest rate 17 times in a row since June 30, 2004, and federal funds rate from 1% to 5.25% on June 29, 2006) drove up the interest rates of subprime mortgage, which led to a bigger pressure on borrowers with less affordability and thus the occurrences of overdue payments. The continuous cool-down of housing market made it difficult for home buyers to resell their homes or refinance by pledging their homes. Additionally, the rise of oil price slowed down economic growth, forcing companies to lay off employees, who therefore became incapable of fulfilling repayment. All these added up to a great number of defaults in mortgage loans and in turn saddled banks with loads of bad debts. Incurring great losses, some banks went to the point of bankruptcy, and the subprime crisis thus began. It is generally recognized that the subprime crisis started from February 22, 2007, when HSBC revealed its report on losses primarily concerning subprime mortgages and reduced its holding of USD10.5 billion worth of subprime related MBS. After the advent of the crisis, subprime loan organizations incurred tremendous losses from bad debts. Some of them were left no choice but to file application for bankruptcy protection. For instance, on April 2, 2007, the second largest subprime mortgage company in the U.S., the New Century Financial Group applied for bankruptcy protection and sacked 54% of its employees. The 10th biggest mortgage agencies in the U.S., the American Home Mortgage Investment Corporation filed bankruptcy on August 6, becoming the second insolvent giant among mortgage companies following New Century. During 2007, at least 100 mortgage organizations closed down, stopped operation or were transferred. As home price and the American economy continued their downturn trend, defaults began to occur among prime mortgages, thus expanding the shadow of the debt crisis. To add fuel to the fire, a number of credit rating agencies quickly lowered the ratings of some financial organizations and financial products; some hedge funds also went shorting, resulting in a swift fall of the share prices

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of many financial entities, such as loan providers, investment banks, investment funds and insurance companies, which subsequently incurred big losses, with some of them filing bankruptcy as a result. In addition, as many investment funds in the U.S. and Europe held a big number of financial derivatives based on subprime mortgages, these funds were also severely hit. On July 16, 2007, two of the funds of Bear Stearns & Co, the 5th biggest investment bank in the U.S., the High-Grade Structured Credit Strategies Enhanced Leverage Fund and the High-Grade Structured Credit Fund went to bankruptcy. Respectively on October 30 and November 5, 2007, Stan O’ Neal, CEO of Merrill Lynch, and Charles Prince, CEO and president of Citigroup resigned over the great losses incurred during their tenures. From December 2007 to January 2008, financial giants such as Morgan Stanley, Citigroup, JP Morgan, Merrill Lynch, and UBS consecutively published reports on the big losses caused by subprime mortgages. Under the panic among investors, the U.S. bond market shrank by a scale as big as 28.27% from the first quarter of 2007 to that of 2008. Meanwhile, the U.S. stock market also fell off the cliff by 45%. A number of commercial banks found themselves not only suffering from an increase of defaults in mortgage loans, but also from a rising defaults ratio in credit card. After a string of painful struggles, the 5th biggest Wall Street investment bank, Bear Stearns & Co. Inc. announced at nine o’clock on March 14, 2008 that, due to the inability to overcome its liquidity crisis, it accepted a capital injection of USD30 billion from J.P. Morgan, which was approved by the U.S. government. On May 30, JP Morgan finished its purchase of Bear Stearns at a price of USD10 per share. Meanwhile, financial organizations that had issued CDO and CDS, which are closely linked to MBS, were all selling their financial assets or looking for acquirer. After the subprime crisis broke out, the U.S. and Europe adopted multiple measures that primarily included injecting liquidity. On August 10, 2007, the central banks around the world jointly injected liquidity to the financial sector. The U.S. Federal Reserve injected USD38 billion after a previous USD24 billion injection. On December 18, the European Central Bank injected EUR348 billion. On February 13, 2008, the U.S. president George W. Bush endorsed a USD168 billion worth of stimulus plan. On March 11, the Federal Reserve announced a USD200 billion project to allow financial organizations, including major U.S. investment banks, to trade their most risky bonds with government bonds that yield safer returns. On April 29, the U.S. Committee on Financial Service of the House of Representative, in an attempt to protect home owners who faced difficulties, passed a legislation that subsidized USD300 billion to refinance

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people on the verge of losing their homes. From September 18, 2007 to April 30, 2008, the Federal Reserve lowered the interest rate for seven times form 5.25% to 0.2% in less than a year. On July 16, 2008, the U.S. Securities and Exchange Commission issued an urgent ban restricting short selling securities of major financial companies, including Fannie Mae and Freddie Mac. On July 18, 2008, the U.S. Securities and Exchange Commission issued a 30-day ban on short selling 19 financial stocks including Fannie Mae, Freddie Mac and Lehman Brothers. On July 30, former President Bush signed into law the Housing and Economic Recovery Act of 2008 , which guaranteed up to USD300 billion to help Fannie Mae and Freddie Mac, and mortgage borrowers. The rise of the U.S. economic growth rate in second quarter to 2.9%, an evident rise from the first quarter figure 0.9%, made people in the economic circle, including the Secretary of Treasury, Paulson, believe that the main part of the risk of the subprime crisis had been released and the U.S. economy was back on the rise. However, to the contrary, the crisis intensified and developed to the Wall Street financial storm in the first half of September 2008. The two biggest real estate mortgage companies sponsored by the U.S. government were Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation). The two companies used to issue MBS only based on regular mortgages, which have clear loan granting standards specifying what kind of loan can be approved. However, under the encouragement from the U.S. government and the impact of other risk preferring funds such as hedge funds and pension funds, these loan granting standards were gradually put aside. In 2007, the two companies themselves held USD394.8 billion worth of subprime MBS. Furthermore, the two companies, assured by their government guarantee, obtained tremendous volume of call loans from banks, which amounted to USD5.2 trillion, 62.5 times their core capital (USD83.2 billion). As the U.S. real estate price continued to fall, even the solvency of prime mortgage borrowers became problematic. This resulted in a fall off the cliff of both the MBS issued by the two companies and their share prices, which eventually led to their liquidity problems. Their market values dropped from respectively USD38.9 billion and USD22 billion at the end of 2007 to USD7.6 billion and USD3.3 billion at the end of 2008. With a crash of their stocks at the corner, the two companies did not seem to be able to survive to the presidential election in November. On the one hand, the decrease of agency debt will cause an overall contraction of the U.S. bond market and a subsequent outflow of capital to equity market or oversea market; on the other hand, as agency debt is one of the major forms of foreign reserve in the central banks of many nations, it was subject to dumping. In view of this, the U.S.

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government took over the two companies on September 7, injecting liquidity by buying preferred stocks related to the two companies, so as to resolve the crisis of honoring bonds. The two companies respectively issued to the U.S. Treasury USD1 billion preferred stocks. The Treasury, in return, injected USD100 billion to each of them by buying their stocks, so as to guarantee the net book value of the two entities. By doing so, the Treasury hoped to release the information that the two companies will not bankrupt. A safer status of bonds of the two companies was hoped to restore market confidence, prop up credit ratings and share prices, and lower the mortgage rates, which would serve as a stimulus to the real estate market. Furthermore, the Federal Reserve, together with 10 biggest U.S. banks, set up a buffer fund of USD70 billion to provide funding guarantee for financial entities potentially subject to bankruptcy and kept the liquidity of the market. Unfortunately, the abovementioned efforts were not enough to stop the crisis. In merely 24 hours from the evening of September 14, 2008, U.S. Eastern Time to the evening of September 15, three pieces of stunning news broke out from Wall Street, drawing the whole world’s attention. On the evening of September 14, the 3rd biggest investment bank in the U.S. and a company with 94 years of history, Merrill Lynch was sold to Bank of America for USD44 billion amidst fears of a liquidity crisis; after failure to obtain capital guarantee from the Federal Government and private capitals, the 4th biggest investment bank in the Wall Street, Lehman Brothers filed for bankruptcy in the morning of September 15 due to a debt of USD613 billion (its total assets were USD639 billion); the 3rd biggest insurance company in the US, American International Group (AIG) was downgraded in its credit rating based on the fact that it held many due contracts that were defaulted. After knowing there were no loan provider for it to avoid bankruptcy, it applied to the U.S. Federal Reserve for short-term loan, so as to avoid downgrade in its credit rating and the subsequent higher financing cost, which will cause increased collateral obligations and requirements by its contractual counterparties to return capitals, a situation that would force it to bankrupt in 48 to 72 hours. In response, the Federal Reserve announced in the evening of September 16, that it would allow its subordinate, the NY Federal Reserve Bank to provide an unprecedented USD85 billion credit facility to AIG in exchange for 79.9% of the equity of AIG, and the right to stop delivering the bonuses or dividends of previously issued common stocks and preferred stocks, so as to help AIG get rid of the prospect of bankruptcy. The string of catastrophic events occurred during September 7 and September 16 was a major blow to the market confidence. The crisis intensified into a credit crisis. A “Wall Street financial storm” or even a “Wall Street

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financial tsunami” as many called, was thus formed. The credit crisis was in essence, a crisis when confidence and trust was lost, namely, many were unconfident that a recovery from the crisis was to take place, and did not believe financial entities, the financial system, even the government to be trust worthy. Despite the fact that the crisis originated from America, many nations worldwide were confronted with similar problems, and a global outburst of economic crisis thus occurred. To tackle the financial crisis, many nations responded quickly in carrying out rescue measures. On September 15, 2008 the Europe Central Bank and the Bank of England respectively injected EUR70 billion and GBP20 billion into their financial markets. On October 8, 2008, the central banks of the world’s major economies, including the U.S. Federal Reserve, European Central Bank, Bank of England, Bank of Canada, Swedbank, United Bank of Switzerland, jointly lowered interest rates in an attempt to stop the financial crisis turning into an economic crisis. However, the plummeting of real economy was almost inevitable. As estimated, the world economy will see a growth rate lower than 1% in 2009, marking a record low for 26 years. Many developed nations will see a downturn in their economies. On November 15, 2008, the group of 20 of the world’s largest economies met in Washington DC and released a statement of the meeting, stressing that at a time of great difficulties for the world economy and financial sector, the participants of the meeting should join hands in the effort to restore growth of the world economy and in the implementation of necessary reforms in the world financial system. On November 23, 2008, at the closing of the APEC 16th unofficial summit of leaders in Lima, Peru, a statement was released, in which a prediction that the financial crisis would come to an end in 18 months was made. After that, despite an unremitting governmental effort of market rescue, including a stimulus package of as much as USD787 billion that was approved consecutively in the U.S. House of Representatives and the Senate on February 13, 2009, the crisis is at the moment still rumbling forward, and is spreading further to Eastern Europe and developing nations. There are still many uncertainties in the crisis which make a precise prediction impossible. The second financial summit of the G20 leaders was held on April 2, 2009 in London. Leaders of the 20 nations reached consensus on a number of topics, including strengthening the coordination of macro-economic policies, stabilizing the financial market, improving supervision in financial sector and reforms in the international financial sector, giving out positive signals. After the meeting, an announcement of G20 leaders was released and a third summit was

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scheduled in September 2009. However, consensus of the summit, especially those concerning a joint effort to keep the international trade environment fair and open and curb trade protectionism, are still pending implementation.

A BRIEF ANALYSIS ON THE WALL STREET FINANCIAL STORM FROM A FICTITIOUS ECONOMY’S PERSPECTIVE Considering the cause of the crisis, opinions vary, including lack of supervision, excessive innovation in financial market, mixed operations, overproduction of the financial sector, etc. Some even suspect the crisis is a conspiracy by the U.S. The author holds that in analyzing the cause of the financial crisis, instead of remaining our study on superficial or external causes and making conjectures, we should probe into the very core of the crisis. By doing so, we can at least conclude that a major cause of the crisis lied in the excessive expansion of fictitious capital as a result of speculation based on an excessive debt level.

The Concept of Fictitious Economy In Das Kapital , Marx mentioned the concept “fictitious capital.” He believed that financial products like negotiable securities, which are produced based on loan capital and bank credit system, are fictitious capital. When an investor buys stocks or securities with a sum of money, he virtually gives the right to use the money to someone else while what remains in his hand is the ownership of the money, represented by a certificate of ownership, such as bonds and stocks. The investor can ask the issuer of bonds for payment of principle and interests, and ask the issuer of stocks for bonuses and guarantee of his rights as shareholder. However, the value of the certificate relies on the credit of the issuer, the party who uses the money, to repay the principles, interests, bonuses and values in other forms. Once the credit of the issuer broke down, the certificate itself is worthless. Therefore, Marx called it fictitious capital.

Expansionary Is One of the Traits of Fictitious Capital One of the important characteristics of fictitious capital is that it is expansionary on the basis of credit system. Marx used a very simple example to illustrate this: The London merchant A booked a batch of goods from the Manchester manufacturer C through agent B , which is to be sold to client D in Eastern India. A , B , C and D can all get short-term loans from the bank through bank discounts with the notes they obtained in the above transactions, thus expanding the fictitious capital.

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The author extends the example and illustrates it as below: assume that the sum of money involved in the transactions is one million, and the term of delivery is half a year. After B and C , A and D , and A and B respectively signed the contracts, they may use the notes in hand to get bank discounts, or make loans from the bank. With B ’s note, manufacturer C can get bank discount or get loans from the bank, with which C can purchase raw material, hire workers and organize production; agent B can also do the same thing in the bank with the note obtained from A , and it is the same case for A ; likewise, D can get bank discount or get loan from the bank with the contract between A and him. As such, the one million in A ’s hand became four million available in half year’s time. Of course, this is a simplified way to put it. In reality, when giving a loan, the bank would certainly make discount in the face value; the manufacturer C would not be so silly as to start production before he gets deposits. Assume that within the following half year, A , B and D all invest the money they borrow from the bank in other businesses and profit, when the contracts and the loans fall due, B will be able to repay one million to C and get the goods from C , which B can deliver to A in exchange for one million from A and repay it to the bank; A will be able to ship the goods to D and get one million from D which A can repay the bank; likewise, after D sell the goods in India, D will have enough money to return to the bank. However, problems in any single link of the whole chain, such as default of anyone among A , B , C and D , will cause the whole value chain to break. Although the defaulter will be punished by law, the bank will also suffer from bad debt. The above assumption was made based on the situation in 19th century when the expansion of fictitious capital was much lower in degree. As technology advanced and financial innovation boomed, financial derivatives have increased dramatically both in number and in types. The initial purposes of financial derivatives were to, first, meet the different investors’ demands for investment vehicles that vary in the degree of safety, profitability and liquidity, and second, reduce risk by hedging. However, financial derivatives also provide for the market various instruments for speculation, and therefore result in a rapid expansion of fictitious capital. There are generally several kinds of expansions of fictitious capital: Overvaluation . When investors have a valuation that is higher than the actual value of the ownership of a particular security, the expansion of fictitious capital occurs. For instance, when investors become over-optimistic about the prospect of the profitability of a listed company, they will buy the stock of the company at a higher price. It is especially true in a bull market, when many investors tend to buy some particular stocks mainly because they are following

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suit or anticipating greater fools (believing that there will be people willing to buy their stocks at higher prices), thus creating bubbles, which hides the potential danger of a future bubble burst that brings losses to these investors. Over-indebtedness . When the financing party holds the belief that the return on assets is higher than the interests of loans, the party often make great-scaled loans to profit as much as possible, thus leading to a debt-assets ratio that often exceeds one hundred. However, when the investing party finds a grim prospect of the investment and revokes the previous investment or refuses to grant new investments, the financing party often faces bankruptcy. High leverage . High leverage means using a comparatively small sum of money to secure a transaction in which a much bigger sum of money is involved. For example, in futures market, buying a futures contract usually requires only a 5% deposit. Multiplier effect . As commonly known, due to the money multiplier, the initial provision of currency amount by the central bank can be multiplied by several times and eventually lead to a greater social currency amount. Similarly, fictitious capital can also be magnified through the multiplier effect. For instance, a bond holder can pledge his bonds to a bank to obtain cash, and use the cash as deposit to purchase futures or other financial derivatives. As such, the initial capital used to buy bonds can be calculated as immature bonds, futures that have not been closed out (the contractual amount can go as high as twenty times that of the deposit), and financial derivatives that have not been closed out, except that it can be multiplied by tens of times in contractual value. Simultaneously, the risks for the bond holder are also multiplied from lower risks of bonds to higher risks of futures and financial derivatives. In this way, he gains access to higher rewards but also become subject to tremendous, often unbearable losses. The cause of the financial crisis lies mainly in the excessive expansion of fictitious capital as a result of excessive indebted investment, which is called too high a leverage ratio. Simply put, leverage ratio is how many Renminbi a business person can earn using RMB1 as initial capital. In the U.S., the leverage ratios of commercial banks vary between 8 and 12; investment banks 25 and 40; that of Freddie Mac and Fannie Mae, assured by the support of the U.S. government, exceeded 62.5 at their highs, which means they used USD832 of capital to issue USD5.2 trillion worth of bonds. Some of the AAA rating bonds had a leverage ratio over 100. High leverage ratio, on one hand, is helpful to the high efficiency of capital operation. Assume a situation where the leverage ratio is 40, and the return on assets is 1% higher than interests rate. The actual return on assets would be

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over 40% in this case. On the other hand, however, with a leverage ratio being 40, 1 million dollars’ worth of business is run with only 250,000 dollars. Any unfavorable change of the situation will result in consequences far bigger than what the 250,000 dollars can cope with, which means measures like borrowing money or selling equity must be taken to accommodate the losses.

The Development of the Expansionary Risks of Fictitious Capital By the end of February 2007, the balance of subprime crisis was estimated to be only USD1.3 trillion. How such a low volume of subprime mortgages generated a financial crisis that swept the world remains a process too complicated to explain for now. To answer this question, persisting and careful work is needed. The author will, however, take the liberty to make his own brief and preliminary analysis in the following part of the article. Through the string of financial innovations mentioned earlier, an industrial chain of “borrower-commercial bank-mortgage issuer-investment bank-insurance company” was formed. Came together with it was another product line of “right to mortgages-MBS-CDO-CDS.” Fictitious capital expanded continuously along the two lines, so did risks. The debt crisis therefore morphed into liquidity crisis, then to credit crisis.

Debt crisis After borrowers obtained loans from commercial banks and other loan providers to purchase properties, they become obliged to make payments to loan providers (such as banks or other financial entities) as the contracts require, so as to repay the mortgages. If the mortgagers default on the time of their payments, they shall make overdue payments; if the mortgagers’ default exceed the longest time allowed for payments, the lenders are entitled to obtain the ownership of the properties based on the proceeds of the mortgages, in which, the properties will be repossessed (in this case, the properties are referred to as foreclosures) and auctioned by the loan providers. Therefore, the risks in the primary mortgage market are mainly defaults and the risks are taken mainly by lenders. When properties price fell and interests rate rose, as the subprime mortgagers were the least risk tolerant, subprime mortgages were where defaults started. By October 2007, the default ratio of subprime mortgages was 16%; by January 2008, the figure climbed to 21%; by May 2008, it reached 25%. As property price kept falling, some of the prime mortgagers became incapable to make repayments, while some others of them deliberately defaulted on loan repayments as the property prices became lower than the margin between the

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purchased prices and the sum of paid principles and interests. As a result, the default ratio of prime mortgages rose as well, with foreclosure occurring much more frequently. In 2007, 1.3 million borrowers lost the right of redemption, marking a 79% increase compared to 2006. In 2008 the figure surged to 2.3 million, marking an 81% increase from 2007. The volume of bad debt resulted from mortgages of families of four in the U.S. was USD9.9 trillion by the end of 2006, which increased to USD10.6 trillion in the middle of 2008. As a result of the low price and bad sales performance of foreclosures, mortgage lenders incurred great losses, whose share prices also plummeted subsequently, leading to the bankruptcy of many of them. A debt crisis thus emerged. Under the influence of the subprime crisis, the debt crisis spilled over from housing mortgages to auto mortgages and other mortgages, including even credit card business. A rising default cases in these markets gave a heavy blow to commercial banks.

Liquidity crisis MBS (mortgage-backed securities) The boom of the primary mortgage market brought into existence the secondary mortgage market that sells and resells mortgages, which, through a process known as securitization, became MBS. MBS usually refers to a type of security that is secured by the obligatory right to the mortgage and issued with a fixed monthly interest rate with repayment of principles upon maturity. At times of rising real estate prices and low loan interest rates, with the precondition that the income of borrowers are sufficient for repayments of the principles and interests of the mortgages, the much higher interests of MBS than that of deposit means sure profits. At the early days of the secondary mortgage market, MBS was only issued by GSE, the most prominent two among which were Fannie Mac and Freddie Mae. Their primary business was buying mortgages in the secondary market and issued agency bonds and MBS. These MBS were securities secured by the two companies, which meant an implicit guarantee of the U.S. government, and therefore presented a very good credit. Since 1989, as the interest rate of MBS issued by the two companies kept on an average level that was 137% higher than the interest rate of the U.S. 10-year public bond, many legal persons invested in MBS. Further development of the secondary market attracted private entities, which also began issuing MBS. Commercial banks were allowed to pack mortgages and sell the packages to Special Purpose Vehicle (SPV) so as to

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isolate the risk of bankruptcy. SPV then issued MBS. The isolation of risks meant that the creditor of the originator was deprived of the obligatory right to the mortgages after the bankruptcy of the originator, as the mortgages have gone through a process known as “true sale.” SPV were actually shell corporations registered in places with preferential taxation such as Cayman Islands. Often founded by entities that have no direct links to the commercial banks, these firms had no regular employees or work place and outsourced all its functions to other professional entities. They brought, often on credit, mortgages from commercial banks, and issued MBS on its own behalf to refinance, so as to raise money to repay the debt from buying mortgages. They entrusted service providers to collect due principles and interests from the borrower in the mortgage loans, and by the same token, entrusted banks to make timely repayments of interests and principles to MBS holders. Their assets and debts were basically equal. The advent of secondary mortgage market changed the original pattern in which commercial banks making mortgage loans assumed sole responsibility and shouldered all the risks of the loans, instead, it allowed commercial banks to share the risks with MBS investors and not to hold the mortgages they issued till the loans fall due. MBS allowed many financial entities and investors from all over the globe to invest in the real estate market in the U.S., and at the same time, disperse the risks among all of them. While the main value of MBS depends on the repayment ratio and property price, when property price was on the rise, the interest rate of MBS would stay higher than the interest rate of deposit with a spread of 2–3%. Therefore, major banks, investment banks and other financial institutions were keen on borrowing money by ways such as issuing securities to invest in mortgages. By the end of March 2007, the balance of U.S. MBS was USD6.3 trillion, among which subprime MBS accounted for USD90 million. The securitization ratio of subprime mortgages rose from 54% in 2001 to 75% in 2006. In order to avoid risks and boost the confidence of investors, the U.S. government made three regulations concerning the issue of MBS. The first regulation was made as prevention from the reduction of principles as a result of prepayment of interests and principles from the borrowers. Issuers of MBS were thus required to retain obligatory right to a larger supporting volume of mortgages for the MBS than the volume of mortgages actually converted to MBS. The second regulation stipulated that in the case that borrowers were unable to fulfill their repayment obligations in the preliminary stage of repayment, investors were entitled to require the issuers to repurchase the securities; the third regulation was that prior to the credit rating, SPV were

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required to invite rating agencies to assess the MBS they planned to issue. Once the rating did not meet the proposed credit standard, SPV were required to go through a process known as credit increment to upgrade their credits by ways such as over collateralization by financial guarantee companies. However, even the abovementioned measures were not enough to cope with problems brought by the slash in property price. After the debt crisis, MBS issuers could not receive due mortgage interests, and were thus incapable to repay the interests and the principles of MBS whose investors asked for redemption by the issuers, which led to their liquidity problems. Under such circumstance, normally issuers would seek to borrow from other financial institutions, or sell their assets (stocks, bonds, etc.) so as to obtain cash to remain solvent. But due to the grim prospect of property market, the credit ratings of issuers were largely lowered, which resulted in a situation where no financial institutions were willing to provide loan to them. The principles of investors thus shrank by great scale, while simultaneously the increase in default ratio further lowered the price of MBS. Moreover, as MBS is a fixed income instrument, its price will fall when interest rate rises. The fall of the price of MBS would lead to the fall of share prices of issuers, barring the issuers from making new loans or selling their assets as an attempt to obtain the capital they need. Liquidity problems formed in this way, if not alleviated, would eventually lead to the bankruptcy of these financial entities. CDO (collateralized debt obligations) Financial entities such as investment banks and funds further securitized MBS. By using a variety of financial engineering techniques, they presented and sold a kaleidoscopic array of financial derivatives in the secondary mortgage market after a string of evaluation, combination and packaging. The most famous one among these financial derivatives was the CDO, which was a type of structured asset-backed security, or ABS. The issuers of CDOs form an assets pool by putting together a wide spectrum of loans, including real estate mortgages, student loans, commercial loans, etc. CDOs are then split into different tranches according to the differences in risks and returns, and then sold to investors with varied risk appetites. A typical CDO was classified into senior, junior and equity tranche. Among them, equity tranche is exposed to the biggest risk (often with no credit rating), as when losses occur in the underlying assets pool as a result of defaults, the equity tranche stays first in the order of bearing the losses. In return, this tranche enjoys the highest returns. Senior tranche (normally with AAA credit rating) is the first in the order of receiving repayments (interests

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and principles) and thus the least exposed to risks compared to the other two tranches, so yielding the lowest returns; the middle tranche, or junior tranche has intermediate characteristics of risks and returns between the aforesaid two, and thus a credit rating between AA and BB. The way in which CDO is issued is similar to that of MBS, namely, the issuers (normally investment banks) create an assets pool (underlying assets) by packing a group of diversified assets, then “truly” sell the CDO to SPV. After risk isolation as such, the holders of CDO cannot recoup their investment when the returns can meet their expectation. SPV is the nominal issuer of CDO. It pledges its underlying assets in support of the issuing of CDO, and obtains capital from the issuing of CDO so as to repay the consideration of the assets of originator. The asset managers of CDO (usually investment banks) are often the holders of the equity tranche, who attract investors based on their past performance and the amount of equity securities they hold in hand. Except from the commission the issuers receive at the time of issue, they also earn management fees at the life of the CDO. Credit rating agencies are in charge of investigating and assessing the ability of underlying assets to sustain risks, so as to determine the proportion and scale of each layer of the CDO, which shall meet the respective rating standard. After the issue, rating agencies will continue to make follow-up ratings. Buyers of CDO are usually insurance companies, banks, pension funds, investment companies, investment banks and hedge funds. Most of them aim at the higher profit margin of CDO (the rate of profit of CDO is generally 2–3% higher than corporate bonds of the same credit rating); more active investors profit through purchasing and selling CDO; hedge funds pledge the CDO they purchased to commercial banks with a leverage ratio ranging from five to fifteen times. Additionally, the introduction of CDOs, namely, CDO secured by other CDO, CDO-Squared and CDO-Cubed, complicated the process of securitization to such an extent that even people working in the financial sector could not explain. By the end of 2007, the volume of U.S. CDO has reached USD19.8 trillion, and the volume of CDO issued to the world approximated USD2.5 trillion. In essence, SPV is an off-balance sheet entity. As bank supervisors and shareholders were not even aware of its existence, it became an unsupervised void. The securitization of mortgage allowed financial entities to transfer mortgage loans they previously granted to off-balance-sheet SPVs and therefore circumvent capital requirements in order to gain higher profits at the cost of equally high potential risks.

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With the onset of debt crisis as the result of a plummeting property price, the underlying assets of CDO saw a large number of defaults. Under the great pressure of repaying debts to creditors, financial entities such as investment banks were left no choice but to sell a great deal of CDOs they held in hand, so leading to a further drop of CDO prices. According to the new mark to market, or MTM accounting standards, financial entities are required to adjust their financial assets on a quarterly basis according to their market prices, which were determined by the recent status of trade of the assets in question. In the case of CDO, the pricing was therefore much lower than what it should be. As the spreads in CDO market is large, financial entities had to lower the prices of these securities to the prices offered in the market. This further aggravated the panic among investors, who subsequently dump more CDOs, thus resulting a further fall in CDO price, in which a one dollar CDO (face value) was traded at seven to eleven cents. When the income from the sale of assets is not sufficient to repay the debts, CDO would also collapse due to insolvency. To reduce risk, investors can obtain credit protection by insuring to insurance companies. MBS and CDO were often insured by monocline insurance entities, whose credit rating was usually AAA. However, in the event of massive downgrade rating of mortgage bonds which these monocline insurance entities insured, the volume of compensation surged, so affecting other products these entities insured, such as municipal bonds. Due to the ensuing liquidity problems, some of these insurance companies became subject to collapse. CDS (credit default swap) Based on CDO, a new financial innovation was introduced, namely, the CDS, or credit default swap. By buying CDS, MBS and CDO investors can hedge against credit risk of the bonds they hold. CDS is in its nature a credit product that resembles insurance, with its buyer being creditors who worry about defaults by borrowers in mortgage loans, and its seller being a party that promises to make the due payments to the creditor in exchange for the pledges of the loans when credit events, such as bankruptcy of and defaults by borrowers occur. Such contracts were usually made over the counter with a 5-year maturity, and were allowed to be traded freely. All such transactions were carried out anonymously, with undisclosed transaction records and prices, making it hard for supervising bodies to function effectively. Similar to all other financial derivatives, CDS can be used to hedge against risks and shield the creditors from losses caused by defaults by the borrowers; likewise, it can also be used as a speculation instrument. The price of CDS is

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dependent on the solvency of the borrowers, including the possibility of default, the possible time of default, the value of the pledges, the cost of collecting money, etc. When real estate price was on the rise and default ratio of mortgages stayed low, CDS stayed cheap. The low price of CDS naturally attracted many investors to purchase a large number of them in order to obtain credit protection at a low price. At the same time, it also attracted some speculators to buy CDS at low price with the intention to sell them at higher prices or obtain compensatory payments when credit events occur. Financial institutions such as insurance companies also took the chance to sell CDS so as to increase their premium income when risks were low. Some speculators, despite the fact that they had not enter any loan business, could earn premiums by simply selling CDS. As such, CDS market expanded dramatically in the financial markets of developed nations in North America and Europe, reaching an estimated unclosed-out contractual amount from USD33 trillion to USD62 trillion. CDS as a speculation instrument also influenced the stock market. When speculators believed that a particular company became overly indebted and was unable to repay the debt, they would purchase a large number of CDS while dumping the stock of the company to manipulate a rise in the price of CDS, after which they would sell the CDS. As a result, the company would find it much harder to refinance from the bank due to the said rise in the price of CDS, and so became more tightly caught in trouble. In such case, CDS has actually become an instrument for gamble, a reckless gamble between speculators among buyers and sellers. After the onset of the subprime crisis, credit events occurred in a large number, and the number of bad debts of CDS rose by 100 times from 1998 to 2008. As the sellers of CDS fell obliged to make a huge compensatory payment while the pledges they repossessed were hard to liquidate, they also faced liquidity problems. For instance, the American International Group, or AIG needed the help of the U.S. government to avoid bankruptcy, as the volume of CDS it held amounted to USD440 billion. To conclude, due to the plummeting of the real estate prices, the risks were conducted to U.S. financial institutions through financial derivatives in the U.S. secondary mortgage market such as MBS, CDO and CDS. Confronting these financial entities with huge risk in liquidity, the subprime crisis morphed into a liquidity crisis.

Credit crisis As the liquidity crisis rumbled on, catastrophic events broke out in a row in the

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first half of September 2008. Starting from the Federal takeover of Fannie Mae and Freddie Mac, then followed the Merrill Lynch acquisition and the collapse of Lehman Brothers, and finally the urgent Federal lending to AIG, these cast a severe credit crisis over Wall Street, which eventually led to a Wall Street financial storm in the middle of the month and subsequently the outburst of a global financial crisis. Credit system is the cornerstone of modern social market economy and fictitious economy. In recent years, as the fictitious capital expanded rapidly with the support of credit system, the fictitious economy saw a boom in western countries, especially in the U.S. Aided by the fictitious economy, they exploited huge wealth from the rest of the world. As mentioned earlier, a situation where many individuals lose personal credit will develop into a debt crisis; one where many financial entities lose credit will develop into a liquidity crisis; one where individuals, financial entities, corporations and even the government lose credit will develop into a credit crisis. When the credit system broke down, owners of non-fictitious capital were unable to resume the right to use their capital and might even lose their ownership of the capital. Due to concerns over the absence of counterparty’s credit, panic among investors grew and spread, driving them to dump all the financial assets they held despite the subsequent great losses, and possibly leading to bank rush of investors as an attempt to retain in their own hands the cash they owned. The underlying reasons for such moves by the investors are, for one thing, to repay debts, and for another, to cope with future difficulties. Banks, encumbered by bad debts as a result of defaults by borrowers as loans came due, and drained of cash as a result of the bank rush, would fell into crisis, and even face bankruptcy. Various financial entities followed each other in dumping MBS and CDO, causing a dig of their prices and giving the bond market a hard hit. The stock market, affected by the dumping by the investors and the slump in share prices, would also tumble. Within the first two days after the outburst of credit crisis, USD150 billion were withdrawn from money market funds, which was followed by a period when USD5 billion were drained away daily. On September 16, the net asset value of Reserve Primary Fund fell to an unprecedented low of less than USD1, with its investors requiring redemption. In the morning of September 18, prior to the opening of currency market, due to panic among investors over a slump in the net asset value of money market funds and a credit crunch of commercial papers, the total volume of transactional orders required to be sold out reached USD500 billion, while the total market value was only USD400 billion. Thanks to the emergent injection of USD105 billion of liquidity from the Federal

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Reserve, the collapse of the market was avoided. On September 21, Goldman Sachs and JP Morgan, the two survivors of the crisis among investment banks, filed applications to convert themselves into banking holding groups, marking the collapse of the U.S. investment banking industry. In the evening of September 25, the largest deposit-loan bank in the U.S., Washington Mutual was seized by the Federal Deposit Insurance Corporation, and its banking assets were sold to JP MorganChase for USD1.9 billion. On September 29, the Dow-Jones Average took a record tumble of 778 points. On the next day, overnight dollar Libor rose from 4.7% to 6.88%. In the wake of credit crisis, governments of the U.S. and European nations all put forth rescue measures and injected liquidity into banks, in a vain attempt to stop the crisis from spilling over to the rest of the world and to real economy. The author holds that, credit crisis is in its nature a crisis of confidence and trust, therefore injecting liquidity can only serve as a temporary solution. To exert a long-term curing effect, government should place its efforts on restoring public confidence and trust on financial institutions, financial system and government.

The Spread of the Financial Crisis to the Real Economy After the onset of the credit crisis, three phenomena were observed. The first phenomenon was credit rationing. As banks perceived an increased risk of loaning out, they tightened the requirements for loans and even the interbank offer rate, making it even more difficult for enterprises and individuals to obtain loans. The second phenomenon was credit rationing of investors. As everybody’s credit was in doubt, the safest option would therefore be keeping the money in one’s own pocket. Worries over investment losses outweighed the desire to profit. When the stock market waned and share prices dropped to a level lower than net asset value, for some, even lower than the net cash value. Buying such stocks would normally be deemed certainly profitable, but very few brought them due to fears of false information. The third phenomenon was credit rationing of consumers. Losses in the stock market and the deduction of property values largely shrank consumers’ assets. With a gloomy economic prospect ahead, consumers opted for austerity in preparation for an even worse future. Finance is the heart of modern economy, and capital the blood. The real economy is driven by nothing else but bank loans, investment and consumption. Credit rationing of banks, investors and consumers will almost certainly have

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tremendous negative influence on the real economy. Since the start of the second half of 2008, the world’s real economy also went into a lull, with a growth rate approximating 2.5%. In 2009, the growth rates of developed nations such as the U.S., Japan and those in the Europe are estimated to be negative; those of developing nations are estimated to hover between 4% to 4.5%; and the world’s average around 1%.

IMPLICATIONS OF THE WALL STREET FINANCIAL STORM ON CHINA After the subprime crisis, various opinions were put forth, trying to draw a lesson from the disastrous event. There are certainly incisive opinions among them, but there are also some misinterpretations and misunderstandings. The author, based on his detailed study on the development and contributing factors of the crisis and his understanding of China’s status quo, expounds on a few implications of the crisis to current China.

Government Intervention in the Housing Market Housing serves both as an expensive necessity of living and an investment instrument that hedge against inflation. Real estate is a pillar industry of the national economy, whose development can fuel the demand on production material, consumer products and services. The real estate industry is closely linked to finance, as property buyers need mortgages and developers need loans from banks. Therefore, property prices and loan interests are the main factors that influence the housing market. According to economic principles, when property prices rise, real estate supply on the developers’ side increases, while demand on the consumers’ side decreases, and vice versa. Furthermore, a lower interest rate increases both supply and demand, whereas a higher interest rate dampens both supply and demand. Under a certain combination of property prices and loan interests, the balance between supply and demand can be reached, the result of the invisible hand of market. According to the dialectic principles, everything is constantly undergoing changes, resulting in a relative balance and an absolute imbalance. According to the emerging complex science, despite the fact that every homebuyer decides by himself when and what to buy in a real estate purchase, his decision, however, is inevitably subject to the influence of decisions made by other people and the external environment. Property buyers, developers, banks, government and other factors exert mutual influences on each other which add up to a

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self-organizing effect that pushes the market to develop in a certain direction. Therefore, although the market seems to be in disorder from a micro and shortterm perspective, it demonstrates a certain direction in its long-term and macro development. As such, the market shows a periodic upward trend despite shortterm fluctuations. As housing is an aspect related to the interests of all households in a nation, government is responsible for the maintenance of social equity in the aspect and should thus conduct macroeconomic regulations over the market. However, governmental regulations over real estate market should be prudent and appropriate, otherwise unhealthy and even severe consequences may occur. The cause of the subprime crisis dates back to the time of Clinton and Bush administration, when they both set increasing home ownership as one of the primary task of their administrations and gave preferential policies to home mortgage industry (including Fannie Mae and Freddie Mac, two government sponsored enterprises), so as to lower loan granting standards. Some of the U.S. congress members also advocated “let every blue collar own their own house.” To this purpose, the HUD established mortgage policies that encouraged the development of subprime mortgage. It also required Fannie Mae and Freddie Mac to purchase more mortgages that were “affordable” to low income and minority households, and to view their several billion dollars worth of investment in subprime mortgages as a welfare product to develop low income housing. For 1996, the HUD gave Fannie and Freddie an explicit target—42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005. The prosperity of the U.S. home market and the example set by Fannie and Freddie encouraged banks to offer more and more loans to high risk borrowers, including even illegal immigrants. By granting such high risk loans, banks aimed at the relatively higher profits. Such high risk loans were mainly categorized into three kinds: the first type, a subprime loan granted to individuals with no income, no job and no assets, which therefore was sometimes referred to as Samurai bond; the second type, adjustable-rate mortgage (ARM), which allowed the borrowers to pay just the interests in the initial grace period, but often imposed a largely increased financial pressure on borrowers at later stages of the term of loan, as the interest rate rose and principles were required to be paid; the third one, option ARM, which offered several patterns of repayment for the borrowers every month, but added all the unpaid accrued interests to the principle upon which the following interests would be calculated. Among the abovementioned three, ARM accounted for

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about 80%. At the same time, the average difference between the interest rate of subprime loan and that of prime loan was narrowed to 280 basis points and further to 130 basis points in 2007. Moreover, mortgage underwriting increasingly loosened. Among all the subprime mortgages granted in 2007, 40% were automatically underwritten, marking the absence of proper verification and record. Such an easy credit served as a catalyst to the whole subprime mortgage market, which indeed came to a boom, posting a tenfold increase in volume and an annual increase rate of 25% from 1994 to 2003. The volume of subprime mortgages and its share in the total loan volume increased from USD35 billion and 5% in 1994, to USD160 billion and 13% in 1999, then to USD600 billion and 20%. Technically, when property price rises, the demand on property will drop, thus to some degree curbing the rise of price. However, the policy support to subprime mortgages by the U.S. government, and the low interest rate offered by the Federal Reserve, together fostered an ultra-prosperous real estate market since 2002, in which many low income households were granted loans to buy homes that they could not really afford and were thus caught in trouble. These policies also encouraged investment and speculation in the market. In 2005, 28% of the home purchases were for investment purpose, and 12% were used as holiday resorts. Highly leveraged speculators traded actual properties and futures properties, posting great risks to the market. After the onset of the subprime crisis in 2007, many low income families found it very difficult to refinance as a means to ease the monthly repayment with high interests after the grace period, and subsequently lost the right of redemption to their homes. By September 2008, the property price in the U.S. had fallen by an average percentage over 20% since the peak in the middle of 2006. This led to the null or negative net value of real estate assets of many home buyers in the U.S. As a result, by March 2008, an estimated 8.8 million mortgagers (accounting for 10.8% of all home owners) owned homes that had become negative assets. The figure was estimated to rise to 12 million by November of the same year. Deliberate defaults and cheating in mortgages became common place. During 2007 the volume of sale of U.S. new real estate plummeted by 26.4%, marking a record drop since the 1980 figure of 23.1%. By the end of 2007, four million complete homes were for sale, and 2.9 million of them were empty. The rise in the default ratio of mortgages depreciated securities like MBS and CDO, thus impairing the net assets and financial state of banks. The Fannie and Freddie were aggravated by the situation to the point of being taken over by the

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state (by June 30, 2008, the combined net asset value of them were only USD114 billion while the value of mortgages they owned was up to USD5.1 trillion, half of which was outstanding account). The global financial crisis triggered by the subprime crisis has brought tremendous damage to the world and cost it dearly. We should draw from this painful experience a lesson that government should take the basic principles of market into consideration in its macroeconomic regulations. Specifically, it should conduct careful analyses on the fundamental stances and behavioral

characteristics of participants in the real estate market, such as home buyers, developers, agencies, and banks, and make all its decisions on the basis of guaranteeing the equilibrium of interests among these parties, so as to devise policies that are correctly timed and properly measured in power.

Over-indebtedness Triggers an Unstable Financial System Fictitious economic system is a metastable system, and comprises of a dissipativity structure, which means it must exchange capital with external

environment to stay in equilibrium. Though such system can reach stability through its self-organizing effect, its stability is precarious and can be broken

by very small perturbations from the external environment. Once the stability is

broken, the system may change within a certain boundary and seesaw between

stability and instability, which from a macro perspective, is stable within a

certain boundary, namely, the system is under regional stability. However, in some cases, after the system loses its stability, it may undergo violent changes,

and may even collapse. After the collapse, the system may restore to another metastable state through a series of profound structural adjustments, but may also go to extinction. Generally speaking, the greater momentum a system has, the smaller the possibility of the system’s extinction is.

There are many reasons that contribute to the metastable nature of fictitious

economic system, while the most fundamental among them is the intrinsic

instability of fictitious capital. The expansion of fictitious capital under the support of credit system posts danger for the credit system itself. The instability

of fictitious capital also lies in the positive feedback that fictitious economic system exhibits. For instance, when a certain financial assets are dumped, more holders of the assets will react by following suit, namely, dumping the assets as

well. Such interactions between people are positive feedback, which increases the magnitude of an effect and causes the fluctuation of asset price.

After WWII, the U.S. gradually began to encourage consumption.

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Consumerism culture stresses the satisfaction of present needs, enshrining the phenomena of “buy now, pay later” into a widely accepted principle. Under the growing push of the culture, the debt to annual household income ratio rose

from 60% in 1974 to 77% in 1990, and by the end of 2007, it has hit 127%, then in the middle 2008, hit 134%. The wealth effect of the rise of property price further

spurred consumption. As the statistics of the Bureau of Economic Analysis shows, starting from 2005, American households have spent 99.5% of the disposable

personal income of its family members on consumption or repayment of interests. When excluding most of the items concerning self-use housing, the savings of

American households has been under zero since 1999, namely, their expenditures

have exceeded disposable personal incomes. In 2008, an average American household owns 13 credit cards and 40% of them have outstanding balance, comparing to only 6% in 1970.

In the several years leading to the crisis, low interest rates and a tremendous

influx of foreign capital created an economy with easy credit, boosting a boom

of real estate market and consumption based on indebtedness and refinance. The metastability of an over-indebted person primarily relied on his ability to repay both the interests and principals, which meant that the growth rate of his asset

price must surpass the growth rates of interest rate. The increase in assets may come from growth in his salaries, his fixed assets or yields on his investment. However, once these anticipations did not realize, his metastable state would hardly maintain, namely, the borrower would likely default or become insolvent.

Financial entities, both as creditors and debtors, obtained less capital influx

from their debtors, resulting in their inability to make due payments to their

creditors. Their metastability was thus broken and may face bankruptcy. It can therefore be concluded that over-indebtedness will destabilize financial entities and subsequently trigger financial crisis.

As consumption took up over 70% of the U.S. economy, the over-indebtedness

of U.S. households will inevitably lead to a massively indebted U.S. economy. From 1996 to 2004, the deficits of U.S. current account increased by USD650

billion, making up an increased 5.8% of its GNP from 1.5%. To accommodate the deficits, the U.S. government attracted foreign capital influx by increasingly

issuing government bonds so as to retain a surplus in capital account. It also used the status of U.S. dollar as the international currency by increasing circulation.

After the outburst of financial crisis, in order to avoid further turmoil in the financial system, the U.S. government had to use its state finance to inject liquidity to the system, which planted long-term troubles to its state fiscal system.

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Preventing Excessive Speculation in the Financial Derivatives Market Financial derivatives are one way of financial innovations. They are created as a means to make the financial system more efficient, and hedge against or disperse risks. However, they can also be used as instruments for speculation. One of the important reasons the subprime crisis eventually became a financial crisis that swept the whole world was the failure of the U.S. government to prevent excessive speculation with supervision over the market of financial derivatives. In early 1990s, major Wall Street financial entities entered the market of securitizing loans in the name of financial innovation, while their actual purpose was to make profits. They devised financial derivatives tailored for different investors and tried hard to sell them, creating an immense market. Admittedly, the securitization of mortgages effectively transferred the risks from loan providers such as commercial banks, and returned relatively high profits to their investors. But the existence and development of subprime mortgages lowered the quality of the mortgage bonds that supported MBS, and also the quality of the asset pools that supported CDO, making both of them toxic assets, which were nevertheless sold to the whole world. The consequences were caused in part by the faulty policies of the government (encouraging subprime crisis), in part by the negligence of duty of the supervising bodies (relaxing the investigating procedures of loan granting) and in part by the misleading credit rating made by rating agencies (they rated USD32 trillion worth of MBS and CDO as AAA). The 2004 verdict of U.S. Securities and Exchange Commission loosened the restraint of a maximum leverage ratio of 10 to 15 for investment banks, allowing them to issue more bonds, the income of which was mostly used to buy MBS and CDO. From 2004 to 2007, the top five investment banks in the U.S. saw a significant increase in their respective leverage ratios. In the 2007 accounting year, its debts exceeded USD4.1 trillion, or 30% of the GDP of the same year, which meant they would only be weaker amid the depreciation of MBS. Some other financial entities pursued excessive profits by issuing and buying CDO with high leverages. Excessive speculation also changed the CDO from an insuring mechanism to a gambling instrument. Excessive speculation resulted in the accumulation of bubbles in the financial market. A sustainable metastable financial market on high levels requires continuous influx of capital. Once the credit system is broken, the confidence of investors will dramatically reduce and lead to a bubble burst, triggering a severe financial crisis. The ignorance of the risks of financial derivatives and the dangerous mind-set of anticipating greater fools (there will be people more foolish than me, so I will be able to sell off my stocks on a higher price)

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eventually locked most investors in the market till the time of the outburst of the crisis, who incurred great losses. During January 1, 2008 and October 11, 2008, the overall market value of the U.S. stock market shrank from USD20 trillion to USD12 trillion, with the size of stock markets of other nations shrinking by an average level of 40%.

The Central Bank Should not Take Inflation Control as the Sole Objective of Its Monetary Policies Inflation, to some degree, is only a currency phenomenon. Currency is a widely accepted and circulating medium for exchange, including, in modern societies, bank notes and coins. Therefore, inflation means the increase in the amount of currency exceeded the overall increase in commodity and services, thus resulting in a continuing increase in the overall level of price, in other words, a process of continuing depreciation of currency. The Federal Reserve under Greenspan, according to general economic principles, often placed its focus on the control of inflation, rather than on avoiding asset bubbles such as real estate and internet bubbles. And it preferred reacting to bubble burst rather than preventing the formation and expansion of bubbles, so as to minimize the side effects on the economy. The author holds that, in a situation of constant expansion of fictitious economy, if the increase in money supply is absorbed by real estate market and stock market, inflation would not occur; in contrast, in the event of falling real estate market and stock market, the inflow of currency they released into real economy would cause inflation. For example, the rising U.S. property price starting from 2002 was accompanied by a low inflation rate, leading to the wrong assumption by the Federal Reserve that the interest rate could be safely lowered. The Federal Funds Rate stayed under 2% from 2002 to 2004, marking a 40-year low in the U.S.; it was kept under an even lower level of less than 1% from July 2003 to July 2004, leading to further expansion of the bubble in the real estate market. The central bank is an agency authorized by the government to administer monetary policies, which regulate money supply through reserves, discount rates and open market operations in order to restrain inflation. Besides, we should also see that in today’s increasingly globalized economy, the general price level of any country is prone to influences from the global price changes of staples such as gasoline and food, which means that imported inflation can hardly be controlled by monetary policies. A tight monetary policy often backfires when used to tackle imported inflation.

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Preventing Moral Hazard Financial entities are the “factories” in the fictitious economic system, which produce a variety of financial products by means of financial innovation and sell them to different investors inside or outside the financial market. However, when the income and bonuses of employees are highly contingent upon their short-term performance, which is the case in many financial entities, especially investment banks, their employees naturally put priority to their annual bonuses over the long-term healthy development of their companies. In their obsession with high profits, some financial entities and their employees risked violating their professional ethics and exaggerated returns and disguised risks, so as to trick investors into buying their financial derivatives. Investment bankers earned their bonuses from fees of financial derivatives they invented, not from the later performance of these products or profits yielded. Their bonuses were paid in cash rather than in stocks, and even if these products underperform in the future, their bonuses will not be retrieved. The high pay of investment bankers will not be affected by their risky operations of these financial products. They made huge money in their risks over high leverage ratios, for instance, the sum of bonuses for Wall Street high management amounted to USD23.9 billion, and that for Richard Fuld Jr., CEO of Lehman Brothers, reached USD34.4 million in 2007. The management’s arrogance over risks also lied in their belief on government aid, namely, they were betting that the government would not let these financial giants to bankrupt due to bad debts, as they were “too big to fall.” One live example was the 1998 Federal Reserve rescue for Long-Term Capital Management. In fact, in the ongoing financial crisis, Wall Street high management still got to retain their personal high profits and give the losses caused by the corresponding high risks to the government’s hand, which, eventually go to the whole society.

MAINTAINING A SUSTAINABLE AND HEALTHY ECONOMIC GROWTH Under the impact of the global financial crisis, China’s economy has also slowed down. From 2004 to 2005, China’s GDP enjoyed double-digit growths, 10% in 2004, 10.4% in 2005, 11.6% in 2006 and 13% in 2007, respectively, which was also the peak of this economic circle. Under the dual impacts of the global financial crisis and China’s own economic circle, the 2008 growth rate dropped by 4% to 9%. On a quarterly basis, the fourth quarter of 2007 saw an 11% growth rate, the first quarter of 2008 10.6%, the second quarter 10.1%, the third quarter 9% and the

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fourth quarter 6.8%. China’s economic growth has evidently slowed down from the third quarter of 2008, sounding an alarm for the nation’s economy. Therefore, swift and powerful measures should be taken to guarantee the sustainable and healthy growth of China’s economy.

The Stimulus Package The Chinese government announced on November 9, 2008 to implement an expansionary fiscal policy and a moderately loose monetary policy, and to arrange RMB4 trillion into the market as a powerful spur on domestic demand, so as to facilitate a steady growth of its economy. In the meantime, the state established 10 measures to expand domestic demand and trigger economic growth, mainly by powering infrastructure construction such as railway, highway and airport in urban areas and other infrastructure projects in rural areas, and supporting affordable housing projects, energy saving projects, culture and education projects, innovative projects, reconstruction projects in disaster-hit areas, etc. Moreover, the state is currently starting its plan to prop up 10 major industries: steel, automobile, ship, petrochemical, textile, light industry, non-ferrous metals, equipment manufacture, electronics and information, and logistics. It is estimated that the USD4 trillion stimulus package will have the following six effects: First, spur employment. Unemployment has always been a major economic and social concern for China. In the past several years of rapid economic growth, the employed population was also increasing, with 2007 alone posting a 12 million increase. However, unemployment pressure was still intense as a result of an annual flow of 9 to 10 million graduates from different educational institutions into the job market, a pool of 6 million laid-off workers with slight annual increase, and 9 million workers from rural areas that needed to be accommodated in urban areas. According to statistics from Chinese Academy of Social Sciences, the registered unemployment rate in urban China was 4%, while the actual figure was closer to 9.6%. A rough estimate shows that for every percentage point decline in GDP there will be one million unemployed people. Statistics from the National Bureau of Statistics and the Ministry of Agriculture shows an estimated 20 million laid-off migrant workers returned to the countryside before the 2009 Spring Festival. Among them, many would face a hard time getting used to the life at home again and overcoming the surplus of labor in the countryside. Therefore, many of them are likely to stay jobless in urban areas, creating social problems. By investing in infrastructure and housing construction, numerous jobs can be provided, easing the unemployment situation.

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Second, spur demand for production materials such as steel and cement. In recent years, China has seen rapid development in its production of steel and cement, which has topped the world in capacity. However, both production yields and prices significantly dropped due to the financial crisis. The investment in infrastructure will hopefully drive up the demand on such products. Third, better ability to save energy and protect the environment. The rapid economic growth of China in the past several years were to some degree, achieved at the expense of extra energy consumption and the environment. An estimated RMB275 million, or 13.9% of the annual GDP was cost by the resource consumption, as well as deterioration and pollution of the environment in 2005. One part of the stimulus package will be used to save energy, so as to guarantee the sustainable development of China’s economy. Fourth, improve the housing welfare system. There is about RMB900 billion of the total RMB4 trillion that would be used for the construction of low-rent housing and affordable commodity housing. Upon completion, these residences will be distributed to low-income people and propertyless households, and in turn allow these people to spend their money elsewhere. Fifth, power domestic consumption. About 20% of the RMB4 trillion will be delivered into the hands of people through salaries, an indirect spur to consumption. Sixthly, prevent deflation. In the wake of the financial crisis, China’s CPI and PPI dropped from the third quarter of 2008. By the end of January 2009, CPI had dropped for nine consecutive months and PPI two consecutive months, evidently marking a danger of inflation. The RMB4 trillion will hopefully steer the two indexes to a more reasonable level and prevent inflation. Four aspects should be carefully handled in making full use of this RMB4trillion package: The first aspect is how to stimulate social investments with RMB1.18 trillion in fiscal investment. As roughly estimated, under normal circumstances, RMB1 fiscal investment will attract RMB5–8 in social investment. However, under the current economic climate, investors are more prudent than usual, especially about investing in infrastructure projects that often mean lower returns and a longer time for returns. For this reason, measures that encourage social investment, such as increasing the issuance of government bonds, lowering the threshold for entering the market, simplifying investment approval procedures, easier financing, etc., are needed. The second aspect is how to support SMEs (most of which are not stateowned or collectively-owned enterprises). Contributing both to economic growth and easing unemployment, SMEs are however, not a favored client for

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banks’ loan business due to higher risks in the operation of these enterprises and higher transaction costs. As a result, many SMEs could not survive the crisis and went bankrupt. In view of this, policies and economic approach should both be applied to facilitate the survival and further development of these enterprises, such as allowing banks to increase the interest rate of loans to these enterprises (the state will cover the increase in interest rates) and SMEs to pledge their accounts receivable for loans. The third aspect is how to reduce faults in policymaking. To do so, the state will need to stick to scientific and democratic decision making, and avoid rashly carrying out unevaluated projects. The fourth aspect is how to prevent corruption in the start-up and implementation of projects.

Analysis on the Economic Statistics of the First Quarter of 2009 According to the data published by the National Bureau of Statistics, China posted a 6.1% growth rate in the first quarter of 2009, which meant a slowdown in the decline. Despite positive changes as such, the author believes it is still too early for celebration. China’s economy is driven by investment, consumption and net export, which respectively contributed 39%, 38% and 23% to the economic growth in 2007. However, in the economic growth of the first quarter of 2009, their contribution dropped respectively to 4.3%, 2.0% and -0.2%, which clearly shows that this growth was driven mainly by consumption. Serving as supplementary evident to this claim are another two sets of data. The first set of data are the growth rates of the primary, secondary and tertiary industrial sectors, which were, respectively, 3.5%, 5.3% and 7.4%, with the tertiary sector ranking the first; the second set of data shows a 15% increase in the sum of social retail goods on a year-to-year basis, which, if excluding the factor of price difference, was 15.9%, a 3.6% increase from the same time last year. Excluding effects of factors such as the rise in consumption during the Spring Festival (traffic, shopping, catering, etc.), the state’s campaign to “send home appliances to the countryside” and the distribution of shopping coupons, travel coupons and other coupons in many places also played an important role in stimulating consumption. We should note that spurs of this kind cannot last for long. China’s economy still needs the drive of investment and export. Export faces a grim prospect and will hardly improve significantly. The import and export volume of the first quarter amounted to USD428.7 billion, 24.9% down in a year-on-year comparison, with a surplus of USD62.3 billion. Actual utilized amount of foreign direct investment was USD21.8 billion, 21%

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down from the same time last year. The absence of credit resulted in a rise in defaults, further hurting export enterprises in China. The author estimates that China’s economy will start to bounce back in the middle of 2009. The second half of the year will be better than the first, and 2010 will be better than 2009. As the goals of economic growth in different regions of China are set higher than 8%, and the central government can still put forth further stimulus measures whenever it needs, it is likely that China will keep an 8% growth rate this year. Nevertheless, in the course of economic development, China should pay attention to the implementation of the scientific outlook of development, underline energy saving and environmental protection, avoid repetitive construction of low-end projects and avoid increasing excessive production capacity.

Opportunities amid Dangers Chinese enterprises can strengthen their management, restructure their product portfolios, and enhance the quality of their personnel by training in order to overcome the crisis. Furthermore, thanks to the crisis they have more opportunities for overseas acquisitions and mergers. China should change its economic development pattern, changing its economy from an export-oriented one to a domestically-oriented one, and from an extensive economy dependent on expansion of inputs for growth to an intensive one that relies on innovations and technological progress for growth; the state, meanwhile, should accelerate its structural reform in economy, strive for energy saving and environmental protection, and improve social welfare system and public service. The financial crisis will strengthen China’s financial cooperation with the rest of the world, especially in aspects like international financial supervision and prevention of financial risks accumulation and expansion. The author holds that economic globalization and regional integration are two parallel and mutually facilitating processes, while the financial crisis, to some degree, will play a positive role in accelerating regional integration. The “10+1” free trade zone between China and the Association of Southeastern Asian Nations will be realized in 2010, while the cooperation between central banks of Asian countries like Japan and South Korea and China is also intensifying; the special drawing right proposed by the Asian Development Bank is already under discussion. The financial crisis will also serve as a catalyst for the reform of the global financial system and the establishment of a new financial order of a changed world. All nations share the same responsibility to establish a steady, balanced

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and fair world currency system, which will not only be helpful in preventing financial crisis, but also in facilitating the formation of a multi-polar world.

PROMOTING CHINA’S FINANCIAL REFORM In the recent 30 years, as the reform and opening up continued to be implemented, significant achievements are seen in China’s financial reform. The author believes that the relatively minor impact that China suffered compared with other nations should be attributed to the powerful government support for the financial system, as well as a better confidence the Chinese public have on the government. We should nevertheless admit that there is still a long way ahead of us in our financial reform, as the overall competitiveness of China’s financial sector still lags behind. As the world’s third largest economy, China is a big buyer and seller in foreign trade, a contrast to what remains a weak voice in the world’s financial market. Changing this requires more domestic financial innovations and strengthened financial supervision. The onset of the Wall Street financial storm in the U.S. generated heated domestic debates over China’s financial reform, with some opinions virtually questioning the direction and progress of the reform. President Hu stated that, “reform and opening-up is a new and great revolution…its direction and approach are unquestionably correct, and its effects and achievements are undeniable. Stopping it or reversing it will only lead us to a dead end.” China, under the precondition of economic and financial stability, should follow the guidance of Premier Wen, i.e. balance the relations between financial innovation and financial supervision, fictitious economy and real economy, and saving and consumption. It should also implement an unwavering, active, and prudent financial reform in China, constantly improve the nation’s financial services, and enhance its financial efficiency and international competitiveness. The author believes there are three primary directions the financial reform of China should follow.

Internationalization While economic globalization has been recognized as an unstoppable trend, as it develops, financial globalization is also happening. In its developmental trend, we can see the following characteristics: The first characteristic is an increasingly fictitious nature of currency. Exchange rates are increasingly becoming an instrument in political games among nations. After currencies got rid of the gold standard and the gold

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exchange system, their values have no more objective standard, which is to say, they are to some degree fictitious. In this case, their values can only be calculated based on their purchasing power. The author holds that there are two kinds of purchasing power, one being domestic purchasing power and the other international. While domestic purchasing power can be evaluated with purchasing power parity, or PPP, international purchasing power should mainly be evaluated based on exchange rates. Under such circumstances, the exchange rate systems of nations become to some degree an instrument of political games among them. When a nation has completely no import, the domestic purchasing power of its currency would equal its international purchasing power, and changes over exchange rates have no effect on the currency’s domestic purchasing power. In contrast, when a nation completely relies on import, the purchasing power of its currency would be completely dependent on the exchange rate. But all nations in the world are somewhere in between these two extremes, which means the exchange rates of these nations’ currencies cannot simply be decided by PPP. If every nation take into consideration the global interests, then a Pareto Optimality may be reached, which is beneficial to everyone. However, no single country in the world would place the interests of the world ahead of its own, thus making the exchange rate systems of nations an instrument of political games to some degree. As is known to all, the Plaza Accord and the Louvre Accord left Japan with a recession lasting for more than a decade. Amid the Southeastern Asian financial crisis, China faced intense pressure to depreciate RMB, while now it faces pressure to do the opposite. These are evident of how exchange rates are used as a political instrument between governments. China, should therefore stick to the principle of “prioritize its own stance and protect its sovereignty.” Naturally, in the decision-making process, many factors should be considered. However, in issues concerning sovereignty such as exchange rate, China can by no means follow the opinions of others. The second characteristic of financial globalization is the increase in both the scale and speed of capital. As technology advances, nowadays, with a push on the button, trillions of fortunes can be transferred to anywhere in the world in a second. The third characteristic is the increasing integration of financial markets in the world, i.e., the links among financial markets become stronger and stronger to the point that even a minor event in one financial market will lead to changes in other financial markets. The Southeast Asian financial crisis began with a liquidity crisis in Thailand, but its effect could be felt all over the world. The subprime crisis in the U.S. sent its effects across border to Europe and elsewhere

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in the world, and eventually developed into a global financial crisis. The last characteristic is the unremitting financial innovations. After WWII, financial innovations made its debut on Eurodollars. In the following several decades, we saw unremitting financial innovations, bringing in front of us generations of financial derivatives. Currently, the total volume of financial derivatives is eight to ten times the size of the global GDP. With so many kinds of financial derivatives as our options, how to prevent financial risks and excessive speculations with these derivatives are important questions needed to be answered. Under an integrating global financial market, China must enhance its international competitiveness of its financial sector, and adapt to the abovementioned characteristics of financial globalization with reforms on itself. The first thing for the country to do is to learn from others’ experience. In terms of financial innovations, China barely has enough knowledge and even less practical experience. It would therefore very likely to be in a disadvantageous position in the international financial competition. Examples abound: the China National Aviation Fuel incident, the China National Cotton Reserve Corporation incident and the State Reserve Bureau’s copper incident, in all of which China incurred great losses. Therefore, China should unceasingly learn international financial products and the rules of the financial game. It should at the same time cultivate its own talent, who should have an international vision and the ability to operate and manage international finance. In this aspect, China should obtain these talents both by bringing in foreign talent and cultivating its own.

Marketization In terms of promoting marketization, the priority, as the author believes, is the marketization of interest rate. Interest rate is the cost of capital, which actually depends on the risks and cost of transactions. Therefore it should be marketized. Either interest rate of loans or that of deposit should be given a range within which the interest rate is allowed to float. Secondly, exchange rate should be marketized. Exchange rate itself reflects a currency’s international purchasing power, which is constantly changing. The exchange rate system of China should be continuously modified according to the requirements of marketization. It should be marketized based on changes over RMB’s purchasing power and its supply and demand. Since July 2005, when China started to adopt a managed floating exchange rate based on market demand and regulated with reference to basket of currencies, RMB has appreciated by 20%. However, such a floating is not

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completely in accordance with market discipline. The author holds that China should allow its exchange rate to float within a target range and intervention from the central bank should be carried out only when the exchange rate exceeded that range. Naturally, RMB will eventually be exchanged freely. In 1996, China began to allow current account, but capital account is still banned. Among the 43 accounts specified by the IMF, only about 20 of them have been basically opened, thus further progress is still to be phased in. This primarily depends on China’s management ability, as China will not be able to loosen its control over exchange rate before it is capable of managing problems concerning exchange rate. Secondly, loosening its control needs a good timing, namely, China should decide when to loosen its control according to the international environment, and the relative strength of U.S. dollar, euro and Japanese yen. The complete freedom of exchanging RMB is only a matter of time. Despite the absence of a schedule, it will not be long before it happens. The marketization of China’s exchange rate is not completed until RMB becomes one of the world’s freely convertible currencies. The third point concerning marketization is China should constantly increase the number of market participants. Currently, most of the banks, security companies and insurance companies are still primarily state-owned, with a very limited shareholding by foreign or private investors. The 36 guidelines concerning non-state-owned economies clearly encourage the participation of private capital in small and medium–sized financial entities. More participants in the financial market will improve China’s financial system. Surely, there should be certain rules concerning the participation so as to protect national security. For instance, it is now stipulated that in banks, shares held by a single foreign capital should not exceed 20%, and shares held by foreign capitals should not exceed 25% of the total.

Systemization First, finance is closely linked to the economy, therefore, finance cannot be separately considered without the economy. Finance belongs to the fictitious economy, while production, circulation, exchange, etc. belong to the real economy. Problems generated by the fictitious economy will transfer to the real economy, and vice versa. The reason the U.S. government spares no effort to fight the current financial crisis is to prevent it from becoming an economic crisis. We should therefore follow the direction pointed out in the report of the 16th NPC and handle the relations between fictitious and real economies correctly. Second, finance is an integrated system, rather than a group of disparate

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parts. Foreign exchange market, stock market, bond market, insurance, futures, etc. are all parts of an integrated system. We should therefore think with this integrated system in mind, rather than confining our thinking to any of the specific aspects. In the long run, China should still phase in mixed operation and comprehensive supervision. Only through comprehensive supervision can China comprehensively avoid risks. Otherwise, different supervising bodies will limit their actions within their own sectors. If the China Securities Regulatory Commission confines all its actions to guaranteeing the safe operation of security market, risks will only be transferred to, for instance, insurance market or foreign exchange market, problems breaking out in the two markets will in turn affect the security market. Third, China should build a multi-layered financial market. Currently, China’s security market has reached a certain scale, but its bond market is still underdeveloped. As a matter of fact, bond market has its own feature, as although the return rate of bonds is lower than stocks, they are safer. China should not limit its efforts in developing its stock market, but should go further to developing bond market, foreign exchange market, futures market, etc. The development of financial futures can be started based on stock index futures. In the course of development, China should be very cautious about excessive speculation and any other potential risks. In institutional economics, a famous saying goes like this, “transaction before institution,” which means that it is impossible to conduct transactions after a perfect institution is set up, rather than that, only when transactions are carried out under a basic institution can problems be spotted and can the system be further improved. Fourth, supervision should be systemized. The current supervising mechanism comprising “one bank and three commissions” should be equipped with a coordinating agency. The systemization of supervision should accomplish the following goals. First, recognize the purpose for supervision is to protect public interest. Unfortunately, when problems occur, the supervising bodies often put the interests of financial institutions ahead that of the public. Admittedly, currently China’s banks, insurance companies and security companies are all state-owned, which means their losses are the losses of all Chinese citizens. However, the wealth of a nation is closely related to that of its people. So goes the saying: “When a main river is filled with water, its branches are the same; when the main river is dry, its branches are the same.” It means only when a nation becomes rich can its people become rich, too. However, the opposite is equally true, as when the branches get dry, the main river would hardly avoid the same fate. Therefore, the wealth of a nation and the wealth of its people supplement each other. In this sense, protecting the interests of people is to a certain degree

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protecting the wealth of the nation. Supervision should start with information disclosure, which requires the transparency of the supervision itself. Information disclosure means protecting the financial consumers’ (investors, depositors, insurance policy holder, etc.) rights to be informed. Only when information disclosure is properly done, can analysis be conducted, can problems be spotted, announced and solved. The supervising bodies should not be responsible for the ups and downs of market, but should be responsible for the truth, completeness and timeliness of the information disclosed. Finally, services should also be systemized. China’s financial entities such as insurance companies, security companies, and banks should all have a better sense of services. Financial sector is in its nature a service industry, which means it should have presented good services from the very beginning of its existence and constantly strive to improve its services. In this aspect, China’s financial entities still have a long way to go if they want to catch up with those of world class. The author was told a story by an overseas student in Japan, who witnessed, when he was having noodles at a restaurant, bank employees coming to the restaurant to collect the restaurant’s daily revenues to deposit into the bank, and would come again the next morning to give change to the restaurant for its use. Admittedly, none of China’s banks would render services at this level. In retrospect of the financial crisis, we should see the two sides of the effect of fictitious economy on real economy, namely, on one hand, fictitious economy facilitates the growth of real economy; on the other, the excessive expansion of fictitious economy and fictitious capital would impede the real economy, and risks in the fictitious economy will transfer to the real economy, as can be seen in the translation of financial crisis into a economic crisis. We should conduct serious thinking, conduct analysis and draw conclusions from the ongoing crisis. We should also lift our confidence and fight the hardship of the crisis under the guidance of China’s central government. As what the author stated on November 22, 2008 in Guangzhou, based on his own analysis, he believes that China’s economy will see a recovery in 2011. The heads in the APEC meeting announced on November 23 of last year that the financial crisis would end in 18 months. Be it 18 months or 24 months, the crisis is bound to end sometime in the future. Just as the famous poem goes: “When winter comes, can spring be far behind?” If we join our hands in the efforts to fight the crisis, another vigorous spring for China’s economy and capital market is bound to come. Completed on April 30, 2009

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338

Index ARCH (Auto -regressive Conditional Heteroskedasticity) 102 ARM (adjustable-rate mortgage) 302-3 basket of currencies 226, 229, 233-4, 237, 240, 244, 246, 316 BEER (behavioral equilibrium exchange rates) 217, 238-9 black market 238, 245 Bretton Woods System 225, 227, 229 capital pools 138 CDO (collateralized debt obligation) 1389, 282, 284, 295-9, 304, 306 CDS (credit default swap) 138, 282, 284-5, 297-8 Central Economic Work Conference 2, 15, 141, 145, 148 central exchange rate 237, 240 CCGI NK (China Corporate Governance Index) 204 China's capital market 178, 191 commodity housing 251, 253-4, 261-5, 267, 270, 275 commodity housing market 255, 262-6, 268, 270, 272-6 commodity properties 254, 264, 268-9 Company Law 39, 114-15, 117, 120, 173, 186, 193 compensation mechanism 174-5 complexity science 41, 50, 54, 90, 94-5, 97-8, 102-3, 123, 214 Contract Law 182-3, 186, 276 corporate governance 165, 188, 204 corporate stocks 160, 179, 196 CPCCC (Communist Par t y of China Central Committee) 2, 15, 55, 59-60, 106, 122, 135, 150, 191

CPI (consumer price index) 7, 148-9, 152, 154, 310 CPV (certified public valuer) 171 credit capital 3, 75, 77-8 credit crisis 282, 287-8, 292, 299-300 credit ratings 77, 287, 295 creditors 77, 294, 297-8, 305 CSRC (Ch i na Se c u r i t i e s R e g u lato r y Commission) 157, 161-2, 164-5, 171-2, 176-7, 183, 187, 189-90, 206-8, 317 currency market 75, 80, 98, 299 currency virtualization 86, 214-15 debt crisis 282, 284, 292-3, 295, 297, 299 bad debts 87, 284, 290, 293, 298-9, 308 decentralization 56, 69-70 defaults 138, 283-5, 292, 296-9, 312 delisting 185-6 divestment 110-11, 115, 117, 119, 129 economic bubbles 88, 200, 220, 222 EEC (European Economic Community) 234 effective demands 255, 262-3, 265 elasticity coefficient of investment 15, 143 EMS (European Monetary System) 236 Engel coefficients 8-9 equity tranche 295-6 ERER (equilibrium real exchange rates) 217, 239 ERM (exchange rate mechanism) 226, 233-4 euro 133, 213, 222, 227, 237, 316 evaluation index systems 95, 204 exchange rate arrangements 224-5, 228, 230-2 exchange rate fluctuations 221-2, 233-4, 243-4

Index

exchange rate misalignment 230, 238-9, 246 exchange rate regime 213, 222-4, 229, 231-2, 246 exchange rate target zone 233-5, 245-6 FDI (foreign direct investment) 17-18, 213, 218-19, 230, 242, 244, 312 FEC (foreign exchange certificate) 229 FEER (fundamental equilibrium exchange rates) 217, 235, 238 fictitious capital 3, 42, 74-84, 89, 126, 159, 214, 218-20, 282, 289-92, 299, 304, 318 fictitious economic system 86, 88, 92, 209, 222 fictitious value system 74 financial assets 88, 101, 146, 174, 191, 199-200, 212, 285, 297, 299, 304 financial capital 45, 123, 136 financial derivatives 83, 220, 277, 284-5, 290-1, 295, 298, 306-8, 315 financial efficiency 277-8, 313 financial institutions 92, 138-9, 153, 242, 294-5, 298, 300, 317 financial market instruments 159-60 fixed assets 15, 142, 152, 305 fixed exchange rate regime 223, 225, 228-9, 231-3, 235 floating exchange rate 223, 225, 228-9, 231-5, 245 foreign exchange reserves 2, 17-18, 43-4, 136, 139, 146, 212, 225-7, 242, 244-5 foreign exchange retention system 229 foreign investment 18, 31, 55, 132, 136, 146, 212, 219, 230 free capital flows 223-4, 228 free convertibility 68, 215 full employment 2, 238 futures 62, 74-5, 80, 83, 87, 106, 243, 291, 317 GEM (growth enterprise market) 110, 120, 125 general investors 40, 120, 181, 184, 192, 195, 197, 207-8

340

Gini coefficient 8, 134 GPSS (general purpose simulation system) 103 GSII (global summar y innovation indicator) 28-9 hard target zone 236-7, 245-6 hot money 18, 147, 150, 233, 244-5 housing guarantee 254-5 housing reform 250-1, 272, 274 IMF (International Monetary Fund) 218, 234, 316 immovable properties 75, 77 incremental taxes 265-7, 270 inflation rate 6, 148, 216, 226-7, 269 initial capital 291 innovation capabilities 41, 43, 45-6 innovation-oriented country 23, 26-7, 29, 31-3, 35, 37, 41, 43-7, 49, 51, 113, 122, 124, 130 insider trading 157, 162, 174-6 institutional economists 39, 54 institutional innovation 33, 38-9, 41, 43, 53, 55, 57, 59, 61, 63, 65, 67, 69, 71, 124 institutional investors 121, 167-9, 205-6, 208, 284 insurance funds 169, 184 intangible assets 101, 171 intellectual property 27-8, 42 interest-bearing capital 75, 79-80 international balance of payments 17-18, 213 international payments 7, 215, 230, 240-1, 244 intrinsic value 75-6, 78 investment funds 139, 219, 284-5 IPCC (Inter-governmental Panel on Climate Change) 20 knowledge capital 3, 42, 45, 78, 126 knowledge economy 41-2, 111

Index

knowledge gap 13-14 learning organizations 49-51 leverage ratio 282, 291 liquidity 80, 83, 138, 146, 150, 159-60, 167, 226, 268, 277, 283, 287, 290, 298, 300 liquidity crisis 81, 282, 285, 287, 292-3, 298-9, 315 loan interest rates 264, 311, 315 low-rent housing system 255-7 Mainland China 106, 109, 123, 194, 208 management innovation 33, 36, 38, 41, 48 market mechanism 213, 233, 251 market subjects 92, 117-18, 124, 158, 236, 240, 271 market supervision 161, 163, 188-9, 207 market value 157, 186, 200, 286, 307 marketization 217, 236-7, 315-16 Marx 74-6, 282, 289 mathematical finance 92, 101-2 MBS (mortgage-backed security) 138, 278, 282-6, 293-8, 303, 306 metastability 84-5, 190, 305 the Ministry of Construction 255-7, 259 the Ministry of Science and Technology 106, 108, 126 monetary policies 92, 141, 146, 149-50, 152-3, 190, 208, 223-4, 230, 232, 235, 307-9 money supply 86, 148, 235, 307 mortgage loans 283-5, 294, 297 NASDAQ 112, 119, 185-6, 201 Na t i o n a l D e v e l o p m e n t a n d R e f o r m Commission 70-1, 108 negotiable securities 80, 282, 289 net assets 116, 181, 188, 201, 238, 304 net capital inflow 200-1 net profits 203, 205, 265-7 nominal exchange rates 225, 227, 245

non-tradable shares 181, 183, 201 NPC (National People's Congress) 2-4, 9, 11, 13, 22, 39, 54, 57-63, 71, 96, 107, 115, 118, 148, 189 open-market operations 150, 236, 307 over-indebtedness 83, 291, 304-5 patents 13, 27, 32, 34, 42, 47 PBOC (People's Bank of China) 150, 153, 229-30, 234, 236, 242, 272 pegged exchange rate regime 231 planned economic system 55-6, 67, 136, 249 policy-oriented market 176-7 power centralization 56, 69-70 PPP (purchasing power parity) 9, 134, 216-17, 275, 314 primary mortgage market 292-3 private capital 128, 287, 316 private placement 101, 168 Property Law 4, 272 property market 261, 267-9, 271-2, 274, 276-7, 295 property price-income ratio 262-3 qualitative variables 98-9 R&D expenditures 14, 35, 48-9 real capital 77-8, 81, 126 real economic activities 3, 76, 79, 81, 200 real exchange rate 227, 237-8 refinance 284-5, 294, 298, 303, 305 registered capital 114-16, 136, 170 REITs 278 RMB equilibrium exchange rate 239, 246 rural labor 5-6 scientific outlook on development 3, 5, 7, 9, 11, 13, 15, 17, 19, 21, 23 second board market 110, 117, 119-20, 122, 204

341

Index

second-hand housing 276 secondary fictitious capital 78, 81 secondary mortgage market 293-5, 298 the Securities and Exchange Commission 286, 306 the Securities Law 115, 117, 157-8, 162, 166, 168, 170-5, 177-8, 182-3, 186, 193 securities market 75-6, 80, 82, 114, 139, 156-8, 161-2, 166-7, 169, 172-3, 175, 177, 180, 196 securities marketization 160, 196 securitization 283, 293, 296 self-organizing effect 92, 94-7, 124, 164, 189, 260, 265, 269, 302, 304 Shanghai Stock Exchange 120, 156, 168, 184, 192, 195-6, 198, 200-2 Shenzhen Stock Exchange 90, 120-1, 156, 168, 184, 200-1 single dominant stocks 162, 167, 181, 186 SMEs (small and medium-sized enterprises) 27, 113, 120-1, 150, 153, 311 social capital 3, 78-9, 126, 146, 158, 181 social equity 9, 55, 62-5, 261, 270, 272, 302 social investment 30, 310 social security funds 11-12, 56, 172, 208 social security system 6, 10-12, 65 socialist market economy 4, 6, 11, 62, 66, 107, 111, 125, 241 soft target zone 235-7, 245 speculative capital 244-5 SPV (special purpose vehicle) 294-6 state-owned enterprises 95, 101, 118, 136-7, 158, 165-7, 171, 180, 205 stock equity 116, 119 stock market bubbles 97, 156, 191, 206 stock speculations 163, 202 strategic investors 184 subprime loans 283, 302-3 subprime mortgages 284-5, 292, 294, 302-3, 306 surplus value 76, 86 sustainable development 2-3, 14, 19-22, 48, 55, 241, 248-9 synchronous growth 4, 12, 65, 241, 243

342

technological innovations 33-5, 41, 48 TFP (total factor productivity) 30-1, 142 TQC (total quality control) 38 TQM (total quality management) 38 tradable shares 167-8, 181, 183, 185, 206 urban investment 152 urbanization 5-6, 21 usufruct 76-8, 159 venture capital 108-17, 119-22, 124-7, 130 welfare housing 252-5, 260-1

Selected Works of Cheng Siwei: Economic Reforms and Development in China Volume 3 This book, in three volumes, presents the thoughts and reflections of the highly-regarded Chinese scholar and statesman, Cheng Siwei. The author outlines his theories for bringing economic reform to China in the context of a global economy. Using the principles of complexity science and finance, the author also elaborates on the characteristics and laws of fictitious economy in China, and from this perspective, studies such issues as the reforms of the Renminbi exchange rate regime and housing system, development of stock market and venture capital investment, and economic challenges and countermeasures in contemporary China. This book has been highly regarded by top-ranked Chinese politicians and distinguished scholars, and is essential reading for anyone wishing to understand the economic complexities of the development of China. • Authoritative commentary by a leading Chinese Statesman • Comprehensive coverage of economic and financial complexities facing China • Detailed examination of developmental issues facing China • Unique insight into China’s unparalleled growth and development

Author

He is now leading the Research Center on Fictitious Economy and Data Science at the Chinese Academy of Sciences. His research mainly covers complexity science, fictitious economy, and venture capital. Over the years, he has published 22 books and 200 articles. His proposal entitled “A Proposal on Speeding up the Development of Venture Capital in China” was ranked No.1 in the first meeting of the Ninth National Committee of the Chinese People’s Political Consultative Conference in 1998, and he has been dubbed the “Father of Venture Capital in China” by practitioners in the field for his groundbreaking work in this area. Chinese Economic Studies

Cheng Siwei

Cheng Siwei is the Chairman of International Finance Forum, and a former Vice Chairman of the Standing Committee of the National People’s Congress of the People’s Republic of China. He is the Dean of Institute of Management at the Graduate University of the Chinese Academy of Sciences, and Honorary Professor of the Faculty of Business Administration at the Chinese University of Hong Kong. He was an academic advisor to the World Bank Institute and Director at the Department of Management Sciences at the National Natural Science Foundation of China.

Economic Reforms and Development in China Volume 3

Interpreting China’s Economy through the Eyes of a Chinese Statesman

Selected Works of Cheng Siwei:

Economic Reforms and

Development

in China Volume 3

Cheng Siwei