The Capital Market in China : A 60-Year Review [1 ed.] 9781623200602, 9781623200053

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Three-Volume Set

The Capital Market in China: A 60-Year Review

The

Capital Market in China:

Cao Erjie

Published by Enrich Professional Publishing (S) Private Limited 16L, Enterprise Road, Singapore 627660 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 2/F, Rays Industrial Building, 71 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Hai Dian Zhong Jie, Haidian District, Beijing, China United States Office: PO Box 30812, Honolulu, HI 96820, USA English edition © 2014 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2012 China Renmin University Press Translated by Barbara Cao Edited by Barbara Cao and Glenn Griffith 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 and retrieval system now known or to be invented, without prior written permission from the Publisher. ISBN (Hardback)

978-1-62320-002-2

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

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.

Printed in Hong Kong with woodfree paper from Japan

Contents Preface........................................................................................................................vii.

Introduction

The Value of Capital................................................................. 1

Chapter 1

How Capital Is Formed: The Mechanism of Capital Formation and the History of Capital Expansion and Innovation............................................................................... 37

Chapter 2

Capital Is Not Only a Product of a Capitalist Society......... 53

Chapter 3

Joint-Stock System: From Socialized Mass Production to Capital Socialization.......................................................... 65

Chapter 4

State Investment, State Intervention, Nationalization, and Privatization: Innovation of the Capital Formation Mechanism by China’s State-Owned Economy................... 87

Chapter 5

A Depreciation Fund as a Ready Accumulation Fund for Expanded Reproduction................................................ 163

Chapter 6

Financial Leasing.................................................................. 193

Chapter 7

Reorganization and Debt-For-Equity Swaps of Distressed Enterprises.......................................................... 207

Notes........................................................................................................................ 223. References................................................................................................................ 229 Index......................................................................................................................... 243

Preface Despite the facts that there was a 40-year period when China avoided the word “capital,” and despite the fact that the U.S. subprime mortgage crisis has evolved into a global financial tsunami, I still choose to name the book “Capital is A Good Thing” [This is the translation of the original Chinese book title.—Ed.], and it will inevitably cause some dispute. In my view, I am judging the contribution of capital to the world and the innovation process of the capital formation mechanism. Although the capital form repeatedly brings disaster to the world, as Marx and Engel said early in the Communist Manifesto it was the “bourgeoisie, during its rule of scarcely 100 years, [which] has created more massive and more colossal productive forces than have all preceding generations together.” As they further explained: “The inexhaustible productive powers of modern industry” is “the first condition of the emancipation of Labour.” A series of questions need to be asked: How is capital formed? How should we look at the efficiency and the expansion of capital? How should we understand capital operation and capital culture? How should we perceive the ratio between investment and consumption? How would we speed up financial reform and direct excessive capital to the capital market? How could we view the global financial crisis? How would we gather financial strength and actively cope with financial crisis and superpower games in the financial area? How would we recognize, be alert to, and prevent a variety of fears towards capitalism? How should the revolutionary party turn workers into men of property? How would we shape a good mechanism which could promote the innovation of the capital formation mechanism and the sustained expansion of capital (namely, capitalization)? and many other similar questions. This book was inspired by an article on core capital written by Xia Xiaojun in 2006. Initially, I had just published “To broaden the room for the innovation of capital formation mechanism” in Financial Times and China Construction Bank Post.

But later I deeply felt that the capital formation mechanism is broad in content and one or two articles are not enough to get the idea across. My life experiences made me feel the need to conduct an in-depth discussion and therefore the desire to write a monograph sprouted up. The first draft of this book was finished in 2007 but the content was repeatedly revised up until 2011, so the publication of this book missed the 30th anniversary of China’s reform and opening up and the 60th anniversary of the founding of the People’s Republic of China. The 60-year socialist construction was a long and bumpy road. In the first 40 years, we gulped down the

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Preface

concept of capital without thought, mentioned the concept in a vague sense, and

avoided using the word “capital.” In the next 20 years, we suddenly became clearminded that capital is a good thing. This should be the best commemoration for

the 30th anniversary of China’s reform and opening up and the 60th anniversary of the founding of the People’s Republic of China.

Marx is great. Although Marx opposed capitalism and capital, he devoted

his whole life to making thorough research on all aspects of capital and its law of motion and contradictions. At last, he focused on share capital and found that

it may be “the transitional forms from the capitalist mode of production to the associated one” and may also be “the most perfected form” which turns into communism.

Later Marxists, especially those who were in power in some countries, lacked

the truth-seeking spirit of the founders of Marxism who had the courage to study the capital movements through the capitalist mode of production. Those

Marxists held paranoid and arrogant attitudes which were incompatible with the

ruling proletariat, displayed condescension, and despised capital for fear of being contaminated by capitalist bacteria. They were against and avoided talking about

capital, so in their economic construction there was an absence of capital culture. Consequently, later Marxists possessed neither general knowledge of capital movements nor the wisdom to cope with the problems.

Deng Xiaoping is great. He bravely proposed that “if socialism wants to gain

advantages comparable to capitalism, it must boldly absorb and draw upon all

achievements of civilization created by human society, absorb and learn from the nations around the world, including the developed capitalist countries, all the advanced mode of operation and management methods that reflect the laws

governing the modern socialist production.” These words become the beacon lighting up our way to build a socialist society with Chinese characteristics.

In the 100 years after Marx’s death, the capitalist mode of production

underwent new developments and the capital formation mechanism experienced

constant innovation. The rapid development of science and technology since World War II pushed forward the progress of productive forces and enabled capitalism to

get away from Lenin’s prediction that it was “decadent” and “dying.” The rulers

of the capitalist countries, especially the leaders of democratic socialist parties peacefully rising to power via parliamentary election, borrowed the socialist

country’s practice of focusing on staff welfare and the public interest. By doing so, they eased the class contradictions, found a way out of the dilemma of being “decadent” and “dying” and pushed the capitalist economy and finance into a new

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phase of prosperity. They also invested in human resources during the economic .

development, and namely increased the spending on the investment in the

capacity and quality of humans. It exerts more and more an important influence on economic development and therefore middle- and high-income groups greatly

increase in the present society and a huge middle class emerges, which Marx failed to foresee.

To follow a road to socialism with Chinese characteristics, to engage in the

socialist market economy, and to build a harmonious society putting human fundamentals first, we must manage capital, promote the innovation of the capital

formation mechanism, and respond to the call of the CPC Central Committee of “enlarging the proportion of the middle-income group” in order to open a broader path for the economic construction of the socialist society.

I devoted all my life to financial practice and research. After more than

60 years engaged in investment I now review the experiences and research of

investment, either investment, loan, replacement of appropriation by loans,

asset depreciation and renovation, finance lease, shareholding reform and listing of a company, capital and bond financing in capital market, enterprise asset restricting, corporate merger and acquisition, bankruptcy and debt-equity swap of an enterprise, or investment funds, asset securitization, financial derivatives

market, etc., as the innovations of capital formation under different conditions which become the means of capital expansion. From the experience of investment

management practice, I understand the nature of capital expansion, and therefore, I would elaborate on various economic issues encountered since the founding of the new China, from the angle of the capital formation mechanism. Those issues include: 1. During the planned economy period, the vicious circle of “production

putting pressure on capital construction, capital construction diverting pressure to the finance department, the finance department placing fiscal pressure on the

Central bank, and the bank issuing more money” resulting from the pursuit of a high target of the State Planning Commission, the lateral transfer of collective funds by local governments, the bad practice of “pushing capital construction

to increase production, then driving overhaul, and finally raising the total costs” and the misappropriation and abuse of loans by enterprises, and the increase of financial excess by expanding the capital through the “small financing

loan” by the local governments; 2. After the reform and opening up policy was

implemented, the contract operation of the local departments and enterprises, the

“fund-raising boom” and “bond boom” of local governments, foundations and financial institutions run by local governments, counterfeited inter-bank lending

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and circumventing of credit ceiling, replacement of appropriation by loans, fiscal

credit and debt-equity swap, red chip stocks, Zibo Securities Trading Automated Quotations System and Chengdu The Red Temple Market for the exchange of

private company shares, etc. Some of those are innovations while others are illegal measures. The review of the 60-year history of capital innovation indicates that

there is but one step from innovation to violation and from truth to absurdity. The financial administrative authority should keep a clear mind, size up the situation and make the best use of the circumstances. It should be able to straighten out

the productive relations based on the institutional reform, stimulate, protect, and control the incentive of all capital and pave the way for innovation of the capital

formation mechanism. It should try its best to transform all the idle social wealth

into wealth-producing capital and open up the way for the development of the productive forces of socialism, instead of being something indifferent to the needs of the people or which punishes innovative cadres or is easily thrown off course by a slight setback.

In the last 30 years, the socialist market economy of China continued rapid

growth with an annual growth rate of more than 9.7% and only half way to the

comprehensive industrialization and urbanization. In the future, the remaining works will definitely drive the sustained high-speed growth of Chinese economy, and I think this process will continue for another two or three decades with the

expected average growth rate of 7% to 8%. In the last 30 years, we searched all

over the world for capital in order to build a prosperous real economy. In the next 30 years, we will spare no efforts to innovate the capital formation mechanism

and not only make the real economy bigger and stronger but also devote ourselves to the development of the capital market and the virtual economy, the

financialization of the economy, and the control over economic financialization. We could transfer our huge savings at the right price against the backdrop of the

global trade imbalance, but must make sure a better return in the financialization of the economy.

At present, the economic and financial globalizations develop very rapidly

and the financial development is far faster than the economic development. In

the recent 10 years, especially in the five years prior to the global financial crisis, the global real economy increased at a growth rate of 5%, while the finance at a growth rate of 20% to 30% and financial derivative products at a growth rate of

70% to 80%. The over-issuance of the U.S. dollars by the U. S. monetary authority resulted in the depreciation of the dollar, and low-interest dollars spread all over. It

gave rise to global excess liquidity and the rapid surge of financial assets, and the

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Preface

scale of and risks born by the financial market were far larger than the promotion and adjustment functions of the financial market to the real economy. But in the end, the virtual economy must serve the real economy because the real quality of life of mankind is decided by the real economy, that is GDP growth, rather than virtual assets. Our current problem is that the excessive development of financial derivatives and the virtual economy is divorced from the real economy and thus losing the foundation. The current global financial crisis is an unprecedented serious financial crisis. Soros attributed this most serious financial crisis to the market fundamentalism which believes in the self-balancing of the financial market mechanism. Soros’ words are very educational. The practical problem is that the prevention, control and management of financial risks fall behind the expansion of the scale of the virtual economy, and financial supervision and global financial coordination lag far behind the development of the real financial market and the virtual economy. But with the deepening understanding of the objective laws of capital movements, we can finally control and manage capital for the benefit of mankind. Economic and financial globalizations are both a change and a challenge for a rising power like China and force one to keep up with the pace of the globalizations. In the face of the global economic financialization, the lower speed of our nation’s economic financialization will result in us being controlled by others and we may also miss a golden opportunity for development in the global economic adjustment. We must learn to swim by swimming. On the one hand, we should develop the virtual economy and the capital market and accelerate the financialization of the economy in order to integrate with the global economy and finance and also benefit from this process. On the other hand, we should learn how to prevent, control, and manage risks in the financial fluctuations, and make the financial market and virtual economy serve, rather than damage, the real economy. Let the economy and finances serve the purpose of improving the quality of life in China’s peaceful rise, especially achieving the prosperity of the people, and commit to the appeal of the Central Committee of the Communist Party of China in “expanding the proportion of middle-income group” to turn the workers into men of property. Cao Erjie August 2011

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Introduction: The Value of Capital

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

What is capital? In general, capital is an accumulation of money, but not all

money is capital. According to Marx’s definition, only when money functions in

production and circulation and brings the added value of surplus value (namely,

profits) on the basis of modern production methods, can money truly become

capital. Until then, money as capital possesses the use value of producing surplus value (profits). In one word, money can turn into capital only when money is able to produce profits.

Capital Is the Prerequisite for Economic Growth and the Prosperity of the People Capital, like labor, is a prerequisite of economic growth. The development of the

economy in any country cannot be done without capital accumulation. The rise of a superpower especially requires capital. The function of capital in a capitalist

society is to exploit surplus value and produce profits while in a socialist society it is to complete the accumulation of surplus labor time. In a developing country where labor resources are abundant, capital becomes even scarcer. Undoubtedly,

without labor, the machines purchased by capital are just heaps of metal, whereas without the capital necessary for purchasing machines, labor will have nothing to

do. The more underdeveloped a country is, the more excessive the labor resources and the scarcer the capital and, therefore, the country has to tolerate exploitation to introduce capital for economic development.

Even in a capitalist country, views on exploitation should be divided into two.

Apart from the exploitation of surplus value, capital serves another important function, that is, to accumulate surplus labor time when the surplus value (profits)

is again transformed into capital and starts capital accumulation. So, Marx thought

that “the surplus labor time, which, even without the existence of capital, must constantly be performed by society, in order to have at its disposal, so to speak,

a fund for development.”1 But under a socialist society with public ownership,

capital is purified into a development fund essential for sustaining and expanding the development of social production in order to complete the accumulation of

surplus labor time by society. As Engels has put it, accumulation is “the most important progressive function of society.”2

China has long avoided discussing capital during its socialist construction. The

15th National Party Congress of the Communist Party of China (CPC) in 1997, for

the first time, confirmed that socialist enterprises should, taking capital as a link,

enlarge the function of capital, and improve the operational efficiency, in order

2

The Value of Capital

to brush away the misunderstanding over capital caused by socialism. The 16th

National Party Congress of the CPC in 2002 proposed that “we should establish the principle that labor, capital, technology, managerial expertise and other production

factors participate in the distribution of income in accordance with their respective

contributions, thereby improving the system under which distribution according to work is dominant and a variety of modes of distribution coexist.”3 The report explicitly regarded “capital” as a kind of production factor which participates in

the distribution of income in accordance with its contribution. The Third Plenary

Session of the 16th Central Committee of the CPC in 2003 stated that we should “vigorously develop the mixed ownership economy participated in by state-

owned capital, collective capital, and nonpublic capital, etc., realize the diversity of investors and make the joint-stock system the principal form of the realization

of public ownership.” The 17th National Party Congress of the CPC in 2007 made

it clear that “we will adhere to and improve the system whereby distribution

according to work remains the predominant mode and coexists with various other modes. We will improve the distribution system to allow factors of production

such as labor, capital, technology and managerial expertise to have a rightful share according to their respective contribution.” A higher requirement made by the

17th National Party Congress was that “conditions will be created to enable more citizens to have property income.”4

It should be said that capital is the prerequisite for a society to feed its

population and achieve prosperity. So, today, 60 years after the reform and opening

up and 30 years after the founding of new China, we must justifiably declare that

capital is good, and economic growth and the prosperity of people require the constant expansion of capital. Here, what matters is not how much capital has been

attracted but a good mechanism of capitalization which promotes the innovation of the capital formation mechanism and the continuous expansion of capital.

It is useless to say that as society employs capital to develop its economy, there

is a need to prevent the negative effects of capital. First, restrictions on capital should be made in the form of laws to prevent the distribution of income between

labor and capital from overly tilting towards capital, especially to prevent the collusion between power and money which would result in a tense relationship between labor and capital and profits eroding wages. Society should place

people first, earnestly safeguard the interests of the vast majority of workers, and

construct harmonious labor relations. Second, sufficient attention should be paid to macro-control and policy guidance while we emphasize the fundamental role of the market in allocating resources in order to prevent blind expansion of capital

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

in the market competition and the waste caused by blind investment and the rash launching of new projects.

Capital Operation: Pursuit of Efficiency and Expansion Marx stated that “[Production] expands annually for two reasons; first because the

capital invested in production is continually growing; second because the capital is constantly used more productively.”5

Profit-seeking is the nature of capital. Enterprises constantly demand

technological innovation, management improvement, amelioration of labor

relations, shorter production cycle, less time-to-market, and faster capital turnover.

In a capital market, there is no lack of enterprises undertaking capital operation and optimizing resource allocation in order to use capital more sufficiently and efficiently.

In this regard, Marx’s Das Kapital paid attention to the following aspects:

First, how did capitalists transfer depreciation funds for compensation into

accumulation funds?

Second, capitalists managed to expand the control over their own capital to

others’ capital by way of credit.

Third, banks turned deposits into interest-bearing capital, so that all the spare

capital could fully function. Banks “act as middlemen between the actual lender and the borrower of money-capital…The other side of the credit system — the

management of interest-bearing capital, or money-capital, develops alongside

this money-dealing as a special function of the money-dealers…Borrowing and lending money becomes their particular business.”6

Fourthly, with the scientific and technological progress and the development

of the socialization of production, industrial enterprises need to increase the size

of minimum capital based on the requirements of technological economy and

economies of scale. Joint-stock investment, beyond the personal financial power of a capitalist, adapts to the socialization of production by means of centralizing

social capital. It gives “an impetus never before suspected to the concentration of capital.”7

Fifthly, the rise of the capital market induced the emergence of stocks, bonds,

bank bills, treasury notes, and other valuable instruments, which Marx termed as “fictitious capital.” Marx also named the formation of fictitious capital as

“capitalization” and believed that the value of fictitious capital was a derivative of the expected yield of real capital in the future.

4

The Value of Capital

Over a century after the death of Marx, the capital market in developed

countries has undergone substantial progress. The expansion of enterprises impels industrial capital to go beyond its own accumulation and undertake capital and

business expansion. Therefore, when capital increases, IPOs, and mergers and acquisitions frequently occurred, capitalization brings about capital operation

in the capital market. Capital operation is a kind of economic behavior which

relates to market financing and the capital expansion of enterprises. That is to say,

only when an enterprise turns its asset with expected returns into securities and undertakes certain financing activities (i.e., cashing those bills and other securities

via financial instruments) in the capital market, could the enterprise make use

of social capital or capitalization to expand its business and capital as well as to

realize annexation. This is what we call capital operation. It is true that capital operation could not turn a stone into gold, but it indeed develops the asset with expected returns into capital.

During the economic reform of China, there is a desperate shortage of capital.

Until the opening of the capital market in the 1990s, parts of the assets with future

returns were able to be, via financial instruments and by means of certificates of title or pledge, capitalized and converted into cash before finally being developed into capital. As a result, in the past 20 years, capital in China grew larger and larger and brought about greater economic growth.

The Construction of Capital Culture Has a Long Way To Go Capital movement involves a wide range of aspects, including: Production,

circulation, capital compensation, fund raising, reshuffling of an enterprise, industrial integration, bankruptcy reorganization, and asset securitization.

There is an inherent law underlying capital movement and development, which composes a rich culture of capital. If China wants to develop its economy, it has

to learn how to deal with capital, and must construct capital culture in its market, legal system, regulation, and corporate governance. The essence of capital culture building is to establish the idea of protecting investment and investors. It is not

only an institutional arrangement and code of conduct, but a social consciousness, moral guideline, or social responsibility. It would form a habit of mutual trust,

understanding, and agreement. After repeatedly being implemented in the market

behaviors of the whole society, it will become a conventional and unconscious spirit. The capital culture building has to solve the following questions.

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

First, the organizational form of capital. No matter if it is a limited partnership

or joint-stock, and at an advanced or lower level, the key is to emphasize limited liability, and coordinate managers and investors to fully motivate both parties.

In the past, we encouraged the joint-stock system and believed that the limited

partnership was a low-level organization form of property, less standard than the shareholding system. Its legal status was not admitted until much later. Limited partnership finds its origins in the commenda agreements in the 16 century. At

that time, sailing the globe could lead to fortunes, but to build a fleet required an

enormous sum of money and churches were forbidden from lending money for

seafaring. Against such a backdrop, commenda agreements bypassed the ban and formed a limited partnership by letting everybody contribute what they had. Following this practice, many famous funds and investment banks in the U.S.

implemented limited partnerships. The reason was simple: This can fully motivate administrators. Administrators devote their wisdom and talent and become

decision-makers and operators, shouldering unlimited liability, while investors make use of administrators’ wits to make a profit and are liable only to the extent of their investments.

Later, the joint-stock system simplified capital, rights, and liabilities in

shares. The investors purchase the shares just like they buy commodities, and

their liabilities are limited to their invested capital, called limited liability. On the other hand, the actually functioning administrators are transformed into “a mere

manager, administrator of other people’s capital.”8 This point is very important because it composes the very basic idea of capital culture to protect investment and the investor.

Second, capital of an enterprise should discriminate between self-owned

capital and borrowed capital, and handle correctly the relationship between debt and equity.

This implies a capital culture as well as a culture of credit. The logic is simple:

You have to own equity before others would lend you some money. For one thing, you must respect equity and reward shareholders with returns on investment.

For another, you must honor credit and repay debt with interests. The lesson from

state-owned enterprises which sank into excessive debts in the middle of the 1990s due to the transformation of fiscal grants in capital construction into repayable loans should be borne in mind. Therefore, an enterprise cannot run without its own capital or reverse the relationship between debt and equity.

Third, the value of a company is by no means its asset but a future profit-

generating ability of the asset.

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The Value of Capital

It is often said that the capital market is where assets can be exchanged for

capital. However, this view is incorrect. Because the capital initially invested in an enterprise, including self-own capital and borrowed capital, has been solidified

in fixed assets such as plant and machinery equipment, and no one can directly

take the houses, machinery equipment, and other fixed assets to capital market for financing, let alone bargain over them. Furthermore, only the asset able to

create future profits can be traded for capital in the capital market. The asset without future profitability cannot be exchanged for capital in the market. Last but

not the least, even though the asset can make profits in the future, there is still a development process before it becomes tradable in the market. The asset should be

restructured to transform the company into a joint-stock one before the company is

qualified for listing. Only when the asset turns into exchangeable and possessable stocks with clear property rights (i.e., certificate of title), would the asset be eligible for circulating and be exchanged with capital in the market.

Fourth, emphasis should be laid on capital returns and recovery.

Capital is the operation fund for building a company and forming an all-the-

year-round stable turnover. It only needs to flow back to the company in the form

of depreciation during a long-term operation of commodity reproduction within the duration of the company, instead of repaying the money to its investors. But during the capital operation and turnover, value-addedness or return should

be generated. The return that investors demand is one higher than the loan interest, which is one of the important parts of capital culture. The underlying reason is that capital is a scarce resource, more costly than bank loans. Loans

have a repayment agreement and are generally able to be paid back, while capital invested in enterprises has to run the risk of receiving no repayment due to market competition and business failure.

But, the operations of equity funds and venture capital have paid particular

attention to capital recovery. Because equity funds realize the reproduction of

equity investment through purchasing shares in the case of a company starting up

or restructuring its asset, and then selling the successfully founded or reorganized

enterprise. This kind of equity funds, from injecting capital for a business start-up or reorganization to recoup the investment after the company is listed, operates

the capital all along by ruling out risks amid high risks and enhancing the capital

efficiency; therefore to open the growth enterprise market (GEM) is very important.

This will create a road for venture capital to be gotten back through the company going public. For quite a long period of time, we have blamed commercial banks for

sending out loans to high-tech enterprises and small- and medium-sized enterprises

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

(SME), but made no efforts to set up GEM. You can lead a horse to water, but you cannot make it drink. This is a result of the lack of capital culture. Fifth, to realize “money begets money” by enterprise investment, we should make allowances for opportunity cost, marginal benefit, and sunk cost. The idea of “money begets money” is inherent in the concept of capital culture. During the first 30 years of new China, school education, including class struggle in its curriculum, made an inappropriate connection between compound interest and usury by the landlord Huang Shiren in the story of The White Haired Girl in the textbooks. For a long time, schools did not clarify compound interest, and banks did not calculate compound interest, so citizens lacked financial awareness and equated the idea of “money begets money” with exploitation. But enterprise investments under the market economy meant to transfer currency into capital, and equip the currency with profit-making ability. Therefore, investment decisionmakers must commit to realize “money begetting money” and balance among opportunity cost, marginal benefit, and sunk cost. 1. We should take into consideration opportunity cost, namely, when you decide to pursue a certain investment, you have to forgo the cost of an alternative. The Chinese philosopher Mencius once said: “Fish is what I desire, and so are bear’s paws. If I cannot have them both, I would choose the latter and forsake the former.” Mencius was so shrewd that he would rather forsake little fish than give up a hard-to-get bear’s paw. This reflects the Chinese ancient idea towards opportunity cost. There is a Chinese proverb that says “pick up a sesame seed only to lose a watermelon.” In this case, the discarded watermelon is the opportunity cost of getting sesame. But Chinese do not use the term “opportunity cost,” they have formed a concept of losses and gains instead. This concept believes that the results of each choice cannot go beyond the three possibilities: Gains outweigh losses; gains and losses balance each other; losses outweigh gains. This concept is the core of opportunity cost and the common practice for Chinese people to weigh pros and cons in their daily life. When people play Chinese chess, this loss-and-gainconcept is even indispensable. The strategies of “better lose the saddle than the horse” and “give up a rook to save the king” are the plainest reflection of the idea of opportunity cost which helps one to avoid being pennywise and pound foolish. 2. We should be concerned with marginal benefits. In industrial production, it is wiser to increase production by improving existing production capability and overcoming the bottlenecks in production than building new factories. In transportation service, to broaden a narrow bridge can help expand

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The Value of Capital

transportation capacity. In enterprise decision-making, applying the same strategy used above, we can achieve marginal productivity by investing in scarce resources; we can expand a company’s strength and greatly enhance its competitiveness by merging another enterprise rather than establishing a new one. The planned economy implemented for a long time in China was accustomed to apply “base-plus-growth” method9 to plan an equal-proportion growth of investment. The government, therefore, cannot concentrate capital on broadening narrow bridges and overcoming bottlenecks but spread the money in a large range of long-term projects. In this way, we not only lost the largest marginal benefit which could be otherwise attainable, but also waste time and money in ineffective sectors and projects. According to the statistics of the ministry of electric power in 1986, the 15-year power shortage resulted in a loss of 1,500 billion in national income. This marginal benefit was able to be obtained with just a little investment in electric power and that is a pathetic lesson of forsaking marginal benefit. 3. Sunk cost should be taken into consideration. There are no more than two ways, and one is to save the paid sunk cost. For example, if we convert the uses of stopped and suspended projects of an enterprise, additional capital of just 20%–30% to the total could revitalize the paid sunk cost of 70%–80% and thus we would maximize marginal benefit of the additional investment. The other way is to make use of others’ sunk cost, including purchasing the discontinued and uncompleted projects of other companies and even acquiring and integrating a whole enterprise. In short, during the transformation to the socialist market economy, capital culture is indispensable. There is a long way to go to construct capital culture, learn to respect the rights and interests of investors and sponsors, and place the protection of investors above all else.

Investment Scale Should Adapt to National Power Capital has its value and we must determine investment scale of each period based on the changes of national power in different stages. In the early socialist economic construction of China, “to tighten our belts for construction” incurred the 30-year painful experience of accumulation (investment) crowding out consumption. The problem lies in that capital injection, namely investment, will experience a long process which has only input but no output. Therefore, Chen Yun suggested repeatedly that investment scale should comply

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

with national power and the relationship between consumption and construction should be properly dealt with.10 After the reform and opening up in 1978, a series of measures, such as suppressing accumulation but accelerating consumption during the sixth five-year plan, improving the economic environment and

rectifying the economic order in 1989, and financial macro-control in 1993, devoted to restraining investment and making the investment scale adapt to the national power during the period of inadequate food and clothing.

But it did not suggest that capital (investment) is not good and the control

over investment scale, especially over investment percentage, should be made

a constant policy. Another experience we got after the reform and opening up is

that due to the construction during the three five-year plans (sixth, seventh, and eighth), national power of China has substantially increased. China entered into a period of building a moderately prosperous society, urban residents overcame the problem of inadequate food and clothing, and middle- and high-income people

which grew in number had the wish and capability to upgrade their consumption structure. In 1995, when drafting the ninth five-year plan, the government still demanded to limit investment rate within 30%, following the policies implemented

during the period of inadequate food and clothing. The inappropriate investment control between 1996 and 1997, combined with the financial crisis in Southeast

Asia, led to deflation, shrinking investment, and stagnant consumption in 1998. In

1998–2004, the Chinese government had to implement a proactive fiscal policy and a prudent monetary policy. On the one hand, national bonds were issued to raise money for additional investment in infrastructure and to boost investment; on the

other hand, consumer credit, together with consumption loans, housing mortgage

loans, car mortgage loans, etc., was started to stimulate domestic demand. After the seven-year expansion of investment and stimulation of consumption demand,

the economy finally picked up in 2004 and walked out of deflation. At last, the average rate of investment during the ninth five-year plan was 35.7%, between

2001 and 2004 the rate reached up even to 36%–40%, and between 1998 and 2004, the rate was 39.2%. It was the growth of investment that boosted the growth of

the economy. This indicated that when national power increased substantially, in order to realize the upgrade of resident consumption structure, the investment scale during the stage of building a moderately prosperous society should fit the increased national power. This is what we have not gotten accustomed to.

Whether it can fit or not is still a sign for whether an economy can develop and become stable. The key is to have enough investment to satisfy the upgrade of

consumption structure and foster the consumption capability of future added

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urban citizens, rather than to reduce investment to encourage consumption since

China has passed the period of fighting for adequate food and clothing. Now, the mistake of construction crowding out consumption no longer exists, but if

investment fails to satisfy the upgrade of consumption structure and provide

consumption facilities or ignore developing future spending power, it will result in a greater mistake.

The growth in national power during the building of a moderately prosperous

society was because the policy of “encouraging some people to become rich first” has raised the income of urban residents. The increase of middle- and highincome population requires more investment for the upgrading of consumption

structure of citizens. At this point, it is related to not only how to accelerate the investments in public utilities, education, employment, social security and

medical and health services, but also how to speed up the institutional reform

of housing, health care and education. The employees’ expenditure on health care, education, and housing, which was, based on a low standard, invested by enterprises and public institutions or through collective consumption, should be

diverted to private investment, personal investment (such as housing) or personal consumption. In this way, various demands and enthusiasms of the originally

restrained personal investment and consumption could be released. But, neither should they be overemphasized at the expense of the other. At present, China’s

central government emphasizes putting people first and improving people’s livelihoods, which requires accelerating affordable housing projects, and increases the construction of low-rent housing, in order to meet the housing consumption

requirement of the low-income population. The government also demands

to strengthen the construction of public service system, including education, employment, social security, and health care. It is precisely for the purpose of upgrading citizen’s consumption that investment should be properly increased to enlarge the consumption in the above-mentioned aspects.

Housing construction is the most useful livelihood project to revitalize

consumption, and it occupies a major part in upgrading citizen’s consumption. After reform and opening up, the total floor space of residential buildings in urban

areas increased from 2 billion square meters to 11.9 billion between 1990 and 2007.

Among them, there was a large number of residential housing projects which were

built as a response to the target of “getting out of the housing plight” before the housing reform from the early 1980s to 1998, in addition to the housing built in the

cities of the old industrial base areas in the 1950s and the makeshift houses erected during the ten-year Cultural Revolution. This large amount of residential housing

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

is the main body of the present housing reform. According to the estimation of Chen Huai (2009), it equaled approximately half of the existing housing resources. However, buildings constructed at that time can no longer meet the needs of

people to improve their living conditions, in terms of either housing layout or dwelling size. These residences have to be rebuilt in the next 15 to 20 years. The

statement that “among the residents who have purchased a public house, 80% want to buy a new house to expand their living space” (Zheng Xinli, 2003) is true.

To upgrade housing consumption demands not only enabling low-income workers to be able to live in low-rent housing and replace their “pigeonholes” of welfare housing with larger dwellings, but also ameliorating the living conditions of the middle-income population. From 2008 to the end of 2010, the government decided

to carry out affordable housing projects and construct or transform 13 million sets of affordable houses or shanty towns, with the accumulative investment over RMB1,300 billion. It can be expected that there will be a lot of differences in the housing market in China.

Maintain Relatively High Investment Rate, Speed Up Urbanization Since 2006, the investment rate has surpassed 50% for five years in a row and the rate even exceeded 67% between 2009 and 2010. Some worried and pointed

out that the investment-consumption ratio in developed countries is 2:8 and in developing countries is 3:7, but in China the consumption rate is less than 60%.

With only a simple contrast, they came to the conclusion that investment in China is excessive and the investment rate is too high. Actually it is a groundless fear. It is true that the high investment rate of China in the recent years relates

not only to the upgrade of consumption structure, but also a special factor that

China’s government has issued a “RMB4 trillion stimulus package” to cope with the financial crisis. Nonetheless, a more rudimentary cause is that during the 60-

year construction of China, there has been a huge gap between urbanization and

industrialization under the condition of a dual economy. The massive supply

resulting from over-industrialization cannot be consumed because urbanization lags behind and is unable to create corresponding effective consumption. A lot of people blame China for its high investment rate, and especially in the recent five

years the rate surpassed 50% with two years even over 67%. This trend is really difficult to sustain. The question is how to accelerate consumption, adjust the relationship between investment and consumption, and change the situation of the

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excessively high investment rate. To rely on the little income of Chinese farmers

and migrant workers to change the mode of economic growth and revitalize consumption is just empty talk. The top priority is to speed up urbanization and

realize the dual expansion of city in land and population. This requires accelerating

the construction of urban infrastructure as well as investing more in residential communities, public facilities, medical services, and education services, in order to

direct the surplus rural labor of several hundred million people to cities and towns to participate in the non-agricultural economy, and at the same time satisfy their

consumption needs in employment and living. In a word, we should count on urbanization to foster future consumption capability.

Firstly, to speed up urbanization. For one thing, several hundred million

surplus laborers should be relocated to cities and towns. In 1978–2008, the

proportion of the urban population of China was raised from 17.92% to 45.7% with only 607 million in the urban population including migrant workers. It is estimated

that by 2020, assuming that the total population is 1.5 billion, people living in

cities and towns will reach 850 million, taking up only 55% of the total. At present,

there are 480 million people in the labor force in rural areas but the actual need for agricultural production is just 170 million. That is to say, 300 million surplus

laborers demand another 300 million employment opportunities. Moreover, those laborers should be transformed into the urban population having registered urban

residences unlike the migrant workers who cannot settle down in cities, and thus remain unable to truly become a spending force of the city.

For another, cities and towns would be expanded. In 1990–2007, China’s urban

built-up area grew from 12,900 square kilometers to 35,500, with an expansion rate

of 175% over more than 10 years. The key to the urban expansion is to transform rural house sites into lands for urbanization through the process of creating towns

in country areas. According to the calculation of Wang Jian (2009), China now has 250 million family households and supposing each occupies 200 square meters,

the total rural house sites amount to 75 million mu (50 billion square meters). If the

urbanization rate is 85%, maintaining 50 million rural households is enough and 80% of rural house sites would be available for the purpose of urbanization, nearly 60 million mu (40 billion square meters). This figure is more than two times as large

as the areas of farmland that the government plans to occupy for construction in

the next 10 years (namely, 23 million mu ≈ 15 billion square meters). In conclusion,

investment in accelerating urbanization should go first, before rural labor surplus

will settle down in cities and towns, turn into newly added urban dwellers of nonagricultural economy, and finally become a source of urban consumption.

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Secondly, we should rely on building a new socialist countryside and

undertake scale operation of agriculture in order to increase peasants’ incomes. At present, there is a policy mismatch. The rural-urban separated household

registration system gave rise to the situation that 160 million farmers-turnedworkers worked in cities but cannot be registered there. Migrant workers lived

in the poor areas of cities while saving money to build in their home villages new houses which they have no chance of residing in. Moreover, the migrant workers still occupied an uncultivated farmland which created a dilapidated village and caused desolation and the loss of arable land. Aging rural population, farmers

engaged in sideline business, an increasing number of left-behind children together with the above mentioned problems restrict the scale development of agriculture, enlarge the urban-rural income gap and cause frequent occurrence

of mass disturbances. It has been reported by Ban Yue Tan (半月談, “Semi-month

Talk”) in February 2011 that by the end of 2010, the total amount of arable land

in China was less than 1.826 billion mu (1.217 trillion square meters), close to the

warning line of 1.80 billion mu (1.20 trillion square meters). More importantly, the

idle rural land has surpassed 100 million mu (66.67 trillion square meters), 1/18

of total national arable land. Therefore, to realize full reform of the century-long small-farm economy and build a strong professional team capable of scientific

farming and intensive cultivation, the Chinese government has to allow more flexibility over rural land, free farmers from the traditional household registration

system and land system, and transfer surplus rural labor to work in cities. This should be a premise for developing a new socialist countryside, implementing scale operation of agriculture, and substantially improving farmers’ income.

Thirdly, China must push forward urbanization and reform the urban industry.

Due to the fact that village and township enterprises (VTEs) which occupy a

big share in China’s GDP and possess an added value of 28.5%, are dispersedly distributed, urban industry must be remolded to facilitate centralized treatment of industrial pollutants and create a favorable external market environment. It will in turn reduce the costs in labor flow, technology and information acquisition, storage and legal service. Additionally, centralized urban industry could benefit more from efficient financial service, compared to those dispersed in rural areas.

The heavy and chemical industrialization and urbanization are in the

ascendant and China’s industrial structure requires upgrading. At the same time, transnational capital of manufacturing business of developed countries flows

toward China, so there is a strong demand for investment. The twelfth five-year

plan of China proposed that we should revitalize the old industrial base of the

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northeast, develop the west, encourage the rise of the central, form metropolitan areas, and drive the growth of the regional economy. These demand the Chinese government to reshape the agglomeration layout of regional economy, speed up the construction of domestic transport infrastructure, and lead the transfer of parts of industrial enterprises to central and western regions. Besides, it is imperative to solve the problems of environmental pollution, climate change, and water

crisis occurring in many cities. By doing so, investment will definitely increase. In

general, only with rapid urbanization, can we create huge long-term demand in China. If in the next 20 years, we can lift the urbanization rate to 75% and have 400

million members of the urban population, there will be a need to increase housing

and public facilities for city expansion, as well as to build a modern urban system

capable of supporting several hundred million more people in the population. It is sure that there will be a huge demand for investment. After all, it is only possible

to completely crack the problems of the growing income gap, three rural issues, and poverty, when the government can successfully transfer rural labor and population to cities, realize urban expansion, and increase employment.

It has long been a controversial topic as to whether the investment rate in China

is high or not. Judging from China’s actual situation, what matters is not the total volume of investment but its efficiency and quality. In my opinion, investments in

high-polluting and high-energy consuming industries, politics-driven investment by which the local government constructs industrial parks in a blind way, and investments in vanity projects should be largely cut down. On the other hand, investments of objective demands should be supported as long as they are beneficial to improving people’s livelihoods, upgrading the consumption structure, increasing

job opportunities and future consumption capability, and building a harmonious society. In a nutshell, in order to enhance the real spending power of farmers, high investment rate is out of absolute necessity. Large investment at least would result

in a great number of fixed assets, which is better than the export business to the U.S. in exchange for treasury bonds with a risk of depreciation.

Now, it is important to note that an insufficient source of capital for local

government and excessive debts would incur bank risk and debt crisis. In addition, several ineffective investment projects could also bring about low production

efficiency of an enterprise and thus cause systematic crisis of debt. The risk of local financing platform loans in 2010 triggered hot discussion among many parties,

and consequently, the China Banking Regulatory Commission (CBRC) even got involved to raise risk weight in calculating capital adequacy ratio as a necessary

preventative measure. In consideration of China’s present industrialization and

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

urbanization, it is of a great possibility that the high investment rate (40%–50%)

will last for the next 20 years. The government must dedicate itself to reforming the economic development mode, revolutionizing the present governmentled investment, and allowing private capital to play its role. At the same time,

investment scale should be kept within controls to prevent impairing domestic demand and fairness; however, to resolve the risks of high investment rate will ultimately depend on the increase of investment efficiency.

It needs to be specially mentioned that to determine whether an investment

is high or not, not only investment rate but also return on capital should be taken

into consideration. For a long period of time, we tended to believe that the return

on capital of China’s enterprises is low and the investment is large in size, high in speed but low in efficiency. In 2006, Song Guoqing from Peking University calculated that since 1999, the return on investment of China was on the rise,

from 6% of 1999 to over 18% of 2006, showing an unprecedented development

trend. This discovery was called by Zhao Xiao11 as a “subversive understanding.” Meanwhile, Qian Yingyi, Bai Chongen, and Xie Changtai published an article “The

Return to Capital in China” in the Brookings Papers on Economic Activity in 2006.12

It calculated the return on capital in China based on two calibers of fixed capital

formation and got the results of 18%–27% and 8%–12%, respectively. Using the latter caliber, they found that the return to capital in developed countries between 2000 and 2003 was between 7% and 13%, which indicated that the rate in China

is no less than those developed countries. Obviously, the high rate of return on investment is a reason for global capital to steadily flow towards China.

Maintain Reasonable Social Financing Scale and Direct Surplus Capital to Capital Markets One of the outstanding problems faced by China’s economy is excessive money supply, also known as “excess liquidity,” in the financial community.

The root of the problem is that the capital market has developed slowly in

China. For a long time, following the mindset of a planned economy, the financial authority of China has placed indirect finance at a leading position for more than

20 years. The financial authority preferred to let banks dominate everything but

only assessed their annual credit growth target, for fear that enormous sums of money would flow out of the controllable pond of banks and jump into the

unruly ocean of direct finance. Consequently, it resulted in a deformed pattern of “excessive large banks but an extremely small capital market.” To solve the excess

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liquidity, the central bank of China proposed enlarging the size of direct financing

in 1996 and suggested for many years to strictly control the monetary and credit

aggregates. In fact, however, lots of loans were issued by banks every year. The key lies in the incomplete capital market which is unable to increase the proportion

of direct finance. Between 2001 and 2008, bank loans have always accounted for

around 80% of the total financing of the non-financial sector while stocks and corporate bonds only took 20% (19.5% in 2009). The substantial growth in the

proportion of stocks and corporate bonds, as reported by the financial media in 2010, is just a possibility of breaking through 30%.

In recent years, direct finance has undergone radical reforms. The SMEs Market

and GEM were opened in Shenzhen successively and the futures market and

stock index futures were launched as well. In addition, the government initiated in succession the pilot projects of asset-backed security based on bank loans, and

margin trading and short selling of brokerages. Especially in 2005 and 2008, the central bank of China started to issue short-term financing bonds and medium-

term notes, respectively, and in 2007 corporate bonds of listed companies were

permitted to be traded. Meanwhile, in the financial market, financial innovation

activities were increasingly active and there was a tendency to circumvent the control over credit scale. The innovation of financing tools, such as entrusted loans, off-balance sheet (OBS) transactions, and structured products accelerated

the financial disintermediation in China. The data of China’s central bank showed

that in 2010 the entrusted loans amounted to RMB1.13 trillion and the banker’s acceptances which was an OBS transaction containing bank’s credit rose up to

RMB2.33 trillion, up 60% and 400%, respectively, compared to 2009. There were still other financing channels, mainly including loans from small-loan companies

or loan companies and industry fund investment. In 2010, new loans of small

loan companies alone were recorded at RMB102.2 billion, an increase of 33.4% over the previous year, equivalent to the annual growth of a small- and mediumsized joint-stock commercial bank. But there was a deficiency in the statistics of

newly-emerged financial institutions and tools released by the central bank. The statistical framework of the central bank gave insufficient attention to the financial tools which recently showed up, such as financial derivatives of OBS business,

structured products, and contingent assets and liabilities, but just stuck to the

balance sheet of commercial banks (Zhang Tao, 2010). The New problem is that

commercial banks generally bypass the credit ceiling through OBS transactions, and thus to simply evaluate new RMB-dominated loans by the central bank can hardly reflect the aggregate financing of the real economy.

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

In the face of financial disintermediation, the working conference of China’s

central bank in 2011 for the first time gave up proposing a new target of annual

credit growth; instead it suggested maintaining a reasonable social financial scale,

which was immediately confirmed by the State Council in January 18 of the same

year. Later in the Report on the Work of Government (March 2011), the government

of China clearly stated that to “keep financing from all sources at an appropriate level” and “increase the proportion of direct financing.” In February 2011, a dramatic change was that after collecting various data, the central bank disclosed a ratio between bank credit and non-credit financing in 2010, which had already

reached 56:44. Sheng Songcheng, director of the Financial Survey and Statistics

Department of the People’s Bank of China, wrote an article in the website of

China’s central bank and said that from 2002 to 2010, the total financing volume increased from RMB2 trillion to RMB14.27 trillion with an annual average growth

of 27.8%, 9.4% higher than that of total RMB loans. The aggregate social financing in 2010 occupied 35.9% of total GDP, increasing 12.9 percentage points compared to 2002. According to statistics, among the RMB14.27 trillion of total social financing

in 2010, new bank loans took up RMB7.95 trillion, decreasing to 56% from 92% in

2002, while the proportion of direct financing rose markedly with corporate bonds

and stocks increasing 6.8 and 1.1 percentage points, respectively.13 This implies

that the monetary policies of China have suddenly shifted its focus from new bank

loans to social financing scale. According to the definition by the central bank, total social financing is a sum of total loans in RMB and foreign currency, entrusted

loans, trust loans, banker’s acceptances, corporate bonds, non-financial corporate bonds, compensation from insurance companies, investment property of insurance companies, among others.

Undeniably, China is slow in expanding direct financing in some ways. For

example, the asset-backed securities account for over 20% of the bond market in

Western countries with a mature market. In contrast, China only started several

pilot projects on asset-backed securities which have worked intermittently. From

2005 to 2008, there were only 19 records of credit asset-backed securities issued in

the inter-bank bond market, with a total amount on offer being RMB66.8 billion, disproportionate to RMB19 trillion bond market of the same period.

The financial reforms should be targeted at speeding up the development of

capital market, expanding direct financing, diverting bank deposits and loans

to the capital market, and broadening the environment and space for capital formation mechanism. I strongly agree with the notion of “keep[ing] financing from all sources at an appropriate level” and it is better to have a quantitative

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target. In 2006, I proposed that we could conceive that within 10 to 15 years, under the government’s great efforts, loans of the bill market will equal bank loans, investment funds will correspond to personal savings of bank, bond market will

have a same size with the stock market, and asset-backed securities will take up

1/4 or 1/3 of the total bonds; at the same time, there will be considerable financial

derivatives to ensure a favorable hedging mechanism of the capital market. This may be an ideal financial pattern beneficial to building diversified capital formation mechanisms.

The development of various types of financial markets cannot be accomplished

overnight, and the government needs to build up a set of fair and impartial

institutional structures accommodating the securitization market as well as a corresponding talent pool while accumulating experiences and lessons. The

capital market should be expanded, the financial market should be developed in a comprehensive way and equipped with abundant financial products, and larger

liquidity demand should be created. Only in this way, can the money of banks be directed to the capital market and the problem of excess liquidity be solved in a wider scope through developing a virtual economy.

To Understand the Global Financial Crisis through Economic Globalization Capital is good, the undesirable expansion of capital during the rapid development of the capitalist economy, however, brings about crises and disasters. The Sterling Crisis in 1990s, the Mexican Pesos crisis, financial crisis in Southeast Asia, the

decade-long recession of Japan, and especially the global financial tsunami evoked by the Wall Street collapse since 2007 are the best proofs.

To examine the global financial crisis triggered by the U.S. subprime mortgage

crisis requires a view of economic globalization.

First of all, this crisis was a result of an inappropriate response to domestic and

international economic and trade imbalance by the U.S.

In economic globalization, the U.S. constantly cut down the production of

material products by first transferring capital to the financial market and then relocating the manufacturing industry to developing countries. In this way, not only the surplus agricultural population in the developing countries got

employed, but also a large number of high-quality products manufactured in those countries were exported at a lower price as substitutes for the U.S. products. As a result, there was a long-term trade surplus and an accumulation of considerable

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foreign exchange funds in those manufacturing countries. A fragile international economic structure was thus formed: The developed countries featured a lower

savings rate but a higher consumption rate while the emerging market countries

featured a higher savings rate but a lower consumption rate. The problem is that when assessing a country in terms of its economy and finance, its speed

of economic development, its trade surplus and deficit, its amount of foreign

exchange reserves, and its transfer of industries, we still adhere to the perspective

of a single sovereign state in the age of globalization. The developed countries including the U.S., despite embarking on economic globalization, failed to

make preparations for the possible complicated changes brought along with the

economic globalization regarding the formulating and practicing of economic and

financial policies. Following the theories of trade and monetary policy adopted when the globalization was not very well developed, those countries stuck to the habit of assessing domestic and foreign economies and finance from an angle of

an individual sovereign state and even made wrong economic responses out of their own national interests or the benefit of the ruling party. In addition, they may

also force late-developing countries to appreciate the currency, put restrictions on exporting high-tech products as in cold war times, limit the mergers and

acquisitions of American enterprises by foreign investors, and implement trade

protectionism in imports and exports in order to increase trade frictions. Taking the 2007 financial crisis as an example, the inexpensive goods from emerging market countries brought about low commodity prices in the U.S., however its economic

and financial authorities failed to understand the interdependent relationships

between the trend of global commodity prices and its domestic financial market under the new condition of globalization, and the U.S. habitually attributed the low prices to its increase of labor productivity and clear macroeconomic policies. When the I.T. bubble burst in 2000 and the September 11 terrorist attack happened

in 2001, to avoid economic crisis, the Federal Reserve lowered interest rates and depreciated the dollar to maintain a long-term loose monetary policy instead of taking measures to strengthen infrastructure and market supervision. This led

to excess liquidity and the excessive subprime mortgage industry inflated into a property bubble. Finally, the over-innovated finance and improper financial

supervision, together with the over-expansion of the housing credit market and financial derivatives market blew the bubble up and made this subprime mortgage debacle spread into a global financial crisis.

Secondly, this crisis in the U.S. was an outcome of financial imbalance which

was caused by the American culture of consumption on debt, the economic

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environment of long-term low interest rates and high consumption, and the instable asset-dependent economy that overly relied on property income.14

With the decreased production of material products in the U.S., the actual

growth of industrial workers’ nominal income allowing for inflation was very slow in the past 20 years. At present, Americans annually spend nearly USD9

trillion, 20% higher than Europeans, three times as much as Japanese, and nine

times as much as Chinese. Nevertheless, since 1985 till now, the savings surplus of Americans has not changed much. The most significant change is that the

consumption of the U.S. citizens is supported by property incomes rather than wage incomes, which was named as an asset-dependent economy by Stephen S.

Roach. Now, property income accounts for 40% among the disposable income of

the U.S. citizens and over 90% of American households owns stocks or investment funds. The wealth of the American people mainly accumulates through the asset

appreciation of stocks and residential property. Within just five years from 1996 to 2000, the income from the premiums in the capital market amounted to USD11 trillion. The home ownership rate of Americans was 64% in 1995 and rose up to

69% in 2006, and the rapid growth of property income covered up the weakness of pay rises. Under the support of cheap credit, household debt accounted for 133%

of the disposable personal income, and the income-based savings turned into a negative in the latter half of 2007. This series of reasons collectively contributed

to the dependence of the income growth of the U.S. residents on wealth effect,

debt-fueled consumption, and the earnings of two-parents working families. People, therefore, have had little reason to save out of their current incomes as they traditionally did. Five years prior to the financial crisis, the U.S. net national savings was only 1.4% of the gross national income (GNI) in general, and thus the

government has to import overseas savings surplus. The huge current account deficits of America absorbed around 75% of global savings surplus. American banks have to raise funds from sources other than savings. They have no choice

but to rely on asset securitization and selling financial derivatives to take in the funds from all over the world, which constituted the purchasing and spending power of the U.S. But the problem lies in the instability of property income. In

fine weather, everything goes smoothly but once there is a financial crisis, asset

bubbles will burst. The Federal Reserve’s data showed that the U.S. household net worth was USD51.5 trillion in the end of 2008, USD11.2 trillion less (a drop

of 18%) than the previous year. Among it, the housing price depreciated USD2.7 trillion and all kinds of investment in the stock market shrank over USD8 trillion. Consequently, the loan default rate rose up and foreign funds stayed away from

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American financial derivatives. The banks in the U.S. could hardly raise any funds in the market and faced liquidity problems, which led to the bankruptcy or closure of banks.

Third, the 2007 financial crisis was not just one of subprime mortgage and

financial derivatives, but also an outcome of over-innovation of the financial

institutions’ blind pursuit of profits and insufficient regulation by financial authorities. The fundamental cause, however, is the latter one. First of all, the

banks issued subprime housing mortgage loans to borrowers with poor credit,

and the modern credit scoring system and automated underwriting system made the issue of loans overly reliant on computer models. The lenders intended to earn high returns by finding out high-risk innovative financial products based on

default rates and quantitative models. In the next place, financial innovation went

beyond limits. Asset securitization has turned housing and car mortgage loans and all kinds of consumption loans into mortgage-backed securities (MBS) and

asset-backed securities (ABS), based on which financial instruments, such as multi-

layer and multi-level collateralized debt obligation (CDO) and credit default swap

(CDS) as a hedge against the risks of CDO, were invented. Most of them were traded over-the-counter (OTC) and became what Buffet had termed “financial

weapons of mass destruction.” The biggest problem remained the regulatory

loopholes which resulted from regulatory philosophy lagging behind the business

model of financial institutions. Lastly, high leverage ratio indulged speculation and uncontrolled risks. In the U.S., the capital leverage ratio was generally 11:1.

The excessive speculation of investment banks were reflected in its high leverage ratio of 28:1 or even 33:1. The recent emerged derivative market with an asset

of over USD600 trillion was satirized by some as a new kind of borrowing and

leverage culture being formed around the world. This cannot be separated from the inadequate financial supervision by the American government.

Fourth, this new round of financial crisis was closely related to the fiscal crisis

triggered by long-term tax cuts, the treasury’s overdraft at the Fed for wanton engagement in military aggression, and the manipulation of the currency by the U.S. government. Monetarists emphasized tax cuts, and from 1985 until now the

tax revenue-to-GDP ratio fell from 27% to 17% in the U.S., 7 to 8 percentage points

lower than that of Europe and Japan. The U.S. treasury security was USD5.7 trillion in size a decade ago, USD7.7 trillion in 2005, and USD12 trillion at the end

of 2009, and it surmounted the statutory debt ceiling of USD14.294 trillion on May 16, 2011, greater than the GDP of 2010. Such a huge amount of outstanding

national debt is not merely a financial problem but a fiscal one. The U.S. Congress

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Joint Economic Committee released a report which said that until the end of

2008, the U.S. government had spent USD1.6 trillion on the wars of Afghanistan

and Iraq. Meanwhile, according to a report named “Costs of War” made by Brown University, the wars were estimated to have cost USD3.7-4.4 trillion, far

beyond the total budget proposed by the Congress and the federal government.

Due to the fact that fiscal surplus was turned into huge fiscal deficit during the Bush era, the Obama administration has to continue debt financing. However, America, by taking advantage of the world currency (i.e., the U.S. dollar), let the

dollars depreciate to make the low-yielding dollars spread unchecked around the

world. By doing this, the U.S. government not only shifted the financial crisis to

the world, but also plundered the whole world with seigniorage. Now, the Euro intends to replace the U.S. dollar, and Russia and Iran refuse to use the dollar. China and many other countries have agreed on expanding the scale of local

currency settlement. G20 nations also have held meetings on the reform of the

international monetary system. All these examples showed the dissatisfaction from various countries in the world with America’s manipulation of currency. Of course, this issue cannot be settled with one or two international meetings. Additionally, America will by no means give up the hegemony easily and a hard push would

probably turn the economic crisis into a military crisis. Currency Wars by Song

Hongbing published in 2007 linked the world economy, politics, and many dramatic historical events with the financial and military wars which occurred in the last 200 years. Some criticized this book as being completely erroneous,

but many of its cases are true examples of Western countries playing the bully by means of monetary hegemony. This book is really thought-provoking and raises alarms for all of us. After all, the United States holds a huge war machine, and the

world must prevent the risks, or even a currency war, brought by the expansion of the financial crisis.

Fifth, this was a crisis of finance seriously breaking away from the real economy

when capitalism developed into a new stage of financial capitalism. In 1999, America abolished the six-decade long severe regulation on the mixed operation of

the finance industry and further promoted the financialization of the economy. The developed countries successively pursued high yields from the capital market and

developed the financial derivatives market, which led to the over-development of the financial sector and the disengagement between the fictitious economy and the real economy. Take as an example the huge international hot money quickly flowing

in international financial markets. The daily turnover in global foreign exchange markets was approximately USD1.4 trillion in 2001, but the number surpassed

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

USD3 trillion in 2007. The daily volume of foreign exchange doubled within six years and the annual trading volume of foreign exchange markets was dozens of times that of global GDP. As the American columnist, Richard C. Longworth,

pointed out in his book Global Squeeze: The Coming Crisis for First-World Nations

that “two weeks’ worth of these dollar transfers fund the movement of all goods and services; The other 50 weeks consist of speculation, pure and simple.” This hot money sought investment opportunities around the world to pursue profit maximization, which displayed both huge charm and destructive power and

aroused the upsurges of international oil and food prices. When the existing transaction channel cannot meet the demand of the hot money, financial derivatives were pushed to undergo innovations, and thus the financial derivatives on the basis of high-leverage and high-risk subprime mortgages were invented.

Economic globalization has promoted the lopsided development of the

financial sector. For one thing, many financial institutions have become “too big to fall.” In the pricing of debt and stock, such a status endowed those institutions with a special competitive edge running counter to the law of the market

(Greenspan, 2009). For another, financial globalization boosted asset securitization

and financial innovation and a shadow banking market parallel to the existing banking system was formed. Ba Shusong wrote an article and said that this market

was very huge and the estimation of the financial asset of those institutions was more than four times the global GDP. The result was that financial assets showed a typical inverted pyramid structure: In general, the traditional money (M1 and

M2) only occupied 1%, broad money 9%, and financial bonds 10%, while financial derivatives accounted for 80% of the financial market. Driven by the high leverage, the financial sector was overextended and the profits of the global financial sector even made up over 40% of the entire U.S. corporate earnings. The problem was

also reflected in that shadow banking operates through counterparties privately negotiating and trading one-on-one in the OTC market. Those financial derivatives are considered OBS items by the regulatory institutions of various countries and are loosely imposed by regulations. As a result, the traditional regulatory means, such as the capital adequacy ratio, cannot fully supervise the derivative market

and this creates a huge gap in regulation, which further pushes forward asset securitization and financial innovation.

In 2006, the global GDP was USD48.2 trillion, the total market capitalization

worldwide was USD50.8 trillion, the total global assets of financial institutions were USD190.4 trillion, and the total market value of derivatives in the world was USD485.7 trillion. They were, respectively, the same as, four times, and ten times

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The Value of Capital

of the global GDP. From 2009 to 2010, the nominal values of global derivatives were severally USD630 trillion, USD743.5 trillion, USD637 trillion, and USD618

trillion (slightly falling after the financial crisis), and this accounted for 11.8 times,

12.57 times, 10.9 times, and 10.13 times the respective year’s global GDP. During this period of time, international financial capital underwent the fastest explosive growth in human history. Financial innovations totally broke away from the basic economic aspects of production-demand and supply, and were more involved

with the financial service demands which were increasingly divorced from reality. Financial innovations entered into a development stage of self-creating financial service demands far away from the real economy.

The global financial crisis was enlightening. American President Barack

Obama expressed the idea that what we have learnt from this financial crisis was

that “21st-century markets could not be properly regulated with 20th-century regulations.”15 He said that to prevent a similar crisis from happening again, the

U.S. must completely renovate the current financial regulatory system. “Wall Street will remain a big, important part of our economy, just as it was in the ‘70s and the ‘80s,” he added. “It just won’t be half of our economy…We don’t want every

single college grad with mathematical aptitude to become a derivatives trader.”16

The global financial crisis indicated that capital has a dual nature. The undesirable expansion of and the inadequate supervision towards capital in the capitalist

countries would bring about crises and disasters to the whole world. As long as we can learn lessons from this crisis, properly handle the relationship between

savings and consumption, financial innovation and financial regulation, as well as the fictitious economy and the real economy, we are able to find out solutions to

the crisis. Capital movement has its laws and if we could make the best use of the laws, we could utilize capital to create wealth for the prosperity of the people and the rise of the country.

Financial Regulations Should Not Be Relaxed The most profound lesson of the latest global financial crisis stemming from America has taught us is that financial regulation should never be relaxed.

Financial regulation comes into being because of the uncertainty of finance.

Not only are the benefits and costs related to the time allocation of financial resources uncertain, but the risks that each financial instrument will bring are

also uncertain. In fact, finance is an on-going process of solving old contradictions while creating new contradictions and risks. The invention of every financial

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

instrument including currency has brought along some uncertainties (namely,

risks) while facilitating people’s economic life, and thus there is a need for a new financial instrument to evade risks. The new financial tools will solve the original contradiction but at the same time produce new uncertainties, and therefore more

new financial tools are needed to be found or invented. It is right under such a condition that various financial instruments and the related markets are occurring

in our economic life, such as indirect financing of bank deposits and loans, direct financing of stocks and bonds, security markets, mutual funds, asset-backed

securities (securitization of assets), financial futures, futures markets, as well as a variety of financial derivatives markets. Financial products which emerge one after

another in this way constantly accumulate risks and crisis in the growing financial

markets and will incur losses and disasters to savers and investors. Financial supervision is the guideline and regulation that governments have summed up in

their attempts to cope with the financial crisis and protect the interests of investors.

Governments are responsible for the supervision towards the operation of financial institutions and products, risk disclosure, information disclosure, and investor protection. Moreover, the high leverage, high correlation, and high asymmetry of

modern financial markets and institutions render new features to the generation

and transmission of risks in the modern financial system and increase the flexibility of financial regulation. Consequently, financial supervision is directly related to

the property, interests, and lives of people, and the stability of finance will directly impact national economic security and social stability.

As a nation owning the most developed financial markets and most active

financial innovation activities, America has been boasting that its financial regulatory system was the most complete. It should be said that America’s banking industry has enjoyed for 30 years a comparatively stable development since the

Great Depression of the 1930s when the monetary system was reformed, a series

of strict regulatory acts were imposed, and separate operation and supervision of banking, securities, insurance and trust industries were established. However, in the 1980s and 1990s, the U.S. government began to relax its financial regulations in order to enhance the international competitiveness of its financial industry.

As a result, the financial institutions gradually expanded their business scope

and various innovated financial products and derivatives markets developed

vigorously. Until November 1999 when the Financial Services Modernization Act was

passed, the boundary in business among banks, securities organizations, insurance companies and other financial institutions were completely eliminated to allow

mixed operation, and universal banking was again permitted to be set up. But this

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The Value of Capital

act ran too far in releasing financial control and the lax regulations have continued for the next 60 years.

Part of the problem is that when Alan Greenspan served as Chairman of

the Federal Reserve from August 1987 to January 2006, he constantly proposed extremely loose control over financial innovations and strongly opposed

intensifying government regulation on finance. In 1998 when the notional value of

derivatives contracts outstanding at U.S. commercial banks grew 30%, Greenspan noted that this “growth underscored the need for such financial instruments

in ‘unbundling’ financial risks around the world.” He believed that “by far the most significant event in finance in the past decade has been the extraordinary development and expansion of financial derivatives; the greater use of OTC derivatives doubtless reflects the attractiveness of customized over standardized products.”17 By 1998, the development of OTC derivatives incurred the Long

Term Capital Management crisis. In 1999, the U.S. Commodity Futures Trading

Commission (CFTC) advocated a tighter regulation on the OTC derivatives market, a move opposed by both Mr. Greenspan and U.S. Treasury Secretary Robert

Rubin. Greenspan even stated that “the fact that the OTC markets function quite effectively” without CFTC oversight “provides a strong argument for development of a less burdensome regime for exchange-traded financial derivatives.”18 In May

2005, Greenspan made the famous assertion that the market was often a more effective regulator than the government.

In addition, government oversight has loopholes. The philosophy of America’s

financial supervision is based on the business model of financial institutions and

overlooks some necessary links between direct and indirect finance. For example, the business pattern of traditional banks is “issuance, holding and recovery”

of financial products, and therefore, financial institutions will actively manage risks. With the development of asset-backed security, banks target the selling and transfer of loans and risks to purchasers as soon as possible and this business

pattern gradually changes into “loan issuance, sale of securitized debt, and risk diversification” (Ba Shusong described it as “issuance and sale, and issuance and diversification”). Consequently, banks give up the basic principle of actively

managing risks, which is the premise of Greenspan’s self-monitoring of financial

institutions. Greenspan always believed that “the enlightened self-interest of

owners and managers of financial institutions would lead them to maintain a

sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions.”19 ThIs is right because of the management idea lagging behind the

business mode of financial institutions that loopholes in supervision have emerged.

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Besides, America always thinks that a relaxed system is needed for the development of hedge funds and thus leaves a blank in regulation. Many countries, including the G7, repeatedly advocated the tighter oversight of hedge funds but only met with objection from the U.S. To make it worse, the profit-seeking nature of capital has

encouraged the greed of financial institutions and their management to risk moral hazard in pursuit of financial manipulation and high salaries or bonuses.

The U.S. subprime mortgage crisis of 2007 was triggered by the dramatic

growth of the unregulated OTC derivatives which became the “financial weapons of mass destruction,” a term popularized by Buffet, and the crisis finally evolved

into a global financial tsunami. The acquisition of Bear Stearns by J.P. Morgan on March 15, 2008 was the first domino. A series of tragedies happened half a year

later: The American government took over Fannie May, Freddie Mac, and AIG;

Lehman Brothers went bankrupt; Bank of America acquired the 94-year-old Merrill

Lynch; and Goldman Sachs and Morgan Stanley were transformed into traditional banks. Unfortunately, the top five investment banks in Wall Street all failed.

In the face of the facts, Greenspan admitted part of the mistake in the

Congressional hearings on October 23, 2008. He said that until 2005 the Fed was still ignorant of the size of the subprime mortgage market, and financial institutions did not do their best to protect the interests of their shareholders as

he had expected. He conceded for the first time a flaw in his market philosophy

of unfettered free markets. He said distressfully that “that is precisely the

reason I was shocked, because I have been going for 40 years or more with very considerable evidence it was working exceptionally well.”20 On March 27, 2009, He

published an article in the Financial Times and admitted that “the risk-management

structure cracked” and “all the sophisticated mathematics and computer wizardry

essentially rested on one central premise: That the enlightened self-interest of

owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions. For generations, that premise appeared incontestable but, in the

summer of 2007, it failed.” Moreover, “even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against

crisis — our regulatory system — functioned effectively. But, under crisis pressure, it too failed.”21

In short, finance has uncertainties (i.e. risks), and the risks are unpredictable.

At present, countries around the world lack experience in the oversight of finance,

especially of those complicated financial derivatives, and financial supervision always falls behind the development of the market. A lesson from this global

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financial crisis is that oversight of finance should be strengthened. We should bear in mind the following experience.

1. Finance serves the real economy. Compared with the real economy, the scale of

finance should basically be stable. When its size expands rapidly and surpasses that of the real economy, the regulatory department must be alert to latent dangers.

2. Encourage should be given to financial innovation but with a limit. Innovation at the initial stage may be allowed to “play edge ball” and make new attempts when the existing policies are not clearly prohibited, but the subsequent

promotion of the innovation must be under supervision and new regulations should be formed.

3. There should be a limit over the size of financial institutions and governments can neither let the institutions be too big to fail nor allow the institutions to

break the market rules in the pricing of debt and equity to exercise monopoly and manipulation.

4. Loans can be securitized and made into asset-backed securities for sale and

credit risk management mechanism (such as provision for bad debts) should

also be transferred along with the loans. There should be a corresponding risk management mechanism for the asset-backed securities.

5. The development of financial derivatives has to make sure that risks are controllable. Financial innovation should be allowed under the condition of

a lower leverage. What Liu Mingkang said was right: “We must resolutely oppose highly leveraged financial innovations.”22

Be Alert to and Prevent Various Fears towards Capital China is at the primary stage of socialism, and should treat with caution the

policies of developing capitalism during the transition from a planned economy to a socialist market economic system.

The objective of new China is to build a socialist country. In the war of

national liberation, Mao Zedong once accurately defined the new democratic revolution in China as a bourgeois democratic revolution, but the leader was the Communist Party instead of bourgeois parties and the goal of the revolution was not capitalism, but socialism. At the new democratic stage when the new China

was just founded, Mao Zedong continued advocating redemption of capitalism

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

and allowing a limited space for the development of capitalism. China, however,

implemented a centralized planned economy in pursuit of socialism with an ownership by the whole, after China entered into large-scale economic construction in 1953, especially after Stalin put forward the theory of product economy, and the three-anti and five-anti campaigns23 were carried out to oppose the bourgeoisie,

and Mao Zedong suggested the “General Line” for the transitional period of “one

industrialization, three transformations.”24 Later on, the government was eager to

eliminate capitalism and speed up the transition to socialism by carrying out the Great Leap Forward and the People’s Communes campaigns in 1958, launching the Cultural Revolution, fully implementing the public-private partnership, even

putting an end to the capitalist redemption on the basis of a fixed rate of interest,25 and abolishing self-employment and farmers’ private plots to cut off tails of capitalism. Judging from the actual development of productive force, China was

still a backward developing country at that time and its economy was on the

verge of collapse due to the decade-long calamity of the Cultural Revolution. As a result, after announcing the policy of reforming and opening up in the Third

Plenary Session of the Eleventh Central Committee of the Communist Party of China (CPC) in November 1978, the party has to face the reality and admitted the facts that China was still in the primary stage of socialism, and the development

of the private economy to a certain degree would promote production, build an active market, and expand employment, which would better meet the needs of

people in many aspects of life and was a necessary and beneficial supplement to a state-owned economy. This action was to correct the mistake of being eager to transform into socialism and the government did not restore the name of “new democratic revolution,” instead it used a new term of “primary stage of socialism.”

For one thing, this name clarified the objective of the socialist revolution under

the leadership of the CPC; for another, since China was at the primary stage of socialism, it was justifiable for the country to recognize the necessity for developing a certain degree of the private economy, namely capitalism, which was a significant and indispensable step to greatly enhance socialist productivity.

During the 16th CPC National Congress in 2002, a greater breakthrough was that the party further identified that “individual, private and other non-public

economies that exist within the limits prescribed by law are major components

of the socialist market economy,” and the party also clearly stated that “we must

unswervingly support, encourage and guide the development of the non-public sector of the economy,” which was given equal importance with the policy of

“unswervingly consolidating and developing the public sector of the economy.”

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The Value of Capital

It was the first time that the government justified individual, private, and other non-public economies in the form of political policy. This policy was reiterated at the 17th CPC National Congress and even written into the constitution. The new constitution identified the new social class including private entrepreneurs, as builders of China’s socialist cause. China is still at the primary stage of socialism, and therefore when formulating policies towards the capitalist economy, the government needs to be vigilant and prevent a variety of fears towards capitalism. Examples of such fears are as follows: 1. For fear of exploitation, China avoided talking about capital and even dared not freely introduce capital and develop the private economy. After China’s reform and opening up, even though the 12th Central Committee of the CPC in 1982 had recognized private economy as a necessary and beneficial part of the socialist economy and being subject to the socialist economy, individual and private enterprises were always attached to a government department in the name of a state-run or collective-run enterprise and endured repeated “exploitations” in order to realize development. With regard to introducing foreign investment, at first the country was merely content with making loans from banks of capitalist countries, issuing bonds overseas, and engaging in compensation trade. Until very lately, the government began to dabble in joint ventures, and not until 1990s did the Chinese enterprises have the courage to issue shares and get listed abroad. This was in fact a fear of being contaminated by capitalism. 2. The fear for capital circulation caused all kinds of blockages in circulation. The government bond was resumed in 1980, but its circulation was not allowed. Until 1987, the circulation of governments bonds was finally piloted. The Chinese government initiated stock market pilots in 1990, but for fear of drainage of state assets, it only allowed circulation of additional issuance of new shares to the public and secondary offering of state-owned shares could merely be transferred via negotiation. Consequently, it gave rise to abnormal price growth of outstanding shares and real depreciation of the non-tradable state-owned shares for a long time and this in turn caused equity division, a chronic disease which successive security market supervisors would hardly risk to treat. The welfare-oriented distribution of the public housing system was reformed in 1998 but there is still a concern for the loss of state assets. Just as equity division would block full circulation in the stock market, the fact that public housings are under the ownership of the central, school, and military

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

authorities together with some explicit and implicit policies, retarded the circulation of old houses, which is a primary cause for the unsmooth trade in the secondhand housing market.

3. Egalitarianism. One example was the avoidance of compound interest after

the founding of new China. Following that, it was the four decade-long “iron

rice bowl” policy in China’s state-owned companies, and then egalitarianism

sacrificed efficiency by distributing the wages of three to five people. Later, convertible bonds were going to be piloted in the stock market among listed

companies. But, the words of a senior leader — “timely help was more

favorable than additional bonus” — altered the original plan and made the bonds to be issued by non-listed companies, which placed the pilot in an awkward position to become a laughing stock.

4. The government was worried about all kinds of financial means in the capitalist market economy lest it was contaminated by “capitalist bacteria,” and gave up easily with a slight risk. For a long period, China had much concern over usury and thus dared not open up to non-government credit. Later on, the

Law of Negotiable Instruments of China refused to use commercial paper and

employed bank acceptance to cover all the business. Corporate bonds were

permitted to be issued only if the company had some engineering projects, which denied the financing function of the bonds.

5. The government was overly cautious about and always on guard over

capitalism. Since the reform and opening up in China, once the private economy had developed a little bit, there would always be a variety of leftist thoughts to question the nature of the economy, whether it was capitalist or

socialist, and public or private. Some people have been worried that a new bourgeois has risen in China and if the proportion of the private sector exceeds the public to a certain degree, it will seriously impact the nature of China’s economy and even national security.

6. Some people would rather be leftist than rightist and provoke controversy at every turn. They even do not allow others to try what they dare not to do.

When the former chairman of China Strategic Holdings, Oei Hong Leong, acquired several beer and tire enterprises in China and got them listed

overseas for financing, some people accused him of making something from nothing and stirred up a debate over the “China Strategic storm.”Chen Guang,

the former municipal party secretary of Zhucheng City, Shandong Province, carried out a reform of 288 enterprises above the county level and sold small-

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sized companies among them. Some people satirized him as “Sold-out Chen,” “a vanguard of privatization,” “wastrel,” and “bellwether for the restoration of capitalism.” Some central departments also warned him by saying that “you cannot solve all the problems by selling up and you could hardly get rid of the ideological constraints.”

7. Pay lip service to revolution. China’s government talked about making a strategic adjustment in the distribution of the state-owned economy when

implementing privatization, while in practice, it protected just the state-owned

property and took no account of encouraging the private economy to step in to take the state’s place in the ownership of business. In the past few years, not a small number of privately-controlled companies ran into equity disputes, and

it was often the case that private capital was in an inferior position. When statecontrolled companies were driven into a corner under the old system, they

had to seek help from private capital. Once they were out of trouble, however, those companies would force the private economy to step down on the excuse of prohibiting the loss of state assets. Meanwhile, the government seldom took the initiative to regulate privatization or protect the active participation of

private capital to ensure that the state asset was willing to withdraw from the

ownership of business while the private capital could come in as a replacement and enjoy development free from the discrimination and disruption from force of habit.

8. In the face of the weakness of privatization, the government denied the entire practice rather than solved the problems with care. In 2004, Professor Larry Lang from the Chinese University of Hong Kong criticized some large statecontrolled enterprises, including Haier and Kelon, for the loss of state assets

in the reform of state-owned enterprises, and many people echoed his opinion and cited several extreme cases to question the direction of the reform.

9. During the equity trading in privatization, transactions of corporate control

were avoided from being mentioned. In fact, a capital market of any country can never be called mature if no corporate control is traded and transferred. Only with the flow of corporate control, can resources be really optimized, and assets restructured, the industry structured, and synergy effects be truly realized. Being state-controlled is not always the story, trading of corporate control

cannot be avoided and must be tackled in either private capital absorption

or management buy-outs (MBO) during the strategic adjustment in the distribution of state-owned economy and the reduction of state-owned stocks.

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Turn Workers into Men of Property Capital is useful. It is a prerequisite for a society to feed and enrich its people. The revolutionary party upheld the slogan of “Workers of all lands, Unite!” to lead

the proletariats to power at the revolutionary stage, and after the party came into power, it had the responsibility to turn workers into men of property.

First, the party should raise the income of workers, upgrade low-income

group to middle-income, and constantly enlarge the proportion of middle earners.

After the reform and opening up, Deng Xiaoping repeatedly criticized the “poor socialism” and “poor communism” clamored for by the Gang of Four. He said that

“there is no such thing as socialism and communism with poverty.”26 “We have

been making revolution for several decades and have been building socialism for more than three. Nevertheless, by 1978 the average monthly salary for our workers

was still only 45 yuan, and most of our rural areas were still mired in poverty. Can this be called the superiority of socialism?”27 “According to Marxism, communist

society is a society in which there is overwhelming material abundance...How can we apply this principle [that is, from each according to his ability, to each

according to his needs] without highly developed productive forces and vast

material wealth?”28 “To apply this second principle [the above principle] will require great material abundance: How could a poor society afford to operate on

the principle of ‘to each according to his needs’? How could a communist society be poor? …Poverty is not socialism, and development that is too slow is not socialism either.”29

Second, to allow workers to use their earned income as capital to make

investments in production and participate in profit distribution by subscribing

stocks, and thereby to allow all the members of society to do the same by making use of their savings. Since China is a developing country with lower social

productive forces and is still at the primary stage of socialism, it has to mobilize all the positive factors and constantly encourage workers and members of society

to make investment of all the temporarily spare money in socialist construction in

order to achieve a rapid growth of socialist economy, highly developed productive forces, and vast material wealth.

Third, to allow intellectual workers to take their technological knowledge,

managerial skills, and other factors of production as human capital to gain profits the way material capital does, and establish a sound system of distribution

according to contributions, which is very necessary. First of all, to permit

technology investment is not only an acknowledgement of technology as complex

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labor, but also recognition of the primary productive forces of science and technology being able to be invested like material capital. In this way, science

and technology personnel would share profits according to their contribution of technology investment and become men of property. Next, to include payment motivation and shareholding in distribution to managers is recognition of

managers being capable of enjoying property rights through their excellent management work. The logic is obvious. If you want to abolish the policy of

the “iron rice bowl” in labor, you ought to also abolish it in management, and

good and bad management should be differentiated. The logical way, therefore,

is that regarding management as a kind of capital to share the fruits of profit maximization (including meager profit and loss), when managers organize and operate corporate capital.

Fourth, the government should create conditions for increasing property

income of the masses. Interest on deposit belongs to property income so does dividends and bonuses from investment by deposit. Housing is a property and

thus the income through renting or transferring surplus houses is also a yield of this nature. Other kinds of property income include: Share premium from buying

stocks, income received from the transfer of land-use rights, royalties from patents

and know-how, etc. The key is that the government should create more conditions for more people to own property income.

In conclusion, the revolutionary party of socialism should shoulder the

responsibility to turn workers into men of property, which would be a significant

and profound power for breaking away from the shackles of thoughts. The government should have the courage to stick to the ideas: “Poverty is not socialism, and development that is too slow is not socialism either;” the objective

of proletarians to call for “Workers of all lands, Unite!” is by no means to continue being have-nots; and by doing so, “the proletarians have nothing to lose but their

chains; they have a world to win.”30 For this reason, the government has to first lift

workers from poverty, create better living and consumption conditions, and turn

men of no property into middle-income earners and owners of their own earned income. Meanwhile, to develop too slowly is not socialism. A socialist country

must mobilize all the positive factors and create conditions to enable more citizens

to have property income. The government must constantly encourage workers and other members of society to put all the factors of production including labor, capital, skills and management, into production and circulation, and to participate

in distribution according to their contributions. All the citizens should get engaged

in the lifelong pursuit of socialist construction and ensure a rapid grow of socialist

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economy. To turn workers into men of property is not a socialist utopia, but a reality for socialism with Chinese characteristics. We should be more far-sighted. If all the workers of the society become men of property and the society as a whole has only propertied men of middle- and high-income, then the government and the citizens should consider how to deal with the investment in property, how to manage their property income, and how to govern this brand-new all-haves society. These will be new questions for political economists to tackle in all seriousness.

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1

Chapter

How Capital Is Formed: The Mechanism of Capital Formation and the History of Capital Expansion and Innovation

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Prologue: 60 Years on the Wheel of Fortune When I visited Japan during the mid-1980s and lunched with Ito Masanori, the vice president of Nomura Securities, we had a conversation on currency and the economy. It was the best Chinese restaurant in Tokyo, and Ito said with pride, “Mr. Cao, I am treating you to the world’s most expensive Chinese cuisine!” He was not wrong, as that was the most expensive Chinese restaurant in Japan, and the Japanese yen was then appreciating. This led to a conversation on currency and economy. It was the heyday of the Japanese and West German economies, and the Japanese yen and Deutsche mark were strong, rising currencies. Ito said, “The world economy is like 60 years on the Wheel of Fortune. It was the century of the British pound before World War I. But after the war, the ‘empire on which the sun never sets’ went into decline. Since World War II, it was the age of the U.S. dollar. Now, Japan and West Germany enjoy the benefits of defeated nations, with rapidly growing economies and non-participation in the arms race. Japan bought the Rockefeller Center and Columbia Pictures, infuriating the Americans; and Japan published a book titled The Japan That Can Say No. If done well, even if it may not be a century of the Japanese yen and Deutsche mark, at least we can be on equal ground with the U.S. dollar!” Perhaps realizing his words might be inappropriate in front of a Chinese guest, Ito quickly laughed. “I must have drunk too much!” Then he followed up: “Maybe the twenty-first century will be the century of the Renminbi!” I replied, “Thank you for your auspicious words. I hope that China can have a rapid economic growth like Japan!” Mr. Ito is my good friend and it is unfortunate that he passed away many years ago. Yet none of us foresaw that Japan would fall into a 10-year-long recession after the Southeast Asian economic crisis, and, in the twenty-first century, China’s economic growth would rank second in the world following the 2008 global financial crisis, and the Reminbi would rise strongly! Of course, the Reminbi is still not a world currency, but as the 2008 Development Report on Developing Countries states: Growth is not everything, but it is the basis of everything. I want to stress that currency is not capital, but capital is, in part, the manifestation of currency. In the end, the Reminbi will make the most important leap towards becoming a world currency! Now, let us discuss the mechanism of capital formation and its innovation.

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How Capital Is Formed

The Initial Forms of Capital: Own Capital and Credit Capital is in part the manifestation of money but not all money is capital. Money is only transformed to capital under the foundation of modern production when it has functions in production and circulation, and can bring about value-addedness (i.e. profit). Only then will currency have the functional value of generating profit, thus becoming capital. Similarly, not all bank deposit is capital. Only when banks accumulate a certain amount of deposits and turn them into loans — that is, transferring the control and the profit-making ability of currency to borrowing companies — does the deposit become capital. This is called capital formation in economics. Capital formation is the process of a country saving its citizens’ net income and investing it to create productivity. The economic development of all countries must rely on capital formation. Savings, investment, and production are the three stages of capital formation. So how is capital formed? From the perspective of companies, initial accumulation is the root of capital formation. This includes money legally earned by capitalists and shop owners, and illegally gained through theft, smuggling, and looting. The initial accumulation of quite a few capitalist countries began from looting, such as the enclosure of colonies and the selling of slaves. Of course, this includes the capitalists’ exploitation of workers through prolonged working hours and an increased work rate. This continuous capitalization of remaining value, this transformation of profit into more capital for expansion and increased productivity, is the basic method of capital formation. Own capital is needed for the startup of a company, and refers to the capital originally owned by the company. All companies need to have a certain amount of own capital and it has five main functions: 1. As operating capital during startup and for turnover — this does not need to be repaid during the operation of the company 2. As return, or value-addedness, during business turnover — this should be greater than loan interest, so capital is a scarce resource that is far more valuable that the interest of bank loans; 3. As debt capacity — companies can use capital as mortgages, to bear debts, or as a guarantee for legal responsibility;

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4. As a reflection of ownership — owners show their control over capital and invested-companies through how much capital they have contributed; and 5. As bearing the risk of business loss in times of difficulties. Obviously, it is not enough to rely on a single capital source and selfaccumulation. Marx stated that “[Production] expands annually for two reasons; first because the capital invested in production is continually growing; second because the capital is constantly used more productively.” 1 Therefore, as production size expands, the size of needed capital will expand, and the pursuit of expansion is logically inevitable. After production is developed, when the own capital of the company is insufficient for turnover and cannot meet the needs of production development, company owners have to expand capital. The most common way is to make use of available capital in the society through credit. There are two common types of credit. The first is business credit which includes prepayment among companies. It is the receivables and payables resulting from buying on credit and payment by installments. The other is bank credit, such as loans and overdrafts (as stated before, bank loan is the transfer of capital control to borrowing companies for the price of interest). As opposed to own capital, when companies make use of others’ capital through credit, it is called “borrowed capital” or “non-owned capital.” Own capital and credit are the two basic forms of the initial capital of companies. Other than own capital, credit is the most common and widespread form of capital expansion in initial capital. Credit creates control rights for an individual — it gives someone absolute control over others’ capital within a certain boundary. There are usually four conditions when companies borrow bank loans: The loan is time-limited; the loan is used with interest; the interest is the price for capital use, and the interest rate is usually dependent on the market’s demand and supply of capital as well as the length of the loan; and the principal plus interest have to be paid at maturity. There is one more limiting condition for bank loans, and that is the evaluation of debt capacity of borrowing companies by the bank. Generally, own capital should not be less than 30%, and this is used to analyze the debt situation of the company, as well as to evaluate credit risk. Similarly, the Basel Agreement stipulates that when commercial banks conduct loan businesses, its core capital should not fall below 8%. As discussed, there are conditions for money borrowing for both banks and companies. This is determined by the debt capacity of the company’s own capital. In other words, if the company has 100 dollars of own capital, it can make use of

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How Capital Is Formed

assets (or debt claim) acquired from this 100 dollars as mortgage (or guarantee of legal liability), and obtain a 70–80 dollars loan. Normally, it will not be able to

obtain a loan of more than 100 dollars since it will exceed the limit of debt capacity of the company’s own capital.

It is the capitalists’ own capital and the resulting accumulation, as well as

the control of others’ capital through the use of credit that form the foundation

of the capital formation mechanism. However, the expansion of capital does not stop here. With the continual expansion of production, and when own capital

and borrowed capital cannot satisfy the needs of capital expansion, there will be a

need for innovation of the capital formation mechanism. In turn, under the basis of credit, partnerships and joint-stock companies are formed in addition to sole proprietorship. However, this is not an expansion of borrowed capital, but an

expansion of own capital through the use of social capital. With expanded own capital, debt capacity is also expanded, and borrowed capital is increased.

On an additional note, Marx has highly rated the innovation of capital

formation mechanisms by banks in Das Kapital. The credit and bank systems

place “all the available and even potential capital of society that is not already actively employed at the disposal of the industrial and commercial capitalists so that neither the lenders nor users of this capital are its real owners or producers.”

Marx even thinks that such a system even “does away with the private character of capital and thus contains in itself, but only in itself, the abolition of capital itself.

By means of the banking system the distribution of capital as a special business, a social function, is taken out of the hands of the private capitalists and usurers.” Of course, Marx continues with a warning, that “at the same time, banking and credit thus become the most potent means of driving capitalist production beyond its own limits, and one of the most effective vehicles of crises and swindle.”2

The Innovation, Development, and Changes in the Capital Formation Mechanism There is no end to capital expansion. In the study of the innovation of the capital formation mechanism, it can be seen that since the Industrial Revolution and the rise of mass production, many innovations appeared in the last 200 years.

This section will discuss some of the main new mechanisms of capital formation, beginning with a brief summary of its development.

With the development of capitalism, the Industrial Revolution, and the rise

of mass production, the limits of individual ownership and single sourced capital

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have been broken. The joint-stock company evolves from sole proprietorship and partnership. The innovation of this system is the creation of a way to centralize

the use of social capital despite a spread of ownership. It is a form of mass capital adapting to mass production.

It should also be noted that the Soviet Union abolished capitalism in the 1917

October Revolution, becoming the first country to adopt a planned economy where capital is centralized to build state-owned companies. This use of capital

resulted in rapid industrialization and the adoption of mass production and it raised the national power of the Soviet Union, and supported its victory against

fascist invasion in World War II. After the war, this mode of capital formation

through state-owned capital became an example for socialist countries such as China and the nations of Eastern Europe. This sequence of events also helps one to understand the intervention of Western powers.

Later, in the rapid development of capitalism, overproduction resulted in

a shrink in investment, which in turn led to economic crises such as the Great

Depression in 1929. The Keynesian theory of government intervention was raised, and President Roosevelt realized the idea with his policies. The experience of the

Soviet Union provides a source of reference, where government investment fills

the missing link of capital formation, under the shrinking of private investment. After this, nationalization went overboard, and a wave of privatization occurred

during the Reagan-Thatcher period. Private capital again replaced government capital in the capital formation mechanism.

When technology begins to develop rapidly, a low depreciation rate cannot

compensate, in terms of capital, the loss incurred from the increased replacement

rate of technology and facilities. As a result, the Western countries created the concept of accelerated depreciation to gain capital advances, and thus invented

a new form of capital formation mechanism. When writing Das Kapital, Marx

discovered that the sinking fund (i.e., the fund for wear and tear of the fixed capital) is, at the same time, a fund for accumulation that can be expanded and used in reproduction. He discussed the issue with Engels.3

Accelerated depreciation has allowed this recovery of the sinking fund into

production to be fully developed. After World War II, rental of facilities appeared under the inducement of accelerated depreciation. This uses facilities as a type

of loan capital on the foundation of credit, and does away with the bank as the intermediary, creating another innovation in the capital formation mechanism.

The development of science and technology requires a large amount of

advanced capital invested in research, followed by a suitable way to recover the

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How Capital Is Formed

invested capital through technology transfer. This in turn gives rise to commercial fees in technology transfer, including one-off licensing fee and royalties from total production, which are ways of getting returns on investment. Such fees in

technology transfer are actually recovery of the intangible asset of invested capital, and are similar to the recovery of depreciation and accelerated depreciation of tangible assets.

Next will be the reform of bankruptcy law. It involves the restructuring of

the insolvent companies and the transformation of the creditor’s rights to equity, allowing the creditor to control and renew the company. This transformation of debt into ownership is another innovation in the capital formation mechanism.

Equity and debt financing in the capital market are good mechanisms that

can increase core social capital. Initial public offerings (IPO) and refinancing can directly expand the own capital of a company. On the other hand, debt financing is a direct financing of the debtor to the creditor that replaces bank credit. As

opposed to bank loans, it is a type of quasi-core capital that has a corresponding time-limit and risk. Equity and debt financing in the capital market are innovations

in the capital formation mechanism as they make use of assets that will have profit-making ability in the future without the bank as an intermediary. The exchange of securities such as stocks, bonds, and bills (or fictitious capital in

Marx’s words) for capital in the market, can lead to an expansion of capital. Marx

termed this formation of fictitious capital as capitalization, which is a derivative of the expected yield of real capital in the future. However, this new mechanism

of financing can directly create capital in the capital market, and expand the real capital. Thus, people in the capital market call this mockingly “misappropriation”.

After the 1970s, innovations in the capital formation mechanism are mainly

related to the rapid development of new and advanced technology. A relatively independent financial system, comprised mainly of venture capital firms and

submarkets, has been formed to support the ventures of scientists. Venture capital firms undertake high risk to provide capital for scientists with no mortgages,

guarantee, and capital to support their inventions and innovations. A submarket is a market with lower listing requirements that allows companies to list, finance, and expand their capital based solely on their growth potential and expected yield. It also provides an exit path for venture capital.

In later developments of the capital market, mergers and acquisitions, as well

as financial and debt restructuring, are introduced. Leveraged buyouts, through

the raising of subprime credit and bonds, make use of social capital to expand the corporation itself, instead of to expand its development. Such mergers are usually

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

planned, organized, and operated by investment banks, and this is a reformation

of the capital formation mechanism. Through mergers, liquidity is increased, assets are optimized, and industrial structure is adjusted. Restructuring results in

businesses complementing each other. It results in corporate synergy, raising the overall value of capital.

The securitization of assets occurs because direct financing has bypassed the

financial intermediary, thus hurting the deposit and loan businesses of banks. Shortterm deposits and long-term loans have increased the risk of banks, and to solve

this problem, a major innovation in the capital formation mechanism is created. It allows banks to covert excess assets into cash and creates a new investment tool

for investors. On the foundation of such asset-backed securities, investment banks developed various new derivatives, such as collateralized debt obligations and credit default swaps that caused the 2007–2012 global financial crisis.

Mutual funds have reformed the capital formation mechanism entirely. This

changed the inherent weakness of financial institutions (such as banks) where the

maturity dates and risks of assets and debts were not synchronized, resulting in a

situation where the institutions have to bear most of the risk. In the formation and operation processes of mutual funds, the concentration of investments, the choice

of investees, the management and manager of funds, have all been commoditized and marketized. Mutual funds can put together and provide a large amount of

assets flexibly, meeting both the investor’s needs for personalized service and the

needs of companies for a huge amount of capital during mass production. In the

development of mutual funds, the manager has to adjust the holdings of different stocks and securities continuously to maximize profit. This forces corporate

operators to work with the aim of profit maximization, or face the punishment of being sold by funds, resulting in a takeover or merger of the company.

In conclusion, the need for capital expansion is the main driving force behind

the capital formation mechanism innovation. There are five main requirements as listed below:

1. To break through the limitation of a single capital source and self-accumulation, and gather capital from the society and other sources through the use of credit.

2. To break through the limitation imposed by financial intermediaries, and gather capital from the society and other sources.

3. For banks to resolve the conflict of uneven deposits and loans, as well as to create

liquidity and gather social capital with new methods. From the perspective of

banks, they have accumulated social capital in the form of deposits with their

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How Capital Is Formed

credit, and then use them for business loans. However, the maturity dates and

risk of deposits and loans may not be synchronized. Banks have to maintain a certain level of liquidity to ensure that there will be loans reaching maturity to

pay up possible withdrawal of deposits. There will be a risk of bank failure if the bank becomes too illiquid due to uneven deposits and loans.

4. Investors require a diverse choice of financial products and investment methods other than making bank deposits. As capital, money must be used in the

production process, and this is a limitation. Under current financial conditions, there is a need for excess capital to breakthrough this limitation, so that investors can invest, adjust their portfolios, and exit their investment flexibly.

5. In the capital market, investors with a huge amount of excess capital are

separated from investors who require huge amounts of production capital.

Investors have to find suitable and reliable investees who can provide an ideal return without excessive risk. A new investment industry is therefore created

to meet this need. Investment bankers, fund companies, and asset management companies have taken up the role of finding outlets for excess capital, and the

role of finding a capital source for investees with urgent needs. They have thus reformed the capital formation mechanism and satisfied the needs of both parties.

The Development of the Capital Market and Fictitious Capital after the Collapse of the Bretton Woods System The capital formation mechanism is related to monetary systems. Before World

War II, most countries in the world adopted the gold standard. After World War II

and until the 1970s, the Bretton Woods system was formed under the lead of the United States, where the currency issuance of various countries was pegged to the U.S. dollar, while the U.S. dollar was pegged to gold. Therefore, before the 1970s, the formation of capital of countries was closely related to material production. Even the capital market was developed based on the stocks and debt financing

of production institutes. After the collapse of the Bretton Woods system in the

1970s, currencies of countries unpegged with the U.S. dollar. Currency is like a wild horse after its removal from material production and it can result in the rapid development of the capital market and fictitious capital.

As a result, two major changes occurred in the world economy since the 1970s.

First, a huge fictitious economy has been formed in addition to the real

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economy. The capital market has helped create various derivatives such as asset-

backed securities, stock index futures, government bond futures, foreign exchange swaps, and interest rate swaps. In 2000, the global GDP was under USD30 trillion,

but the total fictitious economy was worth over USD160 trillion. Of this, stock prices and premium bonds were worth USD65 trillion, while over-the-counter trading of derivatives reached USD95 trillion. In 2004, the total fictitious economy was worth USD248.2 trillion, which was six times that of the global GDP of USD40.8 trillion. In 2006, the global GDP was USD48.2 trillion, the global total market price of stocks was USD50.8 trillion, the global total assets of financial institutions were USD190.4

trillion, and the global total market value of derivatives was USD485.7 trillion. They were, respectively, 105%, 395%, and more than 10 times of the global GDP. The

development of derivatives has rapidly increased in recent years. In 2007, the global

total notional amount of derivatives was USD630 trillion, which was 11.81 times that of the global GDP that year. In 2008, it was USD743.5 trillion, and this was 12.57

times that of the global GDP. In 2009 and 2010, it was USD637 trillion and USD618 trillion, respectively, and this was 10.9 and 10.1 times that of the global GDP.

Second, developing together with the fictitious economy and economic

globalization, there has been a huge amount of fluid capital removed from material

production. In 2007, before the global financial crisis, the global daily volume of foreign currency transactions exceeded USD3 trillion, which has doubled in the six

years since then. In 2010, the global daily volume of foreign currency transactions reached USD4 trillion. The global annual volume of foreign currency transactions is dozens of times that of the global GDP.

These two characteristics are interrelated. The fictitious economy provided

a new platform for the global concentration and circulation of fluid capital. As it absorbs fluid capital, it in turn creates new needs for fluid capital. Therefore,

after the 1970s, the social capital formation mechanism is more related to the development of the fictitious economy and fluid capital.

In the last 30 years, these two major changes have created an essential

financial ecology and a large room for various innovations in the capital formation mechanism.

The Characteristics of the Capital Formation Mechanism Innovation in Western Countries There are five main characteristics of the capital formation mechanism innovation of Western countries with a market economy.

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How Capital Is Formed

1. It is dominated by profit-oriented private investments, and complemented by state-intervention, when necessary, to strengthen the basic market function of resources allocation. Private investment is emphasized in competitive industries, while government investment is emphasized in infrastructure building, public goods and services, and non-profit industries. When private investment shrinks, government investment is strengthened, while privatization is encouraged at suitable times to replace government investment with private investment. When there is a shortage of capital during industrial renewal, the government encourages accelerated depreciation and the rental of facilities through tax exemption and deduction. 2. Financial reform is deepened. Capital market and direct financing is developed outside of financial intermediaries, and various financial innovations are encouraged. New financial products and derivatives are developed to provide new investment opportunities and hedging mechanisms for excess capital. There is also an emphasis on the balance of investment return and risk. Wealth is distributed among investors, capital is financed from investors, while at the same time, risk is distributed among investors to diversify risk. 3. The investment banking industry is developed in addition to the banking industry, becoming a main driving force behind the capital formation mechanism innovation. Investment banks form a finance and investment industry that specializes in capital utilization, assets management (including fund management), corporate mergers and acquisitions, and corporate restructuring. In situations of overcapacity, excess capital and a decreased average profit rate occur, and investment bankers can find growth companies and investment return opportunities among various companies that are not making profits. It also creates opportunities for investment returns through planning and organizing corporate mergers and acquisitions, as well as financial innovation. It has made investment, assets management, and capital utilization into a specialized financial service. 4. The fictitious economy is developed in addition to the real economy, creating more room for the expansion of core social capital. Due to various innovations in capital formation mechanisms, the stock, bond, bill, fund, futures, and derivatives markets, as well as the submarket, are all developed to form a huge fictitious economy. 5. The development of the capital market and fictitious economy has driven innovations in capital formation mechanisms. Such innovations, in turn, drive

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the specialization of financial industries such as banking, securities, trust, and insurance industries.

Of course, the capital market, derivatives market, and fictitious economy

form a doubled-edged sword. They nurture risks as they develop, especially

when overspeculation leads to the formation of economic bubbles, such as the stock market bubble or the real estate bubble. During the Great Depression, the

stock market and real estate bubbles burst. Risk was overconcentrated in banks, resulting in the widespread failures of banks. The 1997 Asian financial crisis and the “Lost Decade” in Japan were both the results of the real estate bubble burst that

led to the failure of banks. After the dot-com bubble burst in the United States in 2000, the NASDAQ Composite index fell from more than 5000 to 2000. Banks were not affected mainly because the capital market and direct financing had dispersed

the risk of banks. When the stock market bubble burst, it was the investors who directly felt the effects of risk and loss. However, the global financial crisis, which started from the subprime mortgage crisis in the United States, led to a worldwide

panic run centered in the repurchase market involving several trillion U.S. dollars. This created a new form of debt crisis in the financial industry. Wall Street was

shaken, while investment banks, commercial banks, and insurance companies suffered heavy losses.

Capital Expansion in China’s Age of Planned Economy In the first 30 years after the establishment of the People’s Republic of China,

cities carried out a centrally planned economy consisting mainly of state-owned enterprises, while villages carried out a social economy was formed by poor farmers and agricultural laborers. This created a publicly-owned capital formation mechanism. The concept of capital was avoided, while the national plan was

emphasized as “law.” All wealth was state-owned, all revenue and expenses were centralized in the government accounts, and all credit was centralized in banks,

but these factors had not stopped the expansion of capital and capital formation mechanism innovations. It is the inherent nature of capital to expand. It will find any opportunity, even in a highly centralized system, to express itself.

Other than centralized infrastructure building plans, the financial department

first issued “small-scale technical loans” and “export product loans” through the China Construction Bank. Then, various “potential development and reform

funds” were directly used from the budget, expanding the capital formation mechanism. In the 1970s, Shanghai, Changzhou, as well as Xiangyang (then known

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How Capital Is Formed

as Xiangfan) and Shashi in Hubei, expanded capital with small-scale loans, thus allowing the local governments to overshoot economic targets. This was a clever innovation in the capital formation mechanism.

The State Development Planning Commission induced an expansion of capital

too. The commission adopted an objective that emphasized production over infrastructure building and infrastructure over finance. It expanded capital and the formation mechanism when financial needs caused the banks to issue money.

Other ways of capital expansion include the lateral transfer of collective capital

by local governments. Companies pushed infrastructure building to increase

production, and then drove repair and maintenance, finally raising the total costs.

The unreasonable use and transfer of debts also contributed to the expansion of capital.

After the economic reform, the planned economy in China was replaced by

a socialist market economy. In the beginning, bank loans replaced government

funding as the capital source for infrastructure building, creating a dislocation of equity and debt in the capital formation mechanism. Bank loans were used for

society building, and were in turn a mechanism for capital expansion. On the other hand, local governments encouraged “financing fever” and “bonds fever,” while local offices organized foundations and local finances. Some banks also engaged

in borderline activities such as lending out long-term loans with interbank lending capital, and lending out convoluted loans that involved a third party acting as an agent. These formed the first invested-capital used in building markets, companies,

and rural companies so as to create the first capital formation mechanisms under a market economy.

Capital markets were developed later. The regulating authority had frequently

prohibited the use of company capital in speculative activities, the use of bank capital in the stock market against regulations, and illegal private financing.

However, due to the expanding nature of capital, capital tends to seek any opportunities in the system. Red chips are listed in Hong Kong, while public-

initiated markets, such as the Zibo trading market and the Chengdu Hongmiaozi market, appeared. When credit regulation was at the tightest, underground financing appeared in Wenzhou, Zhejiang.

These capital expansion methods may sound questionable, but they show

that however tight the administrative regulations, they cannot stop the inherent

expanding nature of capital. “A clear pond has no fish” — economy and finance should not be regulated too tightly. Western markets only regulate actions that

are specifically prohibited. Actions that are not specified in regulations, that were

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neither allowed nor prohibited, are treated with flexibility. Such flexibility is

very important, and such open-mindedness is the key to China’s reform. Many important policies are the evolution results of such flexibility. Looking back at the

various breakthroughs in past “forbidden areas” that have occurred since China’s

reform, it seems that only a thin line separates groundbreaking and rule-breaking, truth and nonsense. The monetary authority has to keep a clear head, be sensitive to changes, be able to optimize production relations through system reform, and

be able to induce and utilize capital. They have to encourage innovation in capital formation mechanisms, to transform as much idle social capital as possible into

wealth-creating capital, and assist in the development of socialist productivity. In

the innovation of capital formation mechanisms, regulators cannot always say no and punish innovative officials. More importantly, there is no reward without risk, and regulators should not throw out the baby with the bath water.

The Role of the Human in Capital Formation Mechanism Innovation Capital formation mechanism belongs to the field of production relations.

Although the ultimate objective of capital formation mechanism innovation is

the expansion of capital, it cannot be separated from human relationships in the

formation of capital. That is, it cannot be separated from the relationships among

investors, investees, banks, intermediaries, and the investment industry. From a

social perspective, to encourage more human resources into developing capital formation mechanisms, and to encourage the transfer of deposits into investments, are the keys to speed up the accumulation and gathering of social capital. These are determining factors in the expansion of core social capital.

Capitalism is profit-oriented, and its objective is to maximize profit. This

characteristic leads to capital being used more efficiently, and an annual increase in production, as pointed out by Marx. This nature of profit maximization is the key

to attracting more human resources into working on capital formation mechanism innovation.

The way the investment bank manages finance can serve as an example.

As stated above, the investment bank specializes in capital utilization, assets management (including fund management), corporate mergers and acquisitions,

and corporate restructuring. Since there is a huge amount of excess capital that has

a tendency to pursue maximum profit, and investment bankers work with the idea of “reward lures talents,” bankers not only created opportunities for excess capital

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to create great profit, but also created a higher-than-average income for themselves. This helps in the deployment of more talents into innovating capital formation mechanism, developing investment banks into a high-income industry. In the example of helping companies with their IPO or listed companies with refinancing, investment banks are skilled in studying and comparing the opportunity cost and marginal value that capital may bring in future operations. They can thus discover the potential value of the capital, present it through specialized financial service, and realize the value by seizing investment opportunities. At the same time, since investment banks work with large amounts of capital, the related intermediary industry is, as a result, developed simultaneously. This includes accounting, the legal system, and the related supporting services, which together forms a highincome group that drives the development of the entire service industry. The capital market and fictitious economy are other examples. The market economy has the ability to adjust supply and demand of a product, through changes in market price. One of their major contributions of the capital market and the fictitious economy is that they further push forward this function of the market economy. A huge amount of fictitious capital has been developed, and the fall or rise of their market price allows the public to adapt to differences in expected profit caused by differences in factors such as price, profit, interest rate, and currency exchange rate. This encourages people to be more active in the use of capital, bringing out the ability of the market in discovering value and in optimizing resource allocation. Excess capital is, as a result, channeled into new industries or regions, so that overproduction and underproduction are adjusted, and the regional economy and industrial structure are improved.

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2

Chapter

Capital Is Not Only a Product of a Capitalist Society

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Prologue: Blind Men and an Elephant Capital is a sensitive topic that can stimulate a lot of debate.

It reminds me of the story of the blind men and the elephant. Four blind men

were told to touch an object and describe what they felt. The first person described

a snake; the second, a piece of canvas; the third, a tree trunk; and the forth, a piece of rope. Of course, it was an elephant.

We are probably like the blind men describing the elephant when we discuss

capital from our own perspectives. The problem is to reach the concept of an elephant from the surface images of snake, canvas, tree trunk, and rope! Let us return to the topic.

In the 60 years of socialism in the People’s Republic of China, the concept

of capital was avoided for 40 years. In these 40 years, capital was confused with

money, and own capital was not distinguished from borrowed capital. When we discuss capital formation mechanism innovation, we have to trace the origin of capital, or we will be haunted by this specter of “capital avoidance.”

The avoidance of capital in China comes from the inflexible socialist economic

theory. Since the socialist revolution had destroyed the capitalist and exploitative systems, it seems logical that capital, which is dependent on the exploitative

system, will cease to exist. There are no capitalists in state-owned companies,

thus all capital distributed to state-owned companies by the national finance were called “funds.” Long after the 1978 economic reform, there is still debate and avoidance within academia on whether companies under socialism need capital like all other companies.

In 1997, the 15th National Congress of the Communist Party of China

confirmed, for the first time, that companies under socialism need capital as links.

To increase the function of capital and to raise the efficiency of companies and capital become recognized goals. The fog on socialist capital was removed, but debate still persists even after 1997.

We have long been avoiding the topic of capital, thinking that it is a product

of the capitalist society, and is only related to how capitalists exploit surplus labor. We think that exploitation does not exist under socialism, so capital that exploits surplus labor does not exist too. These are incorrect concepts. I once published

an article “One Two Three: Questions on Capital” in Investment Studies No. 2, 1998, to explain this problem. In my opinion, if China were to build a socialist

market economic system, the country has to build conglomerates through the market with capital as the link. It has to maximize the function of capital, and raise

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the efficiency of companies and capital. A correct concept on socialist capital is essential: Like all companies, companies under socialism require capital. This is the natural course of economic operation.

Capital Existed before the Capitalist Society Capital is not the product of a capitalist society, it exists before the capitalist society, and before labor is commodified.

Currency has become capital with the development of the commodity

economy. It is manifested as either commercial capital, or usury capital. It creates

growth of wealth through buying cheap, selling expensive, and through high interest from loans. Marx called them “antediluvian forms,”1 and differentiated

them from the capital of economic institutions of modern-day society. At this stage, capital is only related to commodity production and circulation, and labor-power

as a commodity is not a condition. The creation of surplus value is unrelated to capital, as profit is not the transformation of surplus value. The profit from capital

in a pre-capitalist society is a result of the necessary labor and surplus labor of the merchant.

This shows that capital, commodity, and profit existed before the capitalist

society. They are natural products in the development of the commodity economy, and are unrelated to the production and surplus value of the capitalist society.

They, however, should be differentiated from the capital, commodity, and profit as defined by modern economics.

Capital Accumulation Is the Most Important Function of the Advancement of Society Capital, as defined by those in modern economics, is created from money on the

capitalist production foundation where labor is commodified. Capital can be “transformed from a given value to a self-expanding, or increasing, value,” and

“enables the capitalist to extract a certain quantity of unpaid labor, surplus-product and surplus-value from the laborers, and to appropriate it.” In this way, capital,

“aside from its use-value as money, acquires an additional use-value, namely that of serving as capital. Its use-value then consists precisely in the profit it produces

when converted into capital.”2 Marx calls this value of money, which additional use-value can potentially bring a growth larger than the original excess of capital, surplus value.

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Engels once said that Marx had two major discoveries. The first is the

discovery of historical materialism, which proved that the “history of all hitherto existing society is the history of class struggle.” 3 The second is the discovery

of the theory of surplus value. It explains the relationship between capital and labor, and revealed how capitalists exploit the surplus value of workers. Marxist

economy argues that for money to become capital, labor must be commodified.

Marx proved, with various facts, that wages are not equal to the value produced by labor in the production process. The latter is greater than the former, and thus

there is surplus value, and exploitation of such. This is an essential concept in understanding capital under a capitalist society.

Long before Marx, many bourgeoisie classical economists had proved the

existence of surplus value. This surplus part of value is formed from the unequal

pay for labor-produced products. However, as Engels pointed out, their studies stopped there. One of the most influential classical economists, David Ricardo,

had on one hand discovered that value is produced by commodity producers

through labor, in the labor theory of value. On the other hand, he was limited by the principle of equivalent exchange, thinking that it is only through commodity

exchange that the amount received in sales can be greater than the original price

in which the product is brought. Yet if commodity exchange can only be an equivalent exchange, how is value growth possible? This conflict left Ricardian theories in a dilemma. If the labor theory of value and the principle of equivalent

exchange are adhered to, the existence of surplus value cannot be explained. If

surplus value is to be recognized, either the labor theory of value, or the principle of equivalent exchange, or both, is wrong. Marx’s theory of surplus value solved

this problem. In the words of Engels, Marx “analyzed the transformation of money

into capital and demonstrated that this transformation is based on the purchase

and sale of labor-power. By substituting labor-power, the value-producing property, for labor he solved with one stroke one of the difficulties which brought about the downfall of the Ricardian school.”4 Marx differentiated the concepts of labor-power and labor. Capitalists buy labor-power from workers, and pay them

in equal amount of wages in accordance to the principle of equivalent exchange. However, capitalists buy labor-power for their own use, meaning that they use

the labor-power to carry out labor. Since labor-power creates a greater value than

wages in the process of labor, surplus value is created, allowing capitalists to exploit this surplus. Marxist philosophy argues that for money to be transformed

into capital, labor-power must be commodified, so that capital can exploit surplus products and values without paying any price.

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Mao Yushi added a premise for exploitation: It must be an unequal and non-

free exchange. Exploitation does not occur in equal and free exchanges, but occurs in exchanges when one of the parties is under control. Wage delay, wage deduction,

practices that break labor laws, overtime work without pay or subsidies, and an

unsafe working environment are all examples of exploitation. It is not exploitation

if there are no such problems. Since the market is free and competitive, exploitation is impossible as the worker will look for a non-exploitative employer.

The concept that exploitation occurs when one of the parties in the exchange

is under control, is very important. However, a capitalist economy is by nature led by capital, and capital is always in a dominant position in the production process.

Workers only have labor-power, and are always in a disadvantaged position.

Although the market is free and competitive, the non-exploitive employer does not exist since there is a surplus of labor. In the early stages of capitalism, capital lacks

regulation, while allocation between labor and capital is strongly sided to capital. Even for China, which is in the early stages of socialism, some factories in the north have tense employee-employment relationships, and situations where profit

erodes wages are common. Statistics show that the personal income to national income ratio has fallen from 64.10% in 1994 to 57.68% in 2004. Labor remuneration

to national income ratio has fallen from 57.09% to 47.15%. This shows a decreasing

trend in the amount received by workers in social distribution. In the new Labor

Contract Law passed in 2007, the minimum wage is adopted. This is the use of the law to intervene in employee-employer conflicts, to protect workers’ rights, and to ensure a fairer balance of profits and wages.

The first function of capital is that it exploits the surplus value in the capital-

labor exchange. It performs another function, as it simultaneously changes a portion of surplus value back into capital, and brings about accumulation. It is impossible for capitalists to use all surplus value in consumption, and a

considerable portion is transformed as capital to be re-used in production. Marx

calls this process capital accumulation. In Das Kapital, Marx sees accumulation, the transformation of surplus value into capital, and the expansion of production as the same. It is this process that realizes the expansion and production of capital,

or in other words, capital growth. Such capital activity allows capital to snowball

and brings about capital accumulation. Marx points out in Theories of Surplus Value, “This part of the profit consists of “the surplus labor-time, which, even without

the existence of capital, must constantly be performed by society, in order to have at its disposal, so to speak, a fund for development, which the very increase of population makes necessary.”5

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There are two layers of meaning in this quote.

Even without capital, society needs funds for development, which are created

by surplus labor-time. Marx pointed out this necessity when discussing capitalist production methods and this necessity is even more relevant to socialist societies.

Capital realizes the accumulation of surplus labor-time. Other than the

function of exploiting surplus value, capital also helps society accumulate surplus labor-time as it transform surplus value into capital. This accumulation is the most important function of the advancement of society.

Thus, even exploitation should be differentiated. On one hand, it is a shameful

function that exploits the surplus labor of workers and help capitalists fulfill profit goals. On the other hand, when capitalists use a portion of profit as capital, they change surplus value back into capital and use it for capital accumulation

of production expansion. This portion of exploitation helps society accumulate

surplus labor-time, and this accumulation is important for society’s advancement. Therefore, even without capital, even without capitalists exploiting the unpaid

labor of workers, workers have to “exploit” themselves. That is, to accumulate surplus labor-time with unpaid labor.

On another note, Marx was writing in the early nineteenth century, where

capitalism was in its early stages and rapidly developing. There was a mixture of

slavery, feudal, and capitalist systems. What we now call “old capitalism” is the primitive, early, barbaric, and anarchic capitalism. Initial accumulation of capital

originated from the enclosure movement more than 300 years ago, the colonial

slave trade, and the capitalists’ exploitation of workers through longer working

hours and increased work rates. Marx witnessed the violent means of capitalists in the process of initial capital accumulation, writing “capital comes dripping

from head to foot, from every pore, with blood and dirt.” 6 This phenomenon was closely related to poor technology, low productivity, and a lack of regulation

over capital at the primitive stages of capitalism. Marx and Engels write in The Communist Manifesto: “The bourgeoisie, during its rule of scarcely 100 years, has

created more massive and more colossal productive forces than have all preceding generations together.”7 Marx also mentions that the unlimited productivity of

modern industries is the first condition of the liberation of labor. Zhou Youguang states that “capitalists do not only exploit without producing value. Capitalists

worked on the startup, management, and technological aspects of production. Startup is the most difficult step. If we annihilate capitalists, we annihilate talented entrepreneurs. Capitalists are all managers before the appearance of professional management staff. Most state-owned enterprises suffered deficits due to poor

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management. Capitalists are also the first engineers, before the appearance of professional engineers.”8 Marx too, has recognized the work of capitalists in the aspects of business startup, management, and technology.

Under Socialism, Capital Is a Socialist Element With Merely a Capitalist Name Now, let us discuss whether capital exists in a socialist society. The “socialist society” here does not mean the primary stage of socialism as now in China where diverse forms of ownership coexist. It refers to the advanced stage of

socialism which implements unitary public ownership. Or to put the question in another way, in a socialist society with unitary public ownership, can currency,

commodity, enterprise, bank and other factors which have developed within the capitalist mode of production continue to exist independent from capitalism? At this time, can capital as an outcome of the capitalist mode of production get rid of

its capitalist nature? Or to be more frank, is capital still related to the exploitation of surplus labor under a socialist society with unitary public ownership? And can capital exist without capitalism?

Before go into the above questions, we will first see some quotes from Karl

Marx and Friedrich Engels with a hope to draw some inferences.

First, Marx had inferred from the economic realities of capitalism the

distribution of total social product in the communist society in Critique of the Gotha Program and before dividing the total social product among the individuals,

he made several deductions to establish various funds. These funds include: (1) Compensation funds which is a “cover for replacement of the means of

production;” (2) accumulation funds which is used to expand production; (3)

“reserve or insurance funds to provide against accidents, dislocations caused by

natural calamities, etc.” The remains are consumption funds which are “intended

to serve as means of consumption.”9 Here, the compensation and accumulation

funds are equivalent to the capital in our present society. The former is the original social capital while the latter is the additional capital which resulted from the capitalization of the surplus value, namely, the capital proliferation.

Second, when talking about distribution, Engels in the Socialism section of

Anti-Dühring regarded accumulation as “the most important progressive function of society” and repeatedly talked that “accumulation is a social necessity,” and society was required to secure an accumulation fund “for the maintenance and extension of production.”10

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Third, there was a passage in volume 3 of Das Kapital by Marx about the

cooperative factories run by the workers of the capitalist society. “The co-operative factories of the labourers themselves represent within the old form the first sprouts

of the new, although they naturally reproduce, and must reproduce, everywhere in their actual organization all the shortcomings of the prevailing system. But the

antithesis between capital and labour is overcome within them, if at first only by way of making the associated labourers into their own capitalist, i.e., by enabling them to use the means of production for the employment of their own labour.”11

As we have said in the previous section, the capital of the capitalist society,

in addition to the “exploitation of surplus value,” possesses another important role which is to accumulate the surplus labor-time. This accumulation is the most important function of the advancement of society. Therefore, in the socialist

society with unitary public ownership, as long as the social reproduction does not stop, the transformation of capital to productive capital on the basis of socialized

mass production as well as the currency-proliferation movement when currency serves as productive capital (namely, the movement of the accumulation of the

surplus labor-time) also will not stop. Nonetheless, in the socialist society with

unitary public ownership, once society destroys the shell of the capitalist mode of production, capital is deprived of the function of exploitation and is completely

purified into a fund of production and development, necessary for the maintaining and expanding of the social production and development modes. At this time,

capital has undergone the socialist baptism, gotten rid of the original capitalist nature, and become a socialist element — a socialist element with merely a capitalist name. The reasons are as follows:

First, within the state-owned economy and public economy under socialism,

labor is no longer a commodity. The workers as masters of socialist enterprises are

both their own capitalists and their employed labor. Surplus products created by the labor are no longer occupied by the capitalists for free (at this time, capitalists

do not exist in the public economy), and instead the surplus is a kind of voluntary labor contributed by the workers for the social accumulation.

Second, socialist society achieves the public ownership of the means of

production. Within public economy, capital is no longer a means to rule labor force and exploit surplus value, but continuously creates accumulation during the social reproduction and constantly completes the capitalization of the accumulation in order to form a large social development fund.

Third, in the public economy of socialism, there is no surplus value which

results from the capitalists’ exploitation of workers, but surplus labor-time and

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surplus products exist in the social reproduction. This kind of surplus, as Marx

said, is the workers “using the means of production for the employment of their own labour.” This employment of labor, as a kind of accumulation, represents the most important function of the advancement of society.

The capital mentioned in the above paragraphs is within the context of the

public economy of socialism. It is separated from the capitalists, has nothing to do with capitalism and is not exploitative in nature. This capital can be referred to as either “fund” or “capital.” I prefer to maintain the name “capital,” because

there are still capitalist countries and enterprises around the world, and socialist

enterprises need to use their capital in a way conforming to all sorts of commercial practices of international capital and as a basis for commercial dialogues with the enterprises of the international capital. To continue using the name of “capital,”

just as we have kept the original names of commodity, currency, profit and bank, could make it easier to remember the original form. Someone maybe would ask why we could not call it “fund” instead of “capital.” To be frank, capital was

avoided to be called “capital” in the 40 years after the founding of new China and was called “funds” instead. Unfortunately, this name failed to sort things out but

added to the confusion. The first 30 years saw a heavy financial burden caused by the excessive funding, while within the 10 years after the reform and opening up policy, over-indebtedness of enterprises took place.

Further, to make logical reasoning in accordance with the traditional socialist

theory, we could say that only when a large-scale socialized planned economy is

established and all land, factories, means of production are owned by the society, could all exploitation be possibly eliminated. Logically speaking, the relations of production in the socialist public economy should be perfect. No surplus value

resulted from the capitalists’ exploitation of workers exists, but the surplus labortime and surplus products contributed by workers for the social accumulation in

the form of voluntary labor. Meanwhile, there is no capital from the exploitation of laborers but production funds of the accumulation of surplus labor-time and surplus products. Nonetheless, although the Soviet Union, China before the reforming and opening up policy, and the eastern European countries have

implemented planned economies and socialist public ownership systems, the

relations of production of their state-owned economies are still not in harmony. I think there are many reasons for this matter, but the most fundamental ones are:

First, excessive accumulation. There should be a limit to accumulation when

distributing the total social product. The socialist country replaced the capitalists

and turned the surplus value generated from the capitalists’ exploitation of

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laborers into the nominal accumulation of surplus labor-time and surplus products. These surpluses were all turned over to the state for the priority development

of heavy industry and thus there was a great scarcity of consumer goods. The workers were dubbed “masters of the country” but in reality they worked at a low wage. After the jubilation and enthusiasm of the status conversion from workers

to the master of society at the early days of the victory of the revolution, in the face of the long-term low-wage “voluntary contribution,” workers would recognize this “voluntary contribution” as the synonym of “exploitation” which socialist

countries refused to admit. In this case, the “masters” would start to embrace

the thoughts of employment, and the “to give remuneration on the basis of work

done” would develop into “to do work on the basis of remuneration given” and “to spine the work out.” This is a logical punishment of “iron rice bowl” and “reward of egalitarianism.” In Western countries, democratic socialist parties have set a standard of minimal wages to restrain the capitalists’ exploitation of laborers. In the socialist society, laborers are in power and workers are the masters of the

country, but they offer long-term “voluntary contribution” with low wages. How should such enterprises and workers display motivation and vitality?

Second, rigid management and failure in motivating the enthusiasm of

enterprises. In the Soviet Union and Eastern European countries, as well as China

before the reform and opening up, state-owned enterprises would turn all the profits over to the treasury. The state-owned enterprises have neither capital nor

the capitalization of surplus value, and therefore there is no snowballed capital accumulation as in grassroots enterprises. Thus, the state-owned enterprises of

the Soviet Union, Eastern European countries, and China are not as good as the Western capitalist enterprises which possess the capability and vitality of selftransformation, self-accumulation, and self-development.

Third, with only top-down arrangements, the enterprises of those socialist

countries excluded the market. Consequently, the enterprises lacked the information of supply and demand from the market and lost the flexibility and

enthusiasm of independent production arrangement based on the market demand.

Finally, a more fundamental problem is that in the Soviet Union, Eastern

European countries, and China before reform and opening up, the productivity

of society was low and far beyond the level enough for implementing “socialist public ownership.” Therefore, the “planned economy and public ownership”

carried out by those countries surpassed the development stage of the history.

Moreover, the “planned economy” itself is till controversial and even though in a socialist society under public ownership, moderate accumulation, flexible

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management, attention to market, and motivation to employers, enterprises and market are indispensable.

The Coexistence of Two Kinds of Capital at the Primary Stage of Socialism China is now at the primary stage of socialism with diversified forms of ownership, and there are also various forms of capital which can be roughly divided into two categories:

The first is being capitalist by nature. In the primary stage of socialism,

there is still a part of the economy of capitalist nature, including foreign-owned enterprises, Sino-foreign joint ventures and domestic private-capital enterprises.

That is because the productivity at this primary stage is very low and there is a need to make room for the development of the capitalist economy to a certain

degree; therefore, the state recognizes the legitimacy of private capital and its exploitation of a certain degree in the form of law and protects its legal interest. On the other hand, the government protects the legitimate interest of the workers

(such as stipulating the standard of minimal wages) and controls the degree of exploitation of capital via tax laws (such as income tax, windfall tax, and

inheritance tax). Overall, the capital of the capitalist enterprises in the present society is both a restricted capital and a capital whose development must be protected for the development of social productivity forces.

The other is the capital of a socialist nature. In addition to state-owned

enterprises and enterprises under collective ownership which are comprised of government capital and public capital, respectively, there is still a large number

of joint-stock companies of a diverse economic composition. This is a share economy, a mixed ownership economy, and, of course, a socialist economy. It

should be noted that a large number of shares of the economy are held by the massive number of laborers and the source of the capital is the accumulation of

labor income. The nature of the capital should be deemed more as what Marx called the capital of cooperative factory by the workers. In Marx’s words: To make

“the associated labourers into their own capitalists,” and they “use the means of production for the employment of their own labour.”

Specially, the Decision of the Central Committee of the Communist Party of China

on Some Issues concerning the Improvement of the Socialist Market Economy passed by the Third Plenary Session of the Sixteenth Central Committee of the CPC Central

Committee in 2003 decided to “vigorously develop the mixed ownership economy

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participated in by state-owned capital, collective capital, and nonpublic capital, etc., realize the diversity of investors and make the joint-stock system the principal form of realization of public ownership.” This decision has inestimable theoretical significance and will play an important role in promoting the joint-stock reform of state-owned enterprises and the development of a mixed ownership economy.

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3

Chapter

Joint-Stock System: From Socialized Mass Production to Capital Socialization

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Prologue: Financing through the Joint-Stock System by Yantai Power Plant and the Reason Why New York Became a World Financial Center Let us begin with two stories. The first story took place in China after the start of the reform and opening up policy. Shandong Province used to suffer from power shortages while Yantai City, located in the north of the province, contained coal reserves. In 1980, the municipal government of Yantai proposed to the Ministry of Electric Power of China the building of two power plants with an installed capacity of 200,000 kilowatts for each. The first-phase investment required RMB165 million. The ministry, however, did not have such a large sum of money and suggested a joint investment with the local government. Unfortunately, the Yantai government was on a tight budget. At that time, the government came up with the idea of raising funds through issuing shares. The municipal government planned to commission the Yantai City Branch of China Construction Bank (CCB) to float stocks of 110 million to be subscribed to by big electricity consumers and rural communes and production teams. In practice, the Yantai CCB had drafted a financing plan and reported it to the State Planning Commission, the Ministry of Electric Power, and the headquarters of CCB. After several rounds of discussions, the stocks were finally issued in 1981. Li Peng, the then Minister of the Ministry of Electric Power, wrote an inscription for the Yantai government, which read “Financing for a power station, first in the nation.” Actually, the so-called “stock” would generate interest together with dividends, and at last the principal would also be paid back. Strictly speaking, it was not a real stock and it was more like a bond. Despite this, the practice was indeed a pioneering work in China. I do not know whether the shareholding system in the Yantai power plants was successful or not, but the first innovation in capital formation mechanism after the reform and opening up should be attributed to the pilot in the Yantai power plants. This innovation broke away from the restrictions of the planned economy and collected money by introducing a joint-stock system. The second story happened in the U.S. and was told by a famous Chinese economist, Xu Xiaonian. The financial industry was developed earlier in London than other cities around the world, and London was the world’s first financial center. But why did New York exceed London later on to become the global financial center? It is said

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that the primary cause was the introduction of the capacity for a limited liability

company in the U.S. law which was enacted by the Empire State in the late 19th

century. When a company of this nature goes bankruptcy, its investors will only be held liable for the amount invested in the company and not be subject to unlimited

responsibility. This is a very effective way to protect the interest of investors, and therefore many people registered their companies in the State of New York and

New York became a popular investment destination for investors. In fact, this was the prelude to the rise of New York as the world financial center later. Seeing

the financial prosperity in New York, London did the same thing in order to incorporate limited liability into its law.

Socialized Mass Production Requires Capital Socialization The industrial revolution brought about the socialization of production and the production mode of workshop handicrafts was required to make a breakthrough in order to expand the scale of industrial production and capital. At that time,

owing to the introduction of a joint-stock system, the capital formation mechanism

realized its first innovation. It was a concrete manifestation of socialized production which called for capital socialization.

In Western countries, stock companies and stocks first emerged in large-scale

businesses such as voyage trading and banking industries in the 16th century.

Earlier stock companies and stocks were just simple means of fundraising and profit-making through speculation, and had nothing to do with the socialization of production.

In the 16th century, among the ocean steamers which engaged in overseas

voyage trading (in fact, colonial plundering) in the old capitalist colonial countries, such as the U.K. and the Netherlands, there appeared shareholding companies

to raise capital and spread risks owing to the industry’s huge costs. For example, the Muscovy Company (also called the Russian Company) was the first major chartered joint-stock company to be established in the U.K. in 1553, followed by

the Levant Company (later, known as the Turkey Company) which was formed in 1581, and then the East India Company in 1600. These companies raised funds from adventurous merchants and dealt with long-voyage trade by way of

overseas pillaging. Due to a series of reasons, such as the construction of longdistance ocean steamers which needed a large amount of money, the business was

vulnerable to the attacks from aborigines, and large profits were accompanied

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by high risks. The steamers, at first, collected capital stock before each voyage, and returned the money with dividends when the journey was completed. These companies, however, felt the inconvenience of raising money every time before sailing and gradually transformed into companies of fixed shares, distributing

dividends on a regular basis. As a result, a shareholding system came into being.

In 1602, the Dutch East India Company was set up by issuing penny stocks as a joint-stock company. Later on, shareholders had the need to cash in their stocks

so people conducted private mortgage, discounts, and transfer of shares, which evolved into today’s stock transactions. The first stock exchange was established

in 1613 in Amsterdam, the Netherlands, and a group of government-backed jointstock banks showed up in the European and American banking industries in the

late 17th century. The joint-stock companies and stocks at this time, however, were simply aimed at raising funds, making profits through speculation, and spreading risks. They, from the very beginning, displayed a feature of using other people’s

capital to run a risk without a single sign of socialized mass production. The stock companies and security investment did not appear in the industrial sector until the late 18th century.

The delayed development of stock companies and stocks in the capitalist

industrial sector, compared to that in other domains, was mainly due to the fact that the productive force of capitalism at that time was not high enough to break through the constraint of individual capital.

In the earlier stage of capitalism, the workshop handicraft industry was in a

dominant place and the amount of capital needed for production was not very large thanks to the small size of the workshops. Initially, the asset of a workshop

was contributed to by a single capitalist or a few capitalists, and the investors were

the capital users with the ownership and management rights of a workshop being tied closely together. Until the 18th century, the British Industrial Revolution drove

forward the transition of major industrial sectors from handicraft production to large-scale production with machinery, and social productive forces made a great

leap forward. Not only did industrial production expand rapidly, but also basic industries such as transportation, energy, raw materials, and public utilities had the

demand to correspondingly scale up their productions and make huge investments in order to push forward socialized mass production. At this point, the investment scale of industrial enterprises was beyond the financial capability of an individual capitalist. Neither could a capitalist government sustain the massive investment in

the public works sector. Mechanization and socialized mass production demanded a new kind of capital formation mechanism. Consequently, during the late 18th

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century and early 19th century, the heavy investment demand from industries involved in waterways, railways, highways, electricity, telegraph, gas, water, docks, and mining caused these industries to undertake equity financing. So the

first innovation of a capital formation mechanism could be attributed to the jointstock system.

The innovation in capital formation adapted to the needs of mechanization and

socialization of production, overcame the restriction of an individual capital, and

developed from a sole proprietorship and partnership to a joint-stock company collecting funds from the whole society. The joint-stock system, therefore, met the

requirements for developing industrial productive forces, made the industries no longer confined to private ownership and individual capital, and created a way to

collectively use social capital despite a spreading of ownership. Mass production led to capital socialization, just as what Marx had said in Das Kapital: “The world

would still be without railways if it had had to wait until accumulation had got a few individual capitals far enough to be adequate for the construction of a railway. Centralization, on the contrary, accomplished this in the twinkling of an

eye, by means of joint-stock companies.”1 Marx praised joint-stock companies

by stating that “they gave in one word, an impetus never before suspected to the

concentration of capital.”2 From then on, enterprises were able to build great social

productive forces by centralizing mass capital according to the scale of industrial production, free from the limitation of individual capital.

Another innovation of the joint-stock system in capital formation was limited

liability. During the years of workshop handicraft economy, the enterprises’

property organization form was transformed from a single proprietorship to a partnership, namely when the capital of an individual capitalist was not sufficient, at least two capitalists would add in their capital to form a partnership. The

property, however, was merely the accumulation of capital from two or more capitalists who collectively shared the interest and risks, and it was nothing more

than a simple addition of several individual capitalists. For instance, if Mr. Zhang opens a Zhang’s Candy Factory and later Mr. Wang invests in the company, the

company will become Zhang and Wang’s Candy Factory. Of course, the two share the profits and risks of the factory together since both have contributed capital. It has to be noted that this partnership, the same as sole proprietorship,

is accompanied by unlimited liabilities. In addition, the growth in the number of partners would give rise to conflicts in plant control, business decision-making,

profit distribution, and risk sharing. As a result, partnership was transformed into

a limited partnership, that is, everyone contributes whatever he has, either money

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or labor. The one who invests money is only liable to the value of his investment in the company while the one who invests labor is the decision-maker and manager

of the company and will bear unlimited liability. In benefit distribution, the latter,

the same as the former, will receive a certain amount of money in accordance with his contribution, usually 20%–25% of the total profits.

A joint-stock system evolves from the partnership with limited liability and

makes a complete separation between money contributor and labor contributor.

Labor contributor, i.e., “the actually functioning capitalist” transforms “into a mere

manager, administrator of other people’s capital,” whereas money contributor,

i.e., “the owner of capital” turns “into a mere owner, a mere money-capitalist.”3

If the limited partnership developing on the basis of workshop handicraft needs

a contract to specify each partner’s rights, obligations, and responsibilities, a

breakthrough made by the joint-stock system based on socialized mass production

is to simplify capital, rights and responsibilities into shares, due to the large scale

of businesses, huge capital demands, and a great number of investors. In this way, investment resembles the purchase of goods with the only difference being that this time the goods are shares. The obligation of respective investors is clear:

An investor’s financial liability is limited to the value of his investment, which is called “limited liability,” and thus a stock company is usually a “limited liability company.”

The joint-stock system must emphasize a limited liability and a shareholder’s

liability is only limited to his financial contribution. This is very important and constitutes the essence of capital culture — to protect investment and investors.

The Twists and Turns in China’s Practice of a Joint-Stock System China is a socialist country and this calls for the socialization of production.

Logically, China should not hesitate to carry out a joint-stock economy, but for

various reasons, the practice of the joint-stock system has become a tortuous process. In later sections, we will talk about some sensitive topics related to this.

For a long time, the issues of a joint-stock system, stocks, and the securities

markets were the forbidden areas of socialism. At the beginning of 1992 when

the former Chinese leader Deng Xiaoping paid a visit to a few southern cities, he pointed out: “Are securities and the stock market good or bad? Do they entail any

dangers? Are they peculiar to capitalism? Can socialism make use of them? We allow people to reserve their judgment, but we must try these things out. If, after

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one or two years of experimentation, they prove feasible, we can expand them. Otherwise, we can put a stop to them and be done with it. We can stop them all at once or gradually, totally, or partially. What is there to be afraid of? So long as we

keep this attitude, everything will be all right, and we shall not make any major

mistakes. In short, if we want socialism to achieve superiority over capitalism, we should not hesitate to draw on the achievements of all cultures and to learn from other countries, including the developed capitalist countries, all advanced methods

of operation and techniques of management that reflect the laws governing

modern socialized production.”4 This talk provided the Chinese people with a

clear direction for trying out a joint-stock system, securities, and stock markets.

As a matter of fact, new China, in its early economic life, inherited the concepts

of joint-stock system, share capital, stocks, securities and securities trading from old China. In the initial period of new China, when the government confiscated

bureaucratic capital and built a state-owned economy, the government shares

transformed from the confiscated bureaucratic capital were assigned to China’s Bank of Communications for collective management. At that time, I was working for the Bank of Communications (predecessor of CCB) and the bank once

gathered a group of comrades to set up a department, especially responsible for participating in the broad of directors of joint ventures, regularly inspecting the companies’ operation and collecting dividends. People called those joint state-

private enterprises “state capitalism,” and the government encouraged the private

enterprises to implement a joint state-private ownership because it believed

this measure would lead to the peaceful transformation of private capitalism to socialism.

We should be clear here that at the early stage of new China when Mao

Zedong still advocated the new democratic revolution, he supported the need for a great development of capitalism in China. Mao believed that before China

turned to socialist revolution, there must be a long period for private enterprises of democratic management, and China’s industrialization must take advantage

of the growth of private enterprises and the investment from foreign capitalists.

He was also convinced that it was inevitable for new democracy to experience a

long period of capitalist private economy. In that period, moreover, to develop joint state-private enterprises (i.e. state capitalism) was a necessary way to lead to the peaceful transition of private capitalism to socialism. Despite the fact that the

government’s policies allowed and encouraged the joint state-private ownership, people tended to underestimate the value of joint ownership and share capital,

and regarded them as makeshift methods for the transition from capitalism to

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socialism. They thought that the joint ownership will finally be transformed into a unitary ownership by the whole people. By 1952, Mao Zedong saw that industrial

working capital accounted for 67.3% and the working capital of commercialretail sector also reached 40% in China, and thus believed that socialist economic

power had achieved an advantageous and leading position. Accordingly, in 1953, the Central Committee of the CPC officially determined the general line of the Party for the transition period: “Basically, to accomplish the industrialization

of the country and the socialist transformation of agriculture, handicrafts, and capitalist industry and commerce in 10 to 15 years, or a little longer.”5 Therefore,

the “Great Leap Forward” between 1958 and 1960 promoted the joint state-private

ownership with eagerness and zest in the hopes of fulfilling the reform of private

capital ahead of the schedule and entering socialism in advance. Additionally, the 10-year Cultural Revolution after 1966 more directly forced a way to socialism by announcing the cancellation of capitalist redemption on the basis of a fixed rate of interest.

New China took over the stock exchanges from old China when Shanghai,

Tianjin, and Peiping were liberated. At that time, Chen Yun, who was in charge of China’s financial works, thought of utilizing and reforming those stock exchanges to

make them serve new China. Later, speculative capital in Shanghai took advantage of the modern telecommunications facilities of the Shanghai Stock Exchange to

disseminate false information to the whole city, which incurred an inflation of silver dollars and the price tripled within 10 days. Consequently, the Shanghai Military

Control Commission punished the speculators and closed the Shanghai Stock Exchange in June 1949. On the contrary, the Tianjin and Beijing Stock Exchanges

started business in June 1949 and February 1950 in succession. Not until the “ThreeAnti and Five-Anti Campaign” of 1952, did the two suspend operations (in July and October, respectively) due to the reduced number of brokers. There are two points I want to make clear.

First, in the early stages of new China, people, based on their understandings

of new democratic revolution, correctly regarded the joint-stock system as the best form for promoting state capitalism and reforming private capitalism, but they did not make great efforts to develop the system and share capital. On the contrary,

under the leftist thinking of being eager to transition to socialism, people always deemed public ownership as the advanced form of state capitalism and thus were longing to step into socialism as early as possible.

Second, at that time, China followed the economic pattern of the Soviet Union,

and despite keeping stock exchanges, China did not possess the conditions for

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the distribution of securities, which was deemed to be a blind alley. Thirty years

later, when the Third Plenary Session of the Eleventh CPC Central Committee in

1978 ushered in a new era of reform and opening up, the Chinese government decided to strengthen domestic lateral economic ties, attract foreign investment,

and encourage the construction of Sino-foreign joint venture and cooperation projects. This action naturally caused a debate over whether the joint-stock system,

share capital, stock and securities markets were socialist or capitalist in nature. The core issue was whether a socialist market economy should engage in joint-

stock, share capital, stock and securities markets? To put it more directly, do those things exclusively belong to capitalism? Can socialism make use of them? These questions indicated that there was a large realm unknown to the Chinese people. To solve the above questions, we need to refer to Marxism.

Marx: Share-Capital as the Most Perfect Form Leading to Communism We know that as early as a century ago, Marx spoke highly of stock companies by saying that “stock-company business represents the abolition of capitalist private

industry by social capital.”6 When Marx studied the capitalist mode of production,

he examined various forms of capital in the process of social reproduction, and exposed a contradiction in the capitalist mode of production, which cannot be solved by capitalism itself, namely, the contradiction between the socialization

of production and private ownership. Marx investigated not only individual and social capital but also production and circulation capital, fixed and floating

capital, variable and constant capital, and industrial and financial capital. At last, he focused on share capital and found that it may be the “final form” and

“ultimate positing of capital,” and may also be “the most perfect form…leading to

communism.” And the capitalist stock companies would be “the transitional forms from the capitalist mode of production to the associated one.”7 Unfortunately, latter Marxists failed to give due attention to this important theoretical insight of

Marx, so they took an indifferent attitude towards share capital and the joint-stock system in the long-term practice of socialism.

Marx affirmed the positive meanings of share capital and stock enterprises

from four aspects.

1. Share capital manifests itself as a kind of social power and product in the form of social capital and enables capital to reach its final form.

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Marx commented on stock companies by saying that: (1) [The formation of stock companies resulted in] an enormous expansion of the scale of production and of enterprises, that was impossible for individual capitals. At the same time, enterprises that were formerly government enterprises, become public. (2) The capital, which in itself rests on a social mode of production and presupposes a social concentration of means of production and labour-power, is here directly endowed with the form of social capital (capital of directly associated individuals) as distinct from private capital, and its undertakings assume the form of social undertakings as distinct from private undertakings. It is the abolition of capital as private property within the framework of capitalist production itself.8 The socialized concentration of social capital and social undertakings described

by Marx is different from the concentration in a general sense. The concentration in the above block quotation — “a social concentration of means of production

and labor-power” — still refers to the concentration which originally existed in

the general capitalist private capital and private undertakings. On the other hand, social capital and social undertakings under the context of share capital specifically

refers to the socialized concentration of individual private capitals. The individual capitals collected for founding a joint-stock company thereby acquire a social

nature to become “associated individuals,” and are “endowed with the form of social capital.” They manifest themselves as social power and products.

We know that the minimal capital requirement for effective production in

capitalist industry will increase along with the improvement of productivity. The

development of the capitalist mode of production will raise the minimum amount

of capital necessary to operate a business under normal conditions. As for the industries which have a longer production cycle and larger scale, such as railways,

they require in the long-term a huge amount of advanced capital, and thus there must be abundant capital in the hands of the capitalists. In this case, to solely rely on the capital accumulation of a single capitalist is far from enough and the social concentration of capital must play a complementary role. Credit and competition, therefore, become the most powerful levers of concentration. There are two ways

for social concentration: one “by the violent method of annexation” in competition; and the other is on the basis of credit and through “the smoother process of organizing joint-stock companies” to realize “the fusion of a number of capitals

already formed or in the process of formation.”9 The social concentration of a

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joint-stock company achieved through “the fusion of a number of capitals already

formed or in process of formation” is an innovation in the capital formation

mechanism which is the topic for this book. It guarantees adequate capital for industrial enterprises to expand their production scales and achieves the final form of capital in which “the mode of production based on capital is already developed to its highest stage.”10

Marx repeatedly praised the social concentration of capital through establishing

a joint-stock company. In Das Kapital, he commended that centralization, “in the

twinkling of an eye, by means of joint-stock companies,” accomplished capital

growth “enough to be adequate for the construction of a railway.” “The masses of capital fused together overnight by centralization reproduce and multiply as the

others do, only more rapidly, thereby becoming new and powerful levers in social

accumulation.”11 In a letter written from Marx to Nikolai Danielson in April 1879, he praised railways as “couronnement de l’oeuvre,” because “they were the basis

of immense joint stock companies” and “they gave in one word, an impetus never before suspected to the concentration of capital.”12

As for share capital which obtains social attributes through the socialization

of capital, Marx pointed out that “hence mostly share capital, the form in which

capital has worked itself up to its final form, in which it is posited, not only in itself, in its substance, but is posited also in its form, as social power and product.”13

2. Share capital is the ultimate positing of capital after social capital dissolving private capital.

First is the abolition of private capital by share capital.

In the above block quotation, Marx regarded the social funds collected via

stocks by joint-stock companies under the capitalist mode of production as “social capital,” and defined “social capital” as “capital of directly associated individuals as distinct from private capital.” He also defined joint-stock companies as “social undertakings as distinct from private undertakings.”

In other places, Marx referred to “capital of directly associated individuals”

as either “associated capitalists”14 or “collective capitalists,”15 and both terms

emphasize the social attributes obtained through the socialization of capital. As a

result, share capital is transformed into social capital and dissolves private capital. Similarly, enterprises established on the basis of “capital of directly associated

individuals” gain a social nature. Despite the fact that this kind of capital is first

and foremost the private property of capitalists, the enterprises funded by this

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capital become social undertakings instead of private undertakings. Second is the abolition of individual capital by share capital.

Marx talked about the abolition of individual capital by competition and share

capital in The Grundrisse (1857–1858).

The influence of individual capitals on one another has the effect precisely that they must conduct themselves as capital; the seemingly independent influence of the individuals, and their chaotic collisions, are precisely the positing of their general law. Market here obtains yet another significance. The influence of capitals as individuals on each other thus becomes precisely their positing as general beings, and the suspension of the seeming independence and independent survival of the individuals. This suspension takes place even more in credit. And the most extreme form to which the suspension proceeds, which is however at the same time the ultimate positing of capital in the form adequate to it — joint-stock capital.16 These words of Marx elaborated to us how competition realizes suspension

of independence and independent survival of the individual capital through the

interaction among individual capitals, and finally generates joint-stock capital which is “at the same time the ultimate positing of capital in the form adequate to it.” The form of share capital or Joint-stock capital, moreover, abolished the “seeming independence and independent survival of the individuals [i.e. individual capital]” and becomes “the most extreme form” of the suspension.

Third is that share capital is “the abolition of capitalist private industry on the

basis of the capitalist system itself.” Marx believed that stock-company business

“destroys private industry as it expands and invades new spheres of production.”17 We can find explanations of the above words from the supplementary

materials contributed by Engels in Das Kapital.

In the Chapter 27 of Das Kapital Vol.3, Engels listed a number of enterprises

which have developed as “new forms of industrial enterprises” like cartels,

“representing the second and third degree of stock companies…In every country this [bankruptcy] is taking place through the big industrialists of a certain branch joining in a cartel for the regulation of production. A committee fixes the quantity

to be produced by each establishment and is the final authority for distributing

the incoming orders.” “This [insufficient association in production] led in some branches, where the scale of production permitted, to the concentration of the entire production of that branch of industry in one big joint-stock company under single management.”18 In another chapter, Engels went on, “thereafter, gradual

conversion of industry into stock companies” happened, and “one branch after another suffered this fate...Then the trusts, which create gigantic enterprises under

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common management (such as United Alkali); The ordinary individual firm is

more and more only a preliminary stage to bring the business to the point where it is big enough to be ‘founded’.”19 Fourth is the abolition.

When mentioning abolition, Marx said it in four ways: 1. The social capital

forming on the basis of joint-stock enterprises and share capital is “the abolition of capital as private property within the framework of capitalist production itself;”20

2. Joint-stock system is “the abolition of capitalist private industry on the basis

of the capitalist system itself;”21 3. “This is the abolition of the capitalist mode

of production within the capitalist mode of production itself, and hence a selfdissolving contradiction, which prima facie represents a mere phase of transition to

a new form of production;”22 4. Through competition, share capital finally achieves

“the ultimate positing of capital in the form adequate to it,” abolishes “the seeming independence and independent survival of the individuals,” and establishes the form of share capital as “the most extreme form” of abolition.23

When Marx was reviewing capitalist society, he focused on the abolition of

private capital “within the framework of capitalist production itself,” which is the essence of studying a society by Marxism. The reason why Marx criticized

many vulgar economists is precisely because “the vulgus is unable to conceive the forms developed in the lap of capitalist production, separate and free from their antithetical capitalist character.”24

3. The Joint-stock company is a transitional form from the capitalist mode of production to the associated one.

Marx believed that stock companies are the abolition of capitalist private

capital by social capital, and at the same time conducted research based on the

contrast between stock companies and cooperative factories. He thought that “the

co-operative factories of the laborers themselves represent within the old form the first sprouts of the new;” “but the antithesis between capital and labor is overcome

within them, if at first only by way of making the associated laborers into their own capitalists.” The laborers “use the means of production for the employment

of their own labor.” Marx held the idea that the antagonism is resolved negatively in the capitalist mode of production while positively in the associated mode. Marx, however, saw from cooperative factories “how a new mode of production naturally

grows out of an old one.” So he concluded that “the capitalist stock companies, as much as the co-operative factories, should be considered as transitional forms from the capitalist mode of production to the associated one.”25

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Marx continued discussing the transitional form. He said that “in stock companies, the function is divorced from capital ownership, hence also labor is entirely divorced from the ownership of the means of production and surpluslabor. This result of the ultimate development of capitalist production is a necessary transitional phase towards the reconversion of capital into the property of producers, although no longer as the private property of the individual producers, but rather as the property of associated producers, as outright social property. On the other hand, the stock company is a transition toward the conversion of all functions in the reproduction process which still remain linked with capitalist property, into mere functions of associated producers, into social functions.”26 What is important here is that Marx called the future producers of communist society “associated producers” when talking about “the property of associated producers” and “mere functions of associated producers.” It will be helpful for solving the Sphinx riddle in the reestablishment of individual ownership in the future communist society, if we study this notion together with the conception of giving producers “individual property based on the acquisition of the capitalist era: i.e., on cooperation and the possession in common of the land and of the means of production” in the future society,27 and the conception of “free individuals.” In a community of free individuals, people “carry on their work with the means of production in common,” social product is to satisfy the social production and consumption, and “[the] apportionment [of labor time] in accordance with a definite social plan maintains the proper proportion between the different kinds of work to be done and the various wants of the community.” “Labor time also serves as a measure of the portion of the common labor borne by each individual, and of his share in the part of the total product destined for individual consumption.”28 4. Share capital is “the most perfected form” that is “turning into communism” In a letter from Marx to Engels talking about Das Kapital, Marx drafted an outline. In the outline, the words related to capital and share capital were as follows. Capital falls into four sections. a) Capital en general (This is the substance of the first instalment) b) Competition or the interaction of many capitals. c) Credit where capital, as against individual capitals, is shown to be a universal element. d) Share capital as the most perfected form (turning into communism) together with all its contradictions.29

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This outline corresponds with the ideas put forward in Chapter 27, Vol. 3 of Das Kapital and other works of Marx. However, to regard share capital as “the most

perfected form” that is “turning into communism” is the most explicit and best condensation of share capital by Marx. Unfortunately, Marx has not elaborated on why share capital is “the most perfected form” that is “turning into communism” and how share capital could turn into communism and all other contradictions, so that we have to infer from this simple outline and other analysis of Marx on share capital. It is also the case that Marx pointed out some negative impacts of share capital while admitting its positive role. He warned us that “the conversion to the form of stock still remains ensnared in the trammels of capitalism; hence, instead of overcoming the antithesis between the character of wealth as social and as private wealth, the stock companies merely develop it in a new form.”30 He added that in the capitalist mode of production, the joint-stock system “reproduces a new financial aristocracy, a new variety of parasites in the shape of promoters, speculators, and simply nominal directors; a whole system of swindling and cheating by means of corporation promotion, stock issuance, and stock speculation. It is private production without the control of private property.”31 Obviously, all those negative effects should be overcome when we carry out the joint-stock system in today’s world. It has been one and a half century since Marx wrote those words on share capital. One interesting fact is that capitalist countries did not give up share capital easily just because it would lead to communism, but stepped up the development of the joint-stock system, stocks, and securities markets by following the law of socialized production instead. On the contrary, in socialist society, people repeatedly claimed to develop the socialized production to the highest level; however, for a long period of time, they refused the socialized forms including the joint-stock system, stocks and securities markets which could make the most of social capital. More importantly, when China was at the stage of New Democratic Revolution, the government dared to declare without scruple that we encouraged private capitalist enterprises to implement a public-private partnership and would lead a peaceful transformation of private capitalism to socialism. China used to be so close to Marxism on the issues of joint-stock system and share capital, but moved away from the ideas of Marx when the country was eager to transform itself into a socialist country. Now, when China announces again that it would “make the jointstock system the principal form of the realization of public ownership,” the above detours should be avoided.

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Stock System Starts Amid Numerous Ideological Obstacles After Reform and Opening Up The Third Plenary Session of the Eleventh CPC Central Committee in 1978, which proposed the policy of opening to the outside world and invigorating the domestic economy, encouraged all sectors, local governments, and enterprises to be active

in building socialism. Since the construction of socialism needed capital, a great

variety of financing methods emerged and the stock system was among those methods.

As mentioned earlier, the State Development Planning Commission approved

the issuance of shares by Longkou Power Plant, Yantai City, Shandong Province, to big electricity consumers and rural communes and production teams. This was the first case of a government giving a formal consent to stock issuance.

After this practice, joint-equity investment happened frequently. After a

year of research, the State Planning Commission, State Economic and Trade

Commission, Ministry of Finance, People’s Bank of China, and CCB in October 1982 jointly formulated Interim Measures for Trial Implementation of Domestic Joint Venture Construction, in order to promote and guide the healthy development of joint ventures. The Measures put forward that joint venture construction projects

could be set up, regardless of the restrictions of sectors, locations, and ownerships,

between central and local governments, urban and rural areas, the entire society and a group of people, industry and agriculture, industry and commerce,

agriculture and commerce, and military and civilian sectors, according to their

respective advantages in resources, capital, equipment, and technology. This

was the first time that all kinds of financial resources could be invested in joint

ventures; plants, sites, and equipment (including deferred projects) were allowed to be converted into shares; and even technology could be appraised as capital

stock and share profits. The Measures, however, stipulated “three unchanged”

things, namely ownerships, relationships of administrative subordination, and financial relations. Although the Measures just put forward a joint venture rather

than a joint-stock system, it was a necessary road towards the latter.

After the Measures was promulgated, local governments took the initiative to

carry out many trial projects on a joint-stock system. For example, Shenzhen Baoan County Joint Investment Company implemented a joint-stock system in 1983 and

changed its name to China Baoan Group Co., Ltd. in 1991; and Beijing Tiaoqiao Shopping Mall and Shanghai Feilo Acoustics Co., Ltd offered stocks to the public in July 1984 and November 1984, respectively. Following that, some small- and

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medium-sized state-owned enterprises in Guangdong, Liaoning, Shandong,

Zhejiang, Tianjin, and other provinces and cities started to try the joint-stock

system. Some companies engaged in employee stock ownership, and some used

the system as a way of financing, while others regarded symbolic dividends as a kind of welfare to motivate employees.

Why did those companies introduce the pilots of a joint-stock system? The

answer from local governments and enterprises was pretty forthright: They were

forced to by circumstances. Since the enterprises had no money for development,

they had no choice but to raise funds through stocks. Local governments and enterprises were pragmatic, and as long as they could get money, they would take

risks to try new methods. As to the matters of how to regulate companies, disclose

information, transfer stock rights, and get companies listed on stock exchanges, they did not give too much thought. The 120 “problematic stocks left over by history” in the Shanghai and Shenzhen stock exchanges were the side-effects of those pilot projects.

As for large- and medium-sized enterprises, they could receive money from

the government and banks. At the beginning of reform and opening up, the central government decentralized power and transferred profits downwards, and at the same time carried out the management contract system with the surplus

profits of contracted works left to enterprises, in order to allow more autonomy and more financial resources for self-transformation, self-accumulation, and self-

development of the enterprises. If the state continued to implement the joint-stock system, there would be many tough problems to be solved as for how to coordinate between a joint-stock system and a contract system. As far as I can remember, it

was in 1983 when the general manager of China Automobile Corporation, Rao Bin, sought financial help from CCB for the automobile industrial transformation

during the Sixth Five-year Plan period. At first, the general manager intended to issue shares, but when my bank colleagues and I reminded him of many

substantive issues such as financial disclosure, a board of shareholders, dividend sharing required by a joint-stock company, especially the issue of the relationship between higher authorities and the broad of directors, he felt frustrated and was at a loss what to do. At last, he gave up the joint-stock system and chose to float bonds instead.

China’s reform and opening up policies cannot get away from ideological

debates. With the implementation of joint-stock system pilot projects, debates

arose around whether this system was socialist or capitalist in nature, whether it

will lead to privatization, and whether this action will distract people from the

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socialist cause. Later, the report to the 13th CPC National Congress in November

1987 provided a conclusion: “various forms of a system of shares in enterprises have appeared during the reform. These include purchasing of shares by the

state, collective purchase by departments, localities and other enterprises, and purchasing by individuals. This system is one means of raising money for socialist enterprises and can be further implemented on a trial basis.” This document gave a pass for the reform towards the joint-stock system. In 1988, many local governments expanded their scope of pilots, but it did not last long. After the

second half of 1988, China started to rectify its economy, and a political storm emerged one year later, which resulted in another debate on the nature of the system of shares. In May 1990, the State Council issued a document which

demanded the continuous sound implementation of the joint-stock system, but

encouraged people to neither scale up the pilots nor set up new pilot programs in

general. In addition to equity participation and shareholding between enterprises, active pilots of which were still allowed, experiments on employee stock

ownership would no longer be expanded. The State Council, however, promised to undertake supporting reforms for those which had issued stocks to the public in Shanghai and Shenzhen, which paved a way for building stock exchanges and opening securities markets in the two cities.

Liu Hongru (1992) made an incomplete set of statistics which indicated that

at the end of 1991, the total number of pilot joint-stock enterprises of all kinds

amounted to around 3,220 (excluding joint-equity cooperative enterprises in

villages and towns and Sino-foreign joint ventures). Among these, pilot enterprises of institutional ownership added up to 380, accounting for 12%; pilot enterprises of employee stock ownership reached the number of 2,752, up to 86%; and pilot

enterprises offered stocks to the public took up 2%. Among the total capital stock of the 89 enterprises which publicly issued stocks, state shares occupied 47%, institutional shares 29%, individual shares 14%, and foreign capital shares 9%.

At the beginning of 1992, Deng Xiaoping delivered a speech during his

southern tour which laid a foundation for further reform and opening up in

China. He urged Chinese people to further emancipate their minds, to be more

daring in reform and opening up, to quicken the pace of economic development and not to lose any favorable opportunity. Deng mentioned in particular that “we allow people to reserve their judgment, but we must try these things out.” His

words were a great encouragement for the pilots of stock markets in Shanghai and Shenzhen. Later on, Liu Hongru (1992) cited Marx’s words — share capital is “the

most perfected form” which is “turning into communism” — which justified the

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joint-stock system by the classic argument of the founder of Marxism.

Now, some people criticize that China’s practice contributed to deforming

the stock market in regard to the stock ownership arrangement. During the pilot

program of a stock system, China first set up state shares, institutional shares, and

employee shares which turned to establish B shares afterwards.32 This criticism

reflected a lack of knowledge about China’s stock market.

Individual shares aimed to let employees inside or outside an enterprise

own shares. Because the stock system in China was initially established to satisfy the financial need for construction, and the money was primarily collected from

employees of the joint-stock company as well as the general public. In a survey conducted in 1992, the investor structure of Shenzhen was as follows: Enterprise

employees and functionaries accounted for 79%, workers 16%, and unemployed

people 5%. In Shanghai, the structure of individual investors comprised 79.4% of enterprise employees and functionaries, 8% of investors from other industries, 6% of teachers, 4% of people without regular work, and 2.6% of self-employed people.

At that time, rich private entrepreneurs seldom bought stocks, and most individual investors were workers who made a living on labor income. So people assumed

then that shareholding by socialist workers was a characteristic of China’s socialist stock market and was distinct from private ownership. Moreover, employee stock ownership was similar to a worker cooperative which was justified in the classic

Das Kapital, and therefore it could evade the debates over whether the stock system

was socialist or capitalist in nature.

State shares refer to the shares held by the government, which complies

with the policy of “taking public ownership as the basis of the economy.” Institutional shares are set up for the same reason as individual shares, with the

only difference of shareholders being departments and enterprises. When the reformed stock system was piloted later, few individuals were rich enough to join, so the government had to ask several enterprises to be shareholders. Then,

there was a Japanese book called Corporate Capitalism which specifically talked

about cross-shareholdings between enterprises and affected the pilot programs in

China. At that time, people believed that mutual shareholding between Japanese enterprises was of a capitalist nature, while in China since mutual shareholding happened between state-owned enterprises, there was no worry about changing

the companies into capitalist ones. Besides, the central government granted power to enterprises and allowed them to keep a bigger share of profits. Consequently, the extra-budgetary funds of enterprises were increasing year by year. According

to the statistics, the extra-budgetary funds in 1978 were RMB34.7 billion,

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equivalent to only 31% of the budget revenue; and in 1988, the extra-budgetary

funds were RMB236 billion, accounting for 90% of the budget revenue. The crossshareholdings and mutual investment between enterprises would produce similar effects and could also benefit the merger and reorganization of enterprises and enterprise groups.

B shares are foreign shares and to divide stocks into A and B categories was a

practice directly learned from overseas stock markets.

The toughest issue was the circulation of stocks. At the moment, some people

worried that the circulation of state shares would bring about the loss of state assets, and therefore the government had to prohibit the circulation of capital deposit and only allowed the issuance and circulation of shares by incremental

capital at the initial stage of the pilot stock market. Consequently, state shares and

institutional shares were temporarily not permitted to circulate. This “temporary prohibition,” however, lasted for 15 years, resulting in the split share structure

between tradable shares and non-tradable shares and a forbidden area for the successive China Securities Regulatory Commission.

At the initial stage, China’s stock market encountered a contradiction particular

to China, namely, to apply the management methods of a planned economy to

solve the questions and conflicts appeared in the market economy. For example, when choosing companies to be listed, the Chinese government ought to give the chances to the most capable large- and medium-size enterprises in the market, but

it set a quota for listed companies and allocated the quota, as a way of showing care, to the 120 small companies which were the earliest participants in the joint-

stock reform and had problematic stocks left over from history. Take another

example, the operation of a stock market has to comply with the law of supply and demand, and the initial boom prices in the stock market should be stabilized by

listed companies issuing more shares; however, Chinese decision-makers reversed

the order, and demanded to first restrain the share price before increasing issues in

stocks. Besides, in a mature market, convertible bonds are usually issued by listed

companies, but Chinese authorities asked non-listed companies to take a chance and then made those companies go public. There are still many other examples of the contradiction.

In conclusion, China’s share-holding system started among a great number

of ideological obstacles and under a great variety of political pressure. The joint-

stock reform and the opening of the stock market in China were venturous and arduous works. The government must not only have the courage to overcome all

difficulties in the way of socialist economy and remove all ideological barriers, but

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also bear the realities that debates over the nature of the stock market will never end and to apply the thinking of a planned economy to a market economy will create prejudices and misunderstandings. Later, the CPC central committee repeatedly made it clear that the joint-stock system is an organizational form of property in a socialist society. Furthermore, the Third Plenary Session of the Sixteenth Central Committee of the CPC in 2003 stated that the country should “vigorously develop the mixed ownership economy participated in by state-owned capital, collective capital, and nonpublic capital, etc., realize the diversity of investors and make the joint-stock system the principal form of the realization of public ownership.” Over 100 years ago, Marx regarded share capital as “capital of directly associated individuals,” and praised it as “the most perfected form” which is “turning into communism.” The idea of making “the joint-stock system the principal form of realization of public ownership” proposed for the first time by the CPC central committee was a significant theoretical breakthrough, representing an evolution of Marxism during China’s practice of the stockholding system. Until 2005, when equity division reform and full circulation of stocks were carried out, China’s shareholding reform and stock market walked out of initial confusion to make an epoch-making leap. Finally, I would like to emphasize before ending this chapter that there are three important outcomes I would like to see happen as a result of this discussion of the joint-stock system. First, for China to become good at gathering and utilizing social funds to expand capital; second, for China to make good use of employee stock ownership which will benefit both fundraising and management; and third, for China to reorganize companies according to the joint-stock system and get them listed in order to secure property income for the citizens and enlarge the middle-income group.

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Chapter State Investment, State Intervention, Nationalization, and Privatization: Innovation of the Capital Formation Mechanism by China’s State-Owned Economy

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Prologue: The Earliest State Intervention in China and the Counter-Regulatory Effect of Economic Leverage What impressed me most about state intervention was the three-year Great Leap Forward between 1958 and 1960 when Mao Zedong advocated “two targets” (the one obligatory to attain and the other aspired for) with quotas being increased at each lower level, which resulted in a seriously runaway capital construction. In 1962, Chen Yun and Deng Xiaoping presided over the meeting in the West Building at Zhongnanhai and discussed the measures for regulating the economy. The most immediate means of invention included: To close down, suspend, merge, or shift lines of production of problematic enterprises; to cancel unreasonable projects or reduce the staff; and sometimes even to directly increase or reduce investment according to the status of production. Deng Xiaoping named these measures as “special means for special times.” Another impressive incident was the three-year over-investment crowding out consumption. In 1962, there was a severe shortage of home-use hardware and consumer goods: Citizens could not find a place to buy an iron pan and an iron scoop, workers were unable to find a lunch box, and women had no hairpins to use. This situation created a great public outcry, and thus Premier Zhou Enlai had to spare some time from his tight schedule to host the State Council meeting and find ways to secure several tons of steel and aluminum from capital construction for the purposes of increasing the production of household hardware and other metal goods used in daily life. It sounds like a joke nowadays but the state intervention during the planned economy was exactly like this, so awkward and specific. After the reform and opening up, the Chinese government learned to use economic levers. Initially, people still held the view that capital construction should be conducted only in a planned and proportionate way but not by a market principle. The market, however, was so strange that if you cannot make use of market levers, the market will mercilessly crush down your planned and proportionate development by its counter-regulatory effect. There was a true story which happened in Zhangjiakou City, Hebei Province. The city boasted itself as “a city of leather,” and was the collecting and distributing center of leather from pastoral areas far and wide. The State Planning Commission established three large leather factories and introduced advanced leather splitting machines which could separate one piece of leather into three. The factories planned to purchase leather from supply and marketing cooperatives and turn it into leatherware. However,

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at that time, the government encouraged rural communes and production teams to run small factories by giving a favorable policy of “three-year tax exemption” to arouse their interests. Many rural communes and production teams took the chance to open small leather factories which purchased leather at a higher price but sold their products at a lower price than the three larger factories. Being poorly equipped, those small factories were unable to split leather for multiple uses, but due to the tax exemption, they could still make money. Their huge demand led to a shortage of leather in the supply and marketing cooperatives, and consequently the three large factories had to close down due to insufficient raw materials. Now the Chinese government clearly knows that under a market economy, they have to not only rely on price mechanisms to balance supply and demand in the commodity market, but also regulate asset prices in the capital market to attract money capital and optimize the allocation of resources, in order to redistribute industrial production capability and promote the adjustment and optimization of production structure. Despite the fact that these market means have been criticized for their tortuousness, blindness, and anarchy for decades, they are irreplaceable in the real economy. Now, let us get to the point and talk about the innovation of the capital formation mechanism in state investment, state intervention, nationalization, and privatization by the Soviet Union, China, and Western countries. The focus will be the tortuous course of China’s state-owned economy in innovating the capital formation mechanism.

The Priority Development of Heavy Industry Creates a New Formation Mechanism for Government Capital in the Soviet Union The economic systems in Western countries are mainly capitalist economies based on private ownership. After the October Revolution in 1917, Soviet Russia did the exact opposite by striving to build a socialist economy based on state-owned industry and collective agriculture, namely public ownership. Soviet Russia launched a “Red Guard” attack on capital1 for a short period after the October Revolution. The Soviet regime eliminated capitalism in cities and was able to distribute industrial products without compensation under military communism. The government, however, met frustrations when trying to practice the same in rural areas, so it had to resort to grain tax and exchange industrial goods for grains with farmers. Lenin drew lessons from this failure and promoted collective

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farms (i.e. public economy of collective ownership), trading industrial products of the state-owned economy for the agricultural products of collective farms.

It ought to be noted here that the socialist revolution conceived by Marx is

like the one which happened in the developed capitalist countries such as the

U.K. dating back to the 19th century. The Soviet Union, however, lagged behind

in industrial development and its capitalism did not get fully established at that time. It will not benefit the socialist construction in the Soviet Union, if the

country implements solely state ownership and discourages the development

of capitalism. Lenin realized this fact and attempted to make a concession to the

unpaid exploitation of capitalism by advocating capitalist redemption and state capitalism which could make use of foreign funds.

Lenin expressed his vision in his book — State and Revolution — that “as

soon as the proletariat has won political power,” “the whole of society will have become a single office and a single factory, with equality of labor and pay.”2 The

Soviet government realized Lenin’s dream in the state-owned economy. The state financed a great variety of state-owned enterprises in every sector of the society

and implemented a highly concentrated planned economy which was called by Stalin as a “planned economy.” Hence, a single government capital formation mechanism was created, which ushered in a new era of state-owned economy.

The economic construction of the Soviet Union experienced a phase of “priority

development of heavy industry.” Naturally, the law of economic development is to develop light and consumer goods industries first and then with the funds

accumulated during the process to promote heavy industry. Stalin, nonetheless, did the opposite and came up with a slogan of “priority development of heavy

industry.” He said that “the reconstruction of industry involves the transfer of funds from the sphere of producing the means of consumption to the sphere

of producing the means of production. Without this there can be no serious reconstruction of industry, especially in our Soviet conditions.”3 So starting from the Soviet Union, many countries including eastern European countries and

China pursued a priority development of heavy industry by depressing domestic consumption and “tightening the belts for construction.” Of course, for the Soviet

Union, which suffered the hostility from and suppression by the imperialist powers, the merits for giving priority to developing heavy industry were to

establish a complete range of economic system, enhance national strength, and gain victory in World War II so as to counter the fascist aggression of Germany,

Italy, and Japan, although the citizenry’s consumption was reduced. The Soviet Union was a backward agricultural country before the revolution, but Tsarist

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Russia, after all, was greatly influenced by industrial civilizations. Therefore, it

was reasonable that Lenin appreciated Fordism and Taylorism, and Stalin stressed the “Charter of the Magnitogorsk Iron and steel Combine” (i.e., an industrial

system represented by the management mode of Magnitogorsk iron and steel

enterprise), economic accounting, the system of one-man leadership, and the

reliance on specialists in running factories. The state-funded industrialization of the Soviet Union offered an inspiration for practicing state intervention during

the Great Depression by Western countries in the 1930s. Later, in the Brezhnev

era, mathematical economics, which emphasized the optimized allocation of production factors, became popular, and a system of scientific and reasonable planned economy was gradually formulated, which enabled scientific planning to reach its full potential.

According to the statistics, Russia was a backward capitalist country before

World War I. In 1913, the gross national product (GNP) of Russia was equivalent to

only 6.8% of that of the U.S. Its national income per capital was one-sixth of that of the U.K. and less than one-fourth of that of France, and meanwhile its per capital output of major industrial products was only on a par with the least developed

country (Spain) in Europe. Between 1928 and 1937, the priority development of heavy industry by Stalin enabled the Soviet Union to complete the industrialization

within a decade, which took the capitalist countries in Western Europe a century, and turned the state into the No.1 industrial country in Europe. After suffering

through World War II, the Soviet Union continued to develop and finally rose to be

a superpower. In 1985, when Gorbachev came to power, Russia’s GNP equaled 80% of that of the U.S., which was unprecedented in history (Fang Ning, 2007).

A planned economy, however, can hardly satisfy the changing demands of

society. The problem was that the subjective judgment of planners was unable to

reflect the objective reality of economic operation, and however clever a director

of the Economic Commission may be, he cannot predict the supply and demand of thousands of products. The direct results of investment were more often than

not that long-term investments could not receive immediate returns, short-term ones were unlikely to make substantial profits, and the high cost of regulation led to little success. The country came to realize the infeasibility of this practice in the 1960s. The Russian economist, Victor Glushkov, once said in 1964 that if all the

Russians devoted to the plan-making work, it would not be until 1980 that they could complete the compiling of the plan for 1964.

Stalin not only prematurely proclaimed the realization of socialism in the

Soviet Union, but also conceived a complete mode of product economy by

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regarding the abolition of the commodity economy as a token of achieving socialism in the book Economic Problems of Socialism in the USSR published in 1952. He said that “when instead of the two basic production sectors, the state sector

and the collective-farm sector, there will be only one all-embracing production sector, with the right to dispose of all the consumer goods produced in the country, commodity circulation, with its ‘money economy,’ will disappear, as being an unnecessary element in the national economy.”4 Stalin also held the view that this

kind of product economy had been established in the state sector, and the products

manufactured within the sector only needed to be allocated by the state instead of being exchanged for money.

During the first half of the 1950s, the poisonous theory of getting rid of the

commodity economy by Stalin spread widely. The Soviet Union, Eastern Europe,

and China were all looking forward to the setting up of a single national economic body (comprised of representatives from state industry and the collective farms) as

“a single and united sector, with the right at first to keep account of all consumer

product in the country, and eventually also to distribute it, by way, say, of productsexchange.”5 It could be said to be a misunderstanding in the development of the

government capital formation mechanism. The theory, nonetheless, attracted a generation of people with leftist thinking to change the ownership structure at an earlier date and realize a product economy by abolishing commodity economy.

In China, Mao Zedong first doubted about the notion of the means of

production being not products. He wrote in the Critique of Stalin’s Economic

Problems of Socialism in the USSR in 1958 that “Stalin has not comprehensively set

forth the conditions for the existence of commodities. The existence of two kinds of ownership is the main premise for commodity production. But ultimately commodity production is also related to the productive forces. For this reason, even under completely socialized public ownership, commodity exchange will

still have to be operative in some areas.” He especially mentioned that “to say the means of production are not commodities deserves study.”6

Although Stalin admitted retaining commodity production, he called it “a

special kind of commodity production” on various occasions. Stalin said that

“our commodity production is not of the ordinary type, but is a special kind of commodity production, commodity production without capitalists, which is concerned mainly with the goods of associated socialist producers (the state, the

collective farms, the cooperatives), the sphere of action of which is confined to items of personal consumption, which obviously cannot possibly develop into capitalist production, and which, together with its ‘money economy,’ is designed to

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serve the development and consolidation of socialist production.”7 When reading

this passage, Mao Zedong commented that “the ‘sphere of action’ is not limited to items of individual consumption. Some means of production have to be classed as

commodities. If agricultural output consists of commodities but industrial output does not, then how is exchange going to be carried out?” He specially pointed out

that “in China not only consumer goods but agricultural means of production have to be supplied. Stalin never sold means of production to the peasants. Khrushchev changed that.”8

In China, if this “special kind of commodity production” arranged by the

planning agency was a beautiful vision in 1958, the three-year Great Leap Forward

between 1958 and 1960 put all the means of production and consumption in short supply. As a result, the scarcest commodity would be supplied in a planned way (via

purchase certificate). By the 1970s, the consumer goods purchased with certificates included: coarse food grain, flour, rice, cooking oil, sesame oil, cloth, wool, cotton,

meat, eggs, sugar, soybeans, as well as the peanuts and melon seeds during the Chinese lunar New Year. Many industrial products were also supplied in this way, such as cigarettes, matches, watches, bicycles, sewing machines, and, later, TVs and

refrigerators. Some items had to be obtained via a marriage certificate, such as beds, tables, chairs, wardrobes, hot water bottles and 555-brand alarm clocks. Purchase certificates became an expedient under the domestic tight supply. In those days,

there was a popular joke: In 1962, Chen Yun proposed in the Meeting in the West

Building at Zhongnanhai to increase the supply of nourishment to parts of middleand high-ranking cadres, and later the meeting decided to provide an additional 1

kilogram of sugar and soybeans to cadres above level 17, and 1 kilogram of pork and eggs to cadres above level 13. The masses satirized those cadres as “sugar-soybean

cadres” and “pork-egg cadres.” Of course, this talk is beyond the scope of the capital formation mechanism, but it illustrates how the “priority development of heavy industry” and “belt-tightening on construction” have crowded out the production of consumer goods, and caused a man-made overall shortage of consumer goods

and a period of low consumption level of the citizens. It was also the case in the

Soviet Union, China, and Eastern European countries. The followers of Stalin, however, did not notice the causal relationship between priority development of heavy industry and the shortage of consumption goods. On the contrary, they drew

a wrong conclusion and believed that the growth of production lagging behind the growth of consumption reflected a kind of superiority of socialism.

After all, the planned economy in the Soviet Union was different from that in

China. During the Stalin era, namely, the socialist primitive accumulation period,

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the Soviet Union completed the industrialization and urbanization at the expense

of farmers by “exploiting” them in a way more severe than capitalism. When Brezhnev came into power, the proportion of state-owned farms surpassed that

of collective farms, agricultural population became a minority, and industrial

accumulation no longer depended on the “exploitation” of farmers. Moreover,

the industry of Russia was advanced enough to repay agriculture. In 1966, the government put into practice a guaranteed wage system towards all collective

farms in the country, thereafter the welfare of the members of the collective farms was roughly the same as that of city workers in the state-owned enterprises.

A few years ago, Qin Hun touched upon the systematic defects in the Soviet

Union’s planned economy when talking about China’s reform. He thought that

although the “rational” planned economy of the Soviet Union could find an optimal solution to input-output function under operational research and linear

programming, it was unable to adapt to the ever-changing consumer preference

of each person; although the planned system could reach a static planned balance and eliminate the inevitable surplus and deficits which alternately occurred during the trial-and-error process of the market under an extreme condition, it would

not create innovation incentives as the dynamically balanced market competition would; although the planned economy could make a large amount of products in an efficient way according to index in kind, it was far less good than the market

economy when judged by utility gain efficiency. The fundamental problem was, just as Bukharin wrote in The Economics of the Transitional Period, that the planned

economy must eliminate the so-called “freedom of labor” because the freedom of labor was incompatible with the properly organized planned economy and the planned allocation of the labor force. It was far more than the freedom of labor,

and consumer sovereignty was also no longer in existence without considering personal preference. Individuals became “screws” on an integral machine, and

labor, consumption, life, and even thought, displayed logically a tendency of being planned, which was a more serious consequence than the “soft budget constraints”

described by Kornai. Because of this, the rational planned economy with the so-

called “plan optimization” showed an apparently diminishing marginal benefit

after the 1980s, and the Soviet-style planned economy came to an end and desperately needed a thorough reform and a new route (Qin Hui, 2008).

It is obvious that a planned economy is not as good as a market economy, not

to mention the facts that the boom in technology, production, and consumption in

Western market economy countries formed a contrast to the situations in the Soviet Union. Owing to the above-mentioned factors together with the internal political

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struggles within the Russian government, unsurprisingly, the Communist Bloc

including the Soviet Union and the countries of the Warsaw Pact was doomed to failure.

State Intervention, Nationalization, and Privatization in Western Countries In this part, we will talk about state intervention, nationalization, and privatization in the Western World where capital culture was created as capitalism was experiencing the Great Depression and deflation. We should start from the Great Depression in the U.S. in the 1930s and President Roosevelt’s New Deal in 1933.

In 1929, the U.S. laissez-faire style of capitalism reached the height of its

development. In that year, the U.S. GNP for the first time exceeded the target of

USD100 billion with the per capita GNP of USD746.7, and its Engel coefficient

reached 45%, so a lot of people bragged that capitalism had entered a phase

of “permanent prosperity.” Two U.S. presidents — Coolidge and Hoover — boasted that the United States had conquered poverty and “reached a higher

degree of comfort and security than ever existed before in the history of the world.”9 However, the stock market crash of October 29, 1929 (also known as Black Tuesday) exposed at once the capitalist viruses, such as overproduction of

capital, deteriorating enterprises, a rising unemployment rate, a fall in import and export trade, financial decline, and shrinking investment. Meanwhile, the Hoover

administration believed that the market economy could ease the problems, so the

government took a laissez-faire policy which only exacerbated the crisis. During

the four years of Hoover’s presidency, American GNP fell from USD104.4 billion in 1929 to USD55.6 billion in 1933, and national income fell from USD87.8 billion in 1929 to USD 40.2 billion in 1933. On the eve of Roosevelt’s inauguration in March 1933, there was a wave of bank runs, and banks in 21 states of the U.S. announced closure or were going to close down, which made the Coolidge-Hoover prosperity

a dead end. Samuelson satirized this economic bust in his book Economics as revenge by God on those excessively conceited people.

During the U.S. Great Depression in the 1930s, over-investment and under-

consumption led to excess production capacity and, in turn, over-production brought about declining investment and eventually a financial crisis. How terrible

is it if investors stop investing, banks no longer make loans, factories go bankrupt, and workers become jobless in a highly developed capitalist society! At that time, the Keynesian theory of government intervention was raised, and President

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Roosevelt realized the idea with his policies.

In March 1933 when Roosevelt came into power, he asked banks to suspend

business for a week, followed by the purchase of about 6,000 banks by the federal government to turn them into government-controlled banks. Therefore, to

nationalize through government injecting money into enterprises is not a recent

invention for the U.S. and the American government is not suddenly taking a “socialist road” today. Between 1933 and 1937, President Roosevelt ordered the government to invest USD12 billion in large-scale irrigation works, afforestation, road construction, and other public works at the expense of the financial deficit

and national debt, as work-relief programs. The Tennessee Valley Authority (TVA) project was among these programs. It should be said that the Soviet Union’s ten-

year practice of state-funded industrialization which improved economic life,

offered inspiration to the United States. Besides, with the fact of shrinking private

investment, to replace private investment with government investment filled in the missing link of capital formation, which stimulated the investment demand of the government. On the other side, government relief and work relief created job opportunities and boosted purchasing power, which directly aroused consumption demand.

Of course, the effects of the state-centralized investment and work relief in

Roosevelt’s New Deal were less significant than expected. Someone reviewed

afterwards and concluded that these programs had really driven demand and that what revitalized the U.S. economy was the Second World War. More importantly,

the Roosevelt administration implemented a series of policies aimed at promoting

equality. On the one side, the president introduced many policies to improve people’s livelihoods and guarantee the basic lives of ordinary people, such as to

build government-subsidized housing, to protect the right of freedom of association, to implement price controls over key commodities during inflation, to place the

wages of workers from key industries under the control of the government by taking advantage of the wartime system, and to provide medical insurance, unemployment insurance, and social security. On the other side, the government raised taxes on

the wealthy. The first step was to increase the federal tax levied on company profits (according to later statistics, the average tax rate rose from less than 14% in 1929 to

over 45% in 1955). The second was to raise the income tax. The maximum rate of income tax was only 24% in the 1920s, but the rate rose to 63% during Roosevelt’s

first term and 79% during his second term. The third was to improve the estate duty. The highest estate tax rate, which started from 20% in 1929 and continuously grew to 45%, 60%, and 70%, ultimately achieved 77%. These measures reduced the

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concentration of wealth. The richest 0.1% of the U.S. population owned more than

20% of the national wealth in 1929, but this number was only 10% in the 1950s. Another result of these measures was that the median household income roughly

doubled after 1929. For example, only one third of American families installed a

home phone in 1936, while in 1955, 70% of families had a home phone and most families owned a car. In one word, Roosevelt’s New Deal had turned the country

with an extreme disparity between the rich and the poor in the 1920s to a middleclass society after the Second World War (Krugman, 2008).

After the Second World War, Western countries moved one step forward

in state intervention to carry out nationalization. Under the influences of the

Soviet Union and the victory of the anti-fascist war, people in the West were

longing for socialism and there was a tendency to regard nationalization as a

symbol of socialism. The governments of Western countries, in order to cater to their people, carried out large-scale nationalization by making national budgets fund huge investments, replacing private monopoly with state monopoly, and

substituting private investment for the highly centralized state investment to create more space for the development of productive forces. The nationalized

industries included the infrastructure sector (such as air transport, road transport, rail transport, gas, and electricity), raw materials sector (mining and metallurgy), financial sector (banks), key manufacturing sector (automobile industry), and

emerging sector (atomic energy and aerospace). In 1965, the capitalist countries convened a World Capitalism Conference in Philadelphia and published The Capitalist Manifesto. It proposed to “learn from the experience of socialism where

people are the masters, to realize a joint-stock people’s capitalism; learn from the socialist welfare system, to implement a cradle-to-grave welfare capitalism; learn

from the socialist planned economy, to carry out a planned capitalism with state intervention (Bian Hongdeng, 1997).” In many Western countries which were

ruled by the Social Democratic Party, such as Sweden, the governments practiced cradle-to-grave socialism welfarism through the income redistribution function

of taxes, which greatly eased the class contradictions and reformed capitalism. It is ironic that capitalist countries dared to learn from socialism without fear of being communized, while some leftist Chinese frequently stir up the dispute of

whether the country should be part of the capitalist or socialist camp, lest it be contaminated by capitalist bacteria.

Things always reverse themselves after reaching an extreme, and the 20-year

development of state intervention and nationalization brought about stagflation.

Monetarists and supply-side economists criticized state intervention as a road to

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Serfdom. In the 1970s and 1980s, neoliberalism became popular and privatization

appeared successively in Western countries. In the 1980s, the “Reagan-Thatcher

prosperity” emerged, as the information technology revolution and industrial structure upgrading developed in the Western advanced market economy countries.

The United Kingdom during the administration of Margaret Thatcher privatized two-thirds of the state-owned enterprises. In 1986, when French President Jacques

Chirac held the reins of government, he was determined to put into practice

the privatization of the enterprises which had been nationalized in 1982 within two years. Compared to the previous nationalization, this privatization was another return from government capital to private capital in the capital formation

mechanism. From then on, state intervention and privatization were used alternately

by Western countries, which allowed the governments room to maneuver. By 2007 when the U.S. subprime mortgage crisis gave rise to the collapse of Wall Street, the Bush administration had to intervene heavily to rescue Fannie Mae, Freddie Mac,

AIG, and Citigroup, and parts of these companies were again nationalized. The U.S.

government’s practice of using state intervention to save the economy made many fear that the U.S. was supporting socialist practices. The New York Times reporter, Thomas Friedman, author of the bestseller The World is Flat, said in a scoffing manner that “the U.S. and China are becoming two countries, one system.”

Initial Government Capital Formation Mechanism: Allocation of Investment by Sector and by Region After New China was established in 1949, the government proposed the “coexistence

of multiple economic sectors.” Since 1953, however, China implemented the first five-year plan by promoting a large-scale industrial construction centered on 156

major construction projects, and comprehensively learned from the Soviet Union

to pursue a planned economy and expand the economy under public ownership,

namely the state-owned economy. Old China was economically poor and culturally blank with a semi-colonial and semi-feudal economy, and had not established its own independent industrial system and national economic system. In 1954, Mao

Zedong said: “What can we make at present? We can make tables and chairs, teacups and teapots, we can grow grain and grind it into flour, and we can make

paper. But we can’t make a single car, plane, tank or tractor.”10 In fact, according to

the statistics, the industrial sector accounted for less than 10% of China’s national economy in 1949, and the industrial products were not very large in number, including only 158,000 tons of steel, 1.89 billion meters of cloth, 2,000 sets of sewing

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machines, 4,000 sets of radio receivers, and 14,000 sets of bicycles.

The most significant feature of a planned economy is the centralization of

national wealth to develop the economy. After the founding of New China, it took

the country three years to restore its national economy and in 1953 the government started to launch large-scale economic construction. From 1953 to 1978, despite

the mistakes of the three-year Great Leap Forward between 1958 and 1961 and the

decade-long calamity of the Cultural Revolution, the government’s investment in fixed assets of state-owned enterprises amounted to RMB760 billion, which

increased national income from RMB70.9 billion in 1953 to RMB301 billion in 1978 and fiscal revenue from RMB22.29 billion in 1953 to RMB112.1 billion in 1978. By

1978, the proportion of industry reached 72.2%. According to the statistics released by the Leading Group for Financial and Economic Affairs of China, between 1949 and 1978, China’s GDP increased from RMB46.6 billion to RMB362.41 billion, a

growth of 7.78 times; industrial output value grew from RMB14 billion to RMB423

billion, a growth of 30.21 times; agricultural output value grew from RMB32.6 billion to RMB139.7 billion, a growth of 4.29 times; grain output grew from 113 million tons to 305 billion tons, a growth of 2.69 times; cotton output grew from

444,000 tons to 2.17 million tons, a growth of 4.88 times; steel output grew from 160,000 tons to 31.78 million tons, a growth of 198.63 times; coal output grew from 32 million tons to 618 million tons, a growth of 19.31 times; and generating capacity grew from 4.3 billion kilowatt-hour to 256.6 billion kilowatt-hour, a

growth of 59.67 times. Within 29 years, China’s GDP had grown by 8.43% annually on average, and the annual growth rate would be 7.78% if the data during the

three-year (1949–1952) recovery of the national economy were deducted. In the first 30 years of reform and opening up, despite making some mistakes, China was

able to produce automobiles in 1956, develop Daqing Oil Field and manufacture supersonic jets in the 1960s, and detonate the first atomic bomb in 1964. During

the period from the founding of New China in 1949 to the beginning of reform and opening up at the end of 1978, there were still industrial structure problems,

such as serious imbalances between light and heavy industries and a general short supply of consumer goods, but China took less time to make these achievements

than Western countries, and it had established an independent and comparatively complete industrial system and national economic system, which paved the way for the further development of China.

In the first 30 years of New China, the country chose a planned economic

system. The state was the main body of national investment and production, and

enterprises were not independent producers. The investment and production of

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enterprises proceeded by following the government plan, and actually everything

was determined by the government from human resources and property to production and supply. Plants and equipment were invested in by the state,

raw materials and spare parts were allocated by the state, and products were also transferred by the state to the materials sector and the business sector for

centralized procurement and marketing. Income and expenses were managed separately: All income of enterprises, including profits and depreciation, was

turned over to the public finance; and all expenses, including capital construction and renovation costs, should be reported to the department of finance for

financial allocation. The adjustment of manning quota of an enterprise should be approved by the competent national authorities and labor force was deployed

by the state labor and personnel department. The government would guarantee

job assignments of university graduates and their wages were issued based on national standard. The assigned job was euphemistically called an “iron rice

bowl,” but if you were not subject to the government’s arrangement, you would lose everything to become a true “proletarian.”

The State Planning Commission was in charge of national investment

allocation then. But, how to constitute the capital formation mechanism of a state-owned economy considering the vast territory of the country, a great many ministries and local governments, and the requirement of “proportional

development in a planned way” by the planned economy? After several years of

trial and error, the government implemented a policy of “allocation of investment by sector and by region.” In preparation of next year’s investment plan of each sector, the investment of the previous year would be regarded as a base and

an equal proportion of growth would be added annually, which was called a “base-plus-growth” method. The purpose of such an investment allocation was to balance the investment and production capability of each sector in different

regions. Therefore, this investment system was an effective capital formation mechanism in developing the state-owned economy and was part of capital culture in the age of the planned economy, despite having been denounced for many years after the reform and opening up.

There was an argument at that time that the proportional and planned

development of socialist national economy replaced the anarchy of production and competition of capitalism. People believed that the base-plus-growth method

naturally complied with the planning method of a proportional development. In fact, this was a misunderstanding. Because the planned and proportional development calculated via the base-plus-growth method was against the objective

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economic law. Moreover, reproduction of an industry in fact will never develop in

a proportional manner with that of another industry. It should be regarded as a law

of investment activities. For example, there is no possibility that the investment in the production plant of power plant equipment grows proportionately with the

money devoted to its user (the power station). Supposing the production capacity

of a power equipment company is four installed generating sets with an installed capacity of 100,000 kilowatts per year and the first-year production has already

satisfied the electricity demand of the whole society, if the service life (replacement

period) of power plant equipment is 10 years, the simple reproduction of this power equipment company will annually create a social investment demand for

accommodating 400,000-kilowatt equipment. That is to say, within the 10 years

when the first 400,000-kilowatt power station is still in service, the entire society has to make additional investments to expand the power station into one with

an installed capacity of 4 million kilowatts, otherwise the simple reproduction of the power equipment company will be impossible, let alone the proportionate

expanded reproduction. The large-scale construction of the engineering industry during the Great Leap Forward in 1958 and the 10-year Cultural Revolution had resulted in a great deal of idle machinery. The problem was that the excess

production capacity caused by widespread reckless investment during the Great

Leap Forward and Cultural Revolution had covered up the overcapacity in the engineering industry, and as a result, the planning department and the industry

did not spot the problem to reflect on the inherent defects of the “allocation of investment by sector and by region.”

The objective of New China was to build a socialist country. Although the

government advocated the redemption of capitalism and allowed a small space for capitalist development in the initial new democratic stage, China had entered

a period of centralized planned economy in the pursuit of socialism with public ownership, after the country switched to the large-scale economic construction in

1953, especially after Stalin put forward the theory of product economy, “threeanti and five-anti” campaign was carried out to oppose the capitalist class, and Mao Zedong suggested the “General Line” for the transitional period of “one industrialization, three transformations.”

The planned economy in China, the same as that in the Soviet Union and

Eastern European countries, originated from the rigid socialist theory of opposing capital and business credit, and concentrating all the credit in banks. It talked about product economy and denied either commodity or commodity economy. China’s planned economy was more centralized in that it included depreciation

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funds of fixed assets in income to be turned over to the Ministry of Finance and treated the renewal cost of fixed assets as capital construction funds which

should be reported to the state for fiscal appropriation. Besides, Mao Zedong

was constantly against revisionism during the first two decades of reform. It was

reflected in the economic policies of opposing “passive equilibrium of national economy,” “direct and exclusive control of enterprises by the ministry concerned,” “trustization,” “system of one-man leadership” and “inflexible administrative approach of controlling, blocking, and suppressing” in order to get rid of the

unreasonable rules and regulations. It stressed that the government should take

class struggle as a guideline to promote a large-scale mass movement, regard

grain and the mass production of steel and iron as the focus of agricultural and industrial sectors, and replace the rational optimized allocation of resources with

the development of five kinds of small industrial enterprises (iron and steel, coal,

chemical fertilizers, cement, and machinery). Meanwhile, the rigidness in theories

was also manifested in the following ideas: The emphases on public ownership and people’s communes, and the priority development in heavy industry; the

opposition against and the avoidance of capital by regarding all capital as “financial

resources,” state appropriated capital to enterprises as “investment” or “funds”

(such as statutory funding), and fixed capital of enterprises as “fixed funds”; and the replacement of assets and liabilities in a balance sheet with debits and credits.

It was special that China set up a Construction Bank under the administration

of the Ministry of Finance. The bank was responsible for state appropriation for and monitoring of the investment in national capital construction and wherever

there was a construction project, there would be a Construction Bank to be built. Its financial supervision ranged from financial plan to fund appropriation, from budget management to final accounts, from prospective design and construction

to the completion of a project, and from development units to construction units.

In this way, the Contraction Bank was built into a department taking charge of all

the investment (i.e. all the capital), to ensure the efficiency of investment under the circumstance of the national avoidance of capital. Since the bank developed

its own system by distributing its branches around the country and implemented

vertical management, it could monitor construction projects regardless of

administrative divisions. For instance, the Anhui Bengbu bank branch which was responsible for financing the water control projects of the Huai River was able to

appropriate money for the projects not only in Anhui, but also Jiangsu and Henan provinces. The Construction Bank served and was close to the grassroots, and

accumulated a series of experiences in the effective use of capital, thus it had a

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great influence in investment. This advantage was a notable difference between

the China Construction Bank and the capital construction banks and long-term investment banks in other socialist countries. That was why when the planning

department intended to continue the absolute control over investment after

the reform and opening up, the Construction Bank offered practical advice on managing investment by economic leverage from the market angle, and later on proposed the development of the capital market, and pioneered participating in

the capital market and undertaking capital operation. We will elaborate the above issues in the following chapters.

The economic construction of New China experienced three large-scale

excessive leaps in the growth of investment (a synonym for capital expansion). The first time was during the Great Leap Forward between 1958 and 1960; the second was around the later years of the Cultural Revolution from 1970 to 1975; and the

third was in 1978 when the slogan of “going all out to make quick advances”

was put forward and the 22 projects of importing excessive foreign technical

equipment created a large amount of foreign debt. These three times of capital

expansion all happened during the period of the highly centralized pursuit of a product economy with the primary cause being the top leadership. Senior leaders were anxious and eager to find a shortcut to the rapid development of socialism.

Consequently, they felt a strong impulse to enlarge investment (capital) and

pursued “high speed and high target” goals which often resulted in “production

putting pressure on capital construction, capital construction diverting the pressure to financial department, and the financial department pushing the central bank to issue money when investment was growing larger and larger in a uncontrollable

way.” It should be noted that in the first two cases, some local governments, state-

owned enterprises, and construction units did not want to rely on the assigned

investment from higher authorities to form their construction capital, due to their enthusiasm to quickly and efficiently build socialism (in fact, the blindness in

capital expansion). The local governments resorted to either the transfer of money from state-owned enterprises or surplus revenue (in practice, deficit spending),

since they could count on no other financial resources. The local finance had to pay the bill if construction projects were unable to pay back the transferred money or

there was no surplus in revenue, but the ultimate result must be that the Central

finance urged banks to issue money to save the local finance. For those state-

owned enterprises and construction units who had accepted fiscal appropriation, their additional demand of money would come from dishonest acquisition and the misuse of funds or misappropriation of bank loans. Their extra financial demand

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may also be satisfied by diverting the fund for heavy maintenance to capital construction, which would in turn increase costs. At last, those enterprises either

were pressed to repay bank debts or paid less taxes and profits, which would still incur losses to the financial departments and banks.

There were diverse opinions towards the relationship between construction

scale and national strength. Prior to the above three periods, the capital construction

in 1956 exceeded RMB2.8 billion of the budget and additional financial credit of

RMB3 billion incurred a deficit which was solved by banks issuing more money. Zhou Enlai concluded that “investment was too aggressive, management was too

loose, capital was too dispersed, and the market was too tight,” and he advocated “opposing a rush advance” in 1957. At the same time, when Chen Yun summed

up the lessons learned in the economic construction of 1956, he pointed out that “the investment scale should adapt to the financial and material resources of a country, and the adaption determines economic stability.” This is the origin of the famous principle of “construction scale should be compatible with national

strength,” which is also known as the “Theory on National Strength.” Mao Zedong, nevertheless, regarded the 1956 economic construction as a justifiable advance

instead of a “rush advance.” During the meetings in Hangzhou and Nanning, Mao criticized Zhou Enlai and Chen Yun for opposing advances and blocking quick and efficient development. There were still many complaints about the adjustments

to the three-year Great Leap Forward made by Zhou Enlai, Chen Yun, and Deng Xiaoping in 1962. Therefore, the mistake of excessive growth of investment was repeated during the 10-year Cultural Revolution.

Li Rui (1992) roughly calculated the losses incurred during the Great Leap

Forward and Cultural Revolution in his book Preliminary Study on Mao Zedong’s

Leftist Thinking in His Later Years: In 1955, China’s GNP accounted for 4.7% of the world total while the figure dropped to 2.5% in 1980; in 1960 China’s GNP equaled

that of Japan but only accounted for one fourth in 1980 and even one fifth in 1985

of Japan’s GNP; in 1960 U.S. GNP was USD460 billion more than China’s while USD3,680 billion more in 1985. Apart from the economic power, China lagged far behind Japan and Western countries in science and technology, and the gap was growing larger and larger. It was a serious and regretful result from the past 20-

year leftist thinking and practice. According to statistics, the losses created during

the Great Leap Forward were about RMB120 billion and around RMB500 billion

during the Cultural Revolution. During the 30 years from the founding of New China to the Third Plenary Session of the 11th Central Committee of the CPC, China’s total investment in capital construction amounted to RMB650 billion and

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fixed-asset investment was around RMB400-500 billion. Hence it can be seen that

the loss of RMB620 billion during the two significant events was almost equivalent to all the capital construction investment in the first 30 years of New China. This

did not include the intangible and incalculable losses, such as the losses caused by inappropriate talent training and the population explosion.

The over-expansion of investment in 1978 mainly resulted from the

arrangement of foreign-funded construction by Hua Guofeng. He allowed government departments and local governments to borrow and repay convertible

foreign exchange by independently signing contracts with foreign partners, which

was not included in the plan of capital construction and was beyond the state

budget. This decision made investment out of control, and at last, the debts were paid back by the state by taking money from the Department of Finance.

The above-mentioned three excessive expansions of investment, originating

from either central authorities or local governments and grassroots enterprises, all forced financial departments and the central bank to issue money to solve the

leftover problems. Despite different manifestations, these over-expansions were

resolved by inflation filling the vacancy in the government capital formation

mechanism. Therefore, after the reform and opening up, senior Chinese government leaders paid attention to the size of investment to prevent over-investment. This indicated that under a highly centralized planned economy, the plan was the law

and the capital formation mechanism of local governments and enterprises had to conform to the plan of the central government, allowing no creativity.

It was impractical to include every investment into the plan of capital

construction by way of “allocating investment by sector and by region,” under the fiscal system of unified state control over income and expenditure. Although

in the 1950s, the Ministry of Finance excluded four-kind expenditures (techorganizational measures costs, expenses for the trial manufacturing of new

products, labor protection costs, and expenses for miscellaneous construction) from the capital construction plan and the competent departments should submit an additional budget for the four items, there remained countless trivial investments

in the economic life of China. By the 1960s, the government had to create three new channels to supplement the capital formation mechanism.

The first channel was to enable enterprises to draw and utilize by themselves

parts of renewal funds, such as depreciation funds earmarked for industrial enterprises and the compensating funds for maintaining simple reproduction of the excavating and logging industry. The second one was the subsidies and

grants for diverse small-scale innovation and renovation projects, such as grants

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to five-type small industrial enterprises and mobilization subsidies for producing

deficient products, to support the existing enterprises to undertake transformation. The two capital channels will be detailed in Chapter 5.

The third financing channel was to allow the Construction Bank to provide

loans for implementing small projects. For example, the Construction Bank started the business of small-project loans, including small technical loans, loans

for regional building materials production, special loans for industrial exports

production, domestic coordinate loans for introducing foreign equipment by shortterm loans in foreign currency, special technical loans for textile products, etc. However, due to the principle of separate control over fiscal funds and bank credit, the Construction Bank cannot lend savings out and had to ask the Ministry of Finance and local governments to appropriate loan funds.

In conclusion, the investment system of “allocating investment by sector and

by region” constituted the initial formation mechanism of state-owned capital, and renewal funds, renovation subsidies and loan funds were its supplements.

Loans for Small Projects: A Special Tool for Revenue Growth and Capital Innovation Why in the first place did the government start loans for small projects? It was

because in the 1960s when equipment replacement created serious debts in the accounts of enterprises, Sun Yefang appealed to leave depreciation funds to

enterprises, but the Ministry of Finance did not amend the policy until much later. In 1964, the Shanghai Branch of China Construction Bank proposed to offer loans to the enterprises which were desperately in need of renewing their equipment.

The loans were funded by the Municipal Finance Bureau and would be paid back

through depreciation funds of enterprises in the future. This measure solved the

urgent needs of local governments and enterprises, and was later promoted to the whole country. In 1972, the visit of the U.S. President Richard Nixon to China pushed the expansion of international economic exchange. In 1973, the Vice

Premier, Li Xiannian approved the suggestion of the Ministry of Foreign Trade to run specialized factories and workshops of industrial exports and production

bases of agricultural and sideline products as an experiment in certain selected enterprises, counties, and rural cooperatives. In some provinces and cities which

had supplied the Hong Kong and Macau markets, production bases of fresh aquatic products and farm and sideline products were built. Production bases

were also established in some pivotal production areas in the provinces and cities

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which had exported bulk agricultural products and produced valuable traditional local specialties. The construction costs of these pilot factories, workshops and

production bases came from the loan funds for foreign trade appropriated by the Ministry of Finance and the special loans for industrial exports were lent out by

the Construction Bank and would be repaid by the future profits. It was actually a

subcategory of the small-project loan which was an invention of the Construction Bank to break through the planned economic system. Loans for small projects

opened a new way for capital expansion and realized the growth in production and revenue through a different channel.

It should be noted that loans for small projects played a unique role in the

state-owned capital formation mechanism of local enterprises. In addition to

the positive functions of capital expansion, production growth and revenue increase for enterprises, the loans for small projects also expanded capital formation and enlarged fiscal revenue of local governments in the mid-1970s in

Shanghai, Changzhou, Xiangfan, and Shashi, thanks to their flexible and vigorous financial works. Thus, there was a boom of learning from Shanghai, Changzhou,

Xiangfan, and Shashi between 1975 and 1976. The flexibility in finance of these local governments was reflected in the fact that when their revenue exceeded the targeted figure, they would demand the central finance or provincial finance to set aside a portion of money. The money was not kept in reserve for future

urgent use but as a fund to support small-project loans which would be offered to some inexpensive and efficient light textile projects with only one-year loan terms. For example, the Shanghai bicycle factory, Changzhou corduroy factory,

Shashi thermos factory and bed sheet factory, Xiangfan cigarette factory, textile

printing plant, and hosiery factory were able to expand the scale of production

and substantially increase financial revenues through loans for small projects. Another smart practice of the local finance was to ask the corporate borrowers or

their affluent partners in the same industry to repay the loan ahead of time and use this loan fund to solve the financial problems of other enterprises, when the

local governments anticipated a huge fiscal surplus. Some cities turned the small loans over two or even three times a year. In this way, if the fund for small-project

loans was RMB10 million, then the fund would triple or quadruple within just

one year and add tens of millions of fixed capital to the municipal government, laying a foundation for long-term revenue growth. In those places, thus, loans for small projects became a special innovated form of government capital formation

mechanism. It also should be mentioned that the reason why the small loans could

turn into a supplementary measure for promoting production and fiscal revenue

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in those areas was also owing to the fact that state investment gave priority to heavy industry at that time and the textile and light industry could hardly get

any loans. The serious shortage of textile products and general consumer goods

in the lives of citizens created a vacancy for small-project loans to fill. The bicycle factory, corduroy factory, thermos factory, etc. funded by the small loans were

everyday necessities of the people, and thus they were able to repay the loans and

increase revenue within a short period by expanding production and satisfying consumption needs. Conversely, some cities in Northeast China did not grasp the

essence and lent the loans to the heavy industry projects listed in the government’s plan, which turned out to be bad debts and burdens on local finance.

There was a much-told story at that time that shortly after Xiangfan Municipal

Party Committee Secretary Cao Ye took office, he asked Zhang Tixue of the

Provincial Party Committee for some financial support. Zhang Tixue replied, “There

is a cigarette factory in Xiangfan, and it is a treasure bowl. You should make good use of it!” As soon as Cao Ye went back to Xiangfan, he did research on the cigarette

factory. Cao Ye applied for the loans for small projects to expand the factory and turned the small cigarette plant with an annual output of tens of thousands of boxes into a major tax-paying company producing 150,000–200,000 boxes of cigarette per year. The factory was so lucrative that it became an important pillar for production

and revenue increase of Xiangfan City, and in turn substantially expanded the city’s loan funds. It was a typical example of innovating the state-owned capital formation mechanism by taking advantage of loans for small projects.

Under the highly centralized planned economy, China implemented a policy

of “large-scale fiscal allocation with small-scale bank loans,” which suppressed

the financial innovation activities of the banking sector. On the contrary, the financial sector, as a major investor and a representative of public ownership,

was deeply concerned about capital returns (taxes and profits handed over to the state by enterprises). Consequently, the financial sector came up with many

brilliant ideas about financial innovation, and the “loans for small projects” and the later “loans circumventing credit ceiling” were the best examples. It indicated

that all financial innovation was closely related to the innovation of the capital formation mechanism. During that time, the China Construction Bank was under

the administration of the financial sector and had the chance to participate in the operation of loans for small projects. So it was reasonable that the bank was very

skilled at maneuvering financial tools and undertaking financial innovation, after

the reform and opening up. It should be said that the bank’s accomplishments

during this period were largely attributed to its participation in financing activities.

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Innovation in Capital Formation Mechanism: A Contract System The Third Plenary Session of the 11th Central Committee of the CPC in 1978 signified a new era of reform and opening up. The committee believed that

a serious defect in the economic management system since the founding of

New China was the over-centralization of power and the central government

should give more decision-making power in operation and management to local governments and enterprises in a bold manner and a managed way. “To decentralize power and transfer profits downwards” was determined as the

keynote of the economic system reform. This proposal was reflected in the relationship between central finance and local finance as the policies of “a division

of revenue and expenditure between the two levels and each level was responsible

for balancing its own budget” implemented in 1980 and “separate categories of taxes, designated scope of revenues and expenditures, and responsibility contracts at different levels” implemented in 1985. The central government also expanded

the autonomy of enterprises by retaining a portion of profits to be placed at the disposal of enterprises, and carried out the two fiscal policies of “transforming

fiscal grants in capital construction into repayable loans” and “replacing profit delivery of enterprises with taxes.” The measures of “reducing taxes to give more profits to enterprises” and “repaying loans before paying taxes” adopted

during the policy of tax for profits added more financial autonomy to enterprises.

Although these measures enhanced the enthusiasm of enterprises to complete the state plan, they brought about many problems, such as unfair work allocation,

uneven burdens on different taxpayers and wages eroding profits, therefore

the state-owned enterprises reform in 1985 concentrated on the separation of

government functions from those of enterprises, and ownership from management. After 1987, the central government started to promote a contracted managerial responsibility system (or contract system), when the new tax system and the policy of replacing tax delivery with taxes increased the burdens of enterprises,

and the incentive function of taxation and enterprise vitality were weakened. The key of the contract system was to contract out works in accordance with the state

plan: To try out an input-output contract system in sectors like the petroleum sector, a contracted management system in large- and medium-sized enterprises, and a leasing contract system in small enterprises. In 1988, the central committee

expanded the system of dividing revenue and expenditure between the central and local governments to an all-round fiscal contract system (including progressive

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incremental revenues, sharing in total revenue, sharing in total revenue and increased revenue, progressive quota of turned-in revenue, fixed quota of subsidy, etc.), which further motivated the local governments. The most notable feature of the contract system was to encourage local governments, government departments, and enterprises to exceed the production target, and apart from the prescribed portion which would be turned over to the central government, surplus profits were left over to contractors, namely, local governments, government departments and enterprises, to make investments. The reform of this period was later known as the “planned commodity economy” and the core of this economy was to admit enterprises as comparatively independent producers. The contract system greatly stimulated the enthusiasm of local governments, government departments, and enterprises. Local governments possessed more stand-by financial resources, government departments gained the money and energy to practice input-output contracts, and enterprises also acquired the financial resources and vitality for selfrenovation, self-accumulation, and self-development. They accumulated more and more reserve funds for arranging extra-budgetary investments. During this period, the proportion of the central financial income to the total fiscal income dropped substantially, and the investments for capital construction by the state finance decreased. Against such a backdrop, various forms of the surplus from contracted works became an important part of the state capital formation mechanism. After the reform and opening up, profit retention and surplus profits were the largest investment resources within and out of the government plan at first. In 1979, urban and rural residents had weak spending power (their total deposit amount was only RMB21 billion), and there were neither consumer goods nor a consumption service industry. Against such a background, if the central government intended to change the 30-year priority development of heavy industry and unbalanced structure between heavy and light industries and accumulation and expenditure, it had to count on the affluent enterprises which increased their financial capabilities by winning more autonomy. Much needed public baths, shops, kindergartens, continuation schools, schools for children of employees, nursing homes, as well as affiliated companies for absorbing children of employees were built up by making use of the retained profits and surplus profits of those enterprises, and thus a whole system of “enterprises burdened with social responsibilities” was established in some large- and medium-sized enterprises. Although this system was repeatedly criticized later on, it contributed the initial capital to the construction of consumption service facilities outside the government structure and constituted the capital formation mechanism for consumption service facilities at that time.

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The policy of the “decentralization of power and the transfer of profits to

enterprises” and the contract system of this period greatly motivated government

departments, local governments, enterprises, and public institutions to pursue income growth and increase their reserve funds. The contract system, nevertheless, had some flaws: First, enterprises focused on short-term interest and would conduct the behaviors of overusing equipment, overissuing wages and bonuses, and

predatorily using corporate resources; second, contracting enterprises were only

responsible for surpluses instead of deficits, and the separation between ownership

and management on the base of state ownership denied the property rights of enterprises as legal persons and only acknowledged the managerial authority of

the state-owned enterprises. These enterprises were not independent producers of commodities with completely autonomous management rights in a market

economy and thus they were not enterprises in a real sense. For local governments,

since the contract system fixed the revenue to be handed over to the central, a fragmented economy with regional closure and segmentation was intensified.

Another significant result of “the decentralization of power and the transfer of

profits to enterprises” and the contract system was an increasingly reduced central fiscal income. The financial deficits in 1979 and 1980 were RMB13.54 billion and

RMB6.89 billion, respectively, and although this number declined in the following years, the ratio of fiscal revenue to GDP and ratio of the central fiscal income to

national income manifested a straight downturn. In 1978, the proportion of the state revenue in GDP was 31.1% but it went down to 12.3% in 1993. The share of central fiscal revenue in total fiscal revenue declined from 40.5% in 1984 to 22% in 1993.11 The financial constraints of the central government forced itself to seek financial support from local governments. The fragile central finance was unfavorable to the

stability of the whole country, and to reform the tax-contracting system became an objective requirement for the development of a socialist market economy, which paved the way for the financial restructuring towards a tax-sharing system in 1994.

To Transform Fiscal Grants into Repayable Loans and Credit-Based Investment: A Return of Bank Functions The capital formation mechanism of the 1980s in China featured the intervention

of credit in investment. Bank credit was common in Western market economies but experienced a bitter and tortuous course in China. We know that traditional socialist economic theories discriminate against

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business credit and the participation of credit funds in investment. For a long time, the Chinese people have clung to the doctrine that said that only the incremental national income, namely, fiscal revenue, could serve for long-term social investment, while credit funds from banks were limited to short-term purposes.

This was the famous “golden rule” held by the Chinese people for over 30 years

after the founding of New China — a “clear division between short-term and longterm funds, and separate management of public finance and banking system.” Meanwhile, people accepted Marx’s view that “business credit is what capitalists

grant each other” and now that there were no capitalists in a socialist system, and

so there was certainly no business credit either. As early as the 1950s, all kinds of horizontal funds transfers between enterprises were prohibited, and sales on

account and payment in advance were completely banned. On the contrary, the

Chinese government advocated collection with acceptance and cash on delivery. The decision-makers of China thought that by centralizing all the credit to banks

and replacing business credit with bank credit, China would save all the tortuous calculation and enter into what Stalin called a “socialist product economy.”

However, the hasty rejection of credit denied not only reasonable sales on account and payment in advance, which were necessary for commodity economy, but also

bills and clearance. It is just because of this denial that in the first 40 years of New China, people avoided talking about capital, and thus the country lacked a culture of capital and credit.

After the reform and opening up, the Chinese people rethought their

traditional understanding of credit. When the government gave more rights to

state-owned enterprises, it advocated horizontal economic links, allowed business credit, and worked to get banks involved in investment by substituting bank loans for fiscal appropriation in capital construction. Why did the government propose

replacing fiscal appropriation with bank loans? This happened due to pressure from the theoretical circle. At the same time, a Hungarian economist criticized socialist state-owned enterprises for being “thirsty for investment,” and the causes were the soft budget constraint and the meticulous care of socialist governments for their enterprises. Theorists put forward the idea of strengthening the budget

constraint towards enterprises and expanding the autonomy of enterprises to turn them into independent business accounting units, responsible for their own profit and loss. The corresponding reform was the “replacement of profit delivery by

tax payment,” namely, to require state-owned enterprises to pay taxes instead of submitting their profits to the administration. Another policy was to repay capital with interest after the capital construction projects, funded by bank loans instead

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of fiscal appropriations, were put into operation. People believed that if one could

not return the loans, one did not dare to borrow money, which would help to scale down the capital construction. The representative of this theory in the academic circle was Ma Hong whose theory was very aggressive.

The second cause for promoting the replacement of appropriation by loans in

capital construction investment was that the National Construction Committee

(NCC) had the enthusiasm to implement such a policy. The economic plan was formulated by the State Development Planning Commission (SDPC) while the NCC was responsible for managing construction sequence and concentrating all the resources to complete projects. Under the system of projects invested in by

state appropriation, the construction projects asked for more money as soon as they wanted some, and regarded state investment as an endless source of money.

The NCC thought that to change state allocation into bank loans might restrain

the projects’ endless demand for money since the repayment responsibility was increased. At that time, Gu Mu served as the Director of the NCC and appreciated

the intensive knowledge of the Construction Bank on capital construction projects by frequently stating that the “China Construction Bank is a good friend of our NCC.” Gu thought of making the Construction Bank fall under the collective administration of the Ministry of Finance and the NCC when the state appropriation

was replaced by bank loans. The NCC believed that to have another subordinate

body familiar with capital construction was an advantage to its construction management. Logically, the NCC was very active in promoting this policy.

The reform of loans for fiscal allocations was discussed several times among

the SDPC, the NCC, and the Ministry of Finance. Later on, senior government

officials approved this reform, and Hu Guofeng, the then Premier, made it clear

that “fiscal appropriation for capital construction investment would be gradually substituted by bank loans and the change would start from this year (1979).” During March and April 1979, The Shanghai Xinguang Dyeing, Weaving, and

Shirt Manufacturing Mill volunteered to join the pilot program when it heard

that profits resulting from starting production ahead of schedule belonged to the enterprises in the experiment of loans for fiscal allocations. One copper band factory discontinued its request for state appropriation for fear of being unable

to repay the money when it knew that fiscal allocations would be replaced by

bank loans. This verified the initial wish of reducing endless state investment by implementing a reform of substituting state allocation for loans.

The reform of loans for fiscal allocations was a breakthrough in the original

planned economy. In April 1979, Deng Xiaoping proposed replacing fiscal

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appropriations with bank loans and he regarded banks as a lever for economic development and technological innovation in a meeting of the provincial and

municipal first party secretaries during the period for the Central Working Conference. He pointed out: “Banks should also get involved in promoting

national economy, but they now just work as accountants without fully playing their due roles. For small investment with immediate returns, bank loans are more proper than state allocation. If the investments required by factories are less than several hundreds of thousands, a bank can lend money to them and the loans

can be repaid within several years. If this scheme is proved to be workable, bank

outlets should be increased to a wider area.” Deng specially talked about the Construction Bank and its leverage effect. He said that the so-call “Construction

Bank” should not only work out accounts, but also have to seek new business opportunities and deal with economic works.

For the planned fiscal system, to change state allocation for capital construction

investment into loans from the Construction Bank would not impose a heavy burden on financial departments. The Ministry of Finance said that this reform

was just a change of fund supply. It did not alter the planned system of “allocation of investment by sector and by region” of the SDPC and the Construction Bank indeed possessed abundant experience from participating in supervising

investment in capital construction and undertaking equipment loans for many

years. As a result, in August 1979, the SDPC, the NCC, the Ministry of Finance and China Construction Bank collectively asked for the approval from the State

Council to carry out pilot programs in the textile industry, tourism industry, and other industries, in Beijing, Shanghai, and Guangdong Province. This pilot project of loans for fiscal allocations was expanded to the whole nation since 1985.

It also needs to be mentioned that before this reform, the deposits in the

Construction Bank could only be used for short-term construction loans, i.e.,

working capital loans, and no fixed-asset loan (investment loan) can be made there. Since the policy of “decentralization of power and transfer of profits to enterprises” was promulgated, China experienced a tight fiscal balance. Therefore, President Li Xiannian presented on several occasions that the Construction Bank should be more

flexible in its business and would lend to one person the idle deposits of the other person. It was the policy of loans for fiscal allocations that restored the banks’ credit function by allowing bank credit to get involved in investment.

There was an interlude during this reform. In 1979, when Li Xiannian hosted

a meeting discussing expanding consumption by suppressing accumulation, the textile industry demanded more investment. At that time, central finance bore a

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deficit of RMB18 billion, so the Minister of Finance, Wu Bo, told the head of the

Central Bank, Li Baohua, that “the textile industry need money but the financial department really does not have any. Can you lend us RMB2 billion to fund the

Construction Bank to make loans to the textile industry?” Li Baohua replied: “We

are also banks and we should also support the textile industry. How about letting

our People’s Bank of China directly set aside RMB2 billion for providing loans?” In this way, Li Xiannian decided to make the central bank grant RMB2 billion in loans to the textile industry every year and the loans were called “middle- and

short-term equipment loans” (later, the loans were issued by the Industrial and Commercial Bank of China [ICBC] on the central bank’s behalf when ICBC was first set up in 1983). Following that, based on the instruction from Li Xiannian,

the Construction Bank also offered small construction loans about RMB2–3 billion per year and the Bank of China annually provided USD300 million of short-run

foreign exchange loans to export enterprises. As a result, the deformed structure of

“large public finance and small banking system” was changed fundamentally and China entered into a new era of “relying on banks to support construction.”

The biggest merits of the reform of loans for fiscal allocations and the

engagement of credit in investment were to restore the role of enterprises as

independent commodity producers in a market economy and urge most enterprises to accelerate capital turnover and enhance economic performance by teaching them that the capital could not be used without compensation and interest was the

opportunity costs of the capital. Another important contribution of the reform was to activate all the functions of banks by breaking the 30-year prohibition of using fixed assets only for state appropriations rather than bank loans.

To be more specific, the economic reform centering on decentralizing power

and transferring profits to enterprises at the beginning of the 1980s incurred an

increasingly declining proportion of fiscal income in GDP and that of the central

fiscal income in total fiscal revenue. The financial embarrassment made the traditional system of a unified state control over income and expenditure based on fiscal allocation, unable to sustain itself. The most practical contribution of the

reform of loans for fiscal allocations and the engagement of credit in investment was

to give priority to indirect finance in the investment and financing policies during

the 10 years of the seventh and eighth five-year plans. By mobilizing citizens to make savings in banks, China successfully completed the social fixed-asset investment of RMB8.1 trillion (quite a large portion was accomplished by bank loans) and thus realized the growth miracle of the nation’s economy during this period.

Of course, the reform of loans for fiscal allocations has its absurdities and

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distortions. First, a newly built enterprise with no capital base would ask for bank

loans and the bank actually approved its borrowing request. The loan was in fact repaid by tax since the enterprise could use pretax profit to pay back the money.

In this way, debt was considered as equity and the relationship between debt and equity was reversed, which caused the excessive debts of enterprises in the 1990s. Although absurd, it constituted the most important capital formation mechanism

of this period. Second, bank loans were issued on the basis of deposits, but the

investment loan quota was determined by the NCC. “Allocation of investment by sector and by region” was changed into “allocation of investment and loans

by sector and by region” and banks made loans to the projects according to the instructions from the NCC. This was a distortion. Overall, in spite of the weakness in the reform of loans for fiscal allocations, its merits overweighed its demerits

considering the return of bank function. From then on, credit-based bank loans became a major component of the capital formation mechanism.

It is worth noting that the changes in the national income distribution after

the reform and opening up played a vital role in the participation of bank loans in investment. In the first 30 years of New China, the rural areas implemented

a collective ownership and the income of farmers was really low. The income

distribution in the urban areas was a performance-linked pay system in name but

a low-income system in reality. In the enterprises and public institutions of cities, college graduates could only earn RMB50–60 per month, similar to the wages of

employees with a lower educational background, showing a strong egalitarian characteristic. The low wages remained the same for a long period after 1962,

which caused the low savings rates of Chinese citizens. The rural and urban

residents’ deposit balance was only RMB21 billion at the end of 1978, only equal to 5.79% of that year’s GDP. In the distribution pattern of national income, residents were not the principal contributors in national saving and thus by no means the

main providers for investment, neither were enterprises, during the early period of New China. Only the government could play both roles at the same time: Savers and investors. This was a unique feature of China’s national income distribution.

After the reform and opening up in 1978, the income distribution pattern

underwent changes. Deng Xiaoping proposed allowing a part of the people to

become wealthy first, excluded the transportation for sale over a long distance from speculation and profiteering, and allowed farmers to find jobs or do business in cities. At the same time, enterprises broke the “big rice bowl” system

of equalitarian treatment by paying higher wages together with bonuses to their competent employees. The growth of employment rates and the decline of

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dependency ratios together with the above factors collectively boosted the rapid

increase of the savings of urban and rural residents. In 1987, the balance of savings

deposits of urban and rural residents reached RMB433.4 billion, taking up 36.23% of that year’s GDP (RMB 1. 2 trillion), increased by 20 times compared to the

number of 1978 of RMB21billion. Savings became an important source for banks to support economic development through loans. Meanwhile, many theorists regarded household saving deposits as a potential trouble and worried that the

residents would snap up consumer goods in the market. According to the statistics of 1995, the newly increased household saving deposits amounted to RMB810

billion and the year-end balance reached RMB2.966 trillion, equivalent to 50.7% of that year’s GDP (RMB5. 848 trillion).

The continuous increase of household savings reflected a substantial

improvement in people’s wealth since the reform and opening up. A series of reforms relating to the decentralization of power and the transfer of profits

to enterprises reworked the distribution pattern of national income and fundamentally changed the transfer mechanism from savings to investment. This indicated that after the reform and opening up, the Chinese government was no

longer the main body of savings and investment, and residents and enterprises

took the government’s places as savings contributors and investment contributors, respectively. The separation between the two kinds of contributors provided a broader room for financial reform and demanded an effective social financing

system to simultaneously give full play to the roles of banks and the capital market and lead the transition of savings towards investment.

The Investment Boom between 1982 and 1992: The First Contest between Market and Planned Commodity Economies Decision on Economic System Reform made during the Third Plenary Session of

the Twelfth Central Committee of the CPC clearly put forward in October 1984 that socialism practiced a planned commodity economy on the basis of public ownership and demanded the development of a socialist commodity economy

beyond mandatory planning. But this document restricted commodity economy only to the product field and especially emphasized that “under socialism, labor force, banks, land, and mines are not commodities.” This was a result of historical limitation.

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But the expansion of capital had no end. Although the government called

China’s economy a “planned commodity economy,” the economy was by no

means a market one. Since the market was full of vitality and energy, it wanted to break through the restriction of being planned. The most notable events were the four investment booms between 1982 and 1992.

1. The first investment boom occurred when enterprises and local government

used their stand-by financial resources to make investments after the policy of decentralizing power to lower-level governments and granting more profits to enterprises in 1982.

2. The second one was the credit boom caused by four banks competing to offer loans on the basis of deposits when the state appropriations were replaced by bank loans in 1984.

3. The rise of financing through securities, investing through trust companies, and establishing financial institutions by local governments between 1987 and 1988.

4. The fourth boom was created by various investments from outside the government structure and the government’s’ enthusiasm in building

development zones after the southern tour talks of Deng Xiaoping between

1992 and 1993. The real investment accounted for 147.8% of the budget, and 8,700 new development zones were built in reality despite only 119 having been approved by the state beforehand.

The four investment booms all happened during the transitional period from

a centralized economy to a market economy. Different from the previous three

investment expansions which were fueled by the investment impulses of higher authorities, these four expansions were carried out under reasonable instructions

from the central government, but the problems of these four investment expansions laid in local governments, government departments, and enterprises. So the

investment boom took place in spite of the fact that the higher authorities clearly demanded control over investment scale. Another difference was that the sources of the four investment booms were mainly extra-budgetary funds and bank loans.

The excessive growth of investment during the reform and opening up was

a result of the ameliorating of production relations and the arousing of greater

enthusiasm of local governments, government departments, and enterprises to build a socialist society during the process of decentralizing power and

transferring profits downwards. Meanwhile, many policies of this time were transitional in nature or incomplete, and thus many systematic defects which

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were conducive to the excessive growth of investment were exposed during the implementation. As the central government motivated enterprises and

local governments to devote themselves to socialist construction, the blindness accompanied with this motivation encouraged the excessive growth of investment in various aspects, which became the impetus to make use of the limited financing

sources scattered in government departments, local governments, enterprises and banks to expand investment. The problem was that government departments, local

governments, and enterprises possessed just a little money and intended to only

invest in local areas or their own business instead of other provinces or by means of a joint venture. They were short-sighted and did not consider their sustainable capability when making investments. Just imagine under the conditions that more than 2,000 counties demanded development and several hundreds of thousands of enterprises asked for reform, how could investment not over-expand? The investment boom during 1982 to 1992 exposed two problems:

The first one was that the planning department did not admit the role

of economic leverage in investment and it had no idea about how to adjust

investment by using economic leverage. The mainstream thinking at that time was that investment in capital construction could only be arranged by the state and was

free from the impacts of economic leverage. As a result, the planning department and competent authorities diverted all their attention to distributing the dozens

of billions of budgetary investment and bank loans instead of guiding the social

investment of hundreds of billions. The planning department neither led the extra-

budgetary funds to the state-guided plan by using a series of encouraging and restrictive policies via the distribution system, nor encouraged local governments and enterprises to raise funds from multiple sources for the construction projects.

The planning department felt completely at a loss what to do with the

suddenly emerged hundreds of billions of extra-budgetary investments. At first,

the department set quotas to restrict the capital expansion for fear of the excessive

growth of investment, and then collected energy and transportation funds and construction tax from the extra-budgetary funds in order to compensate for the shortage of funds in the budget. Later on, the government worried that the extra-

budgetary funds would take up the existing investment scale, so it stipulated “10 leaving out”12 and “5 exclusions”13 with the hope of controlling the investment

scale by ruling out several occasions in measuring the size of investment. In brief, the government neither encouraged nor led the extra-budgetary capital to support the key projects in the state’s plan, but regarded the extra-budgetary funds as

a threatening force to the government’s plan to be restricted and prevented.

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Consequently, the investment distribution system just led the government

departments, local governments, and enterprises to ask for projects and compete for investment, and this stimulated the expansion of investment. This system was not beneficial to the control, leading, and managing of investment by the state.

The second problem was that government departments, local governments,

and enterprises took advantage of the counter-regulatory effect of some improper fiscal and taxation policies to facilitate the repeated constructions, when they saw opportunities in market demand and gained the impetus to expand capital.

The fiscal contract was an example. Local governments were at the same time

taxpayers and tax gatherers, which deformed some economic levers to become catalysts for investment expansion. The Chinese government set a high tax rate

for some products (such as televisions and refrigerators) to suppress investment, however, to contract fiscal targets to local governments encouraged investment

growth since high-tax products now were turned into an important source of fiscal revenue for local finance. During this period, local governments and enterprises

introduced more than 100 color TV production lines, 56 refrigerator production lines, and 200 granite production lines, which were all high-tax products and attracted

excessive investment, resulting in overcapacity, market saturation and sluggish sales. Taking the input-output contract system as another example, this method

motivated different sectors to increase production, and stimulated them to seek

financial resources from or contend for investment with local governments and broaden social funds. On occasion an investment would be made to increase

some unnecessary product processing capability, for the purpose of adapting

to the existing interest pattern of certain areas or enterprises. For instance, to introduce 11,000 tons of ethylene went against the economies of scale, but the

competent department in the central government gave in to the local governments

and introduced 5 similar projects, which turned a microeconomic unreasonable expansion into a macroeconomic one.

The same thing happened in the reform of materials allocation structure. To

grant the allocation power of products from small enterprises to local government

was intended to arouse the enthusiasm of local governments, increase production, and invigorate the material market, and yet it encouraged excessive investment towards small enterprises from the local authorities.

Financial reform initiated from the replacement of state appropriation by

bank loans in capital construction investment and the participation of credit in

investment. This reform took the initiative in supporting economy and enlivening finance, and opened a door for investment expansion via credit. For one thing,

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the reformed financial system enabled local government to use bank loans as a

means of investment expansion, while the slogan “more savings, more loans” put

forward by the central government deteriorated the inborn defect of credit-based

loans. For another, the vision of the central bank to build four major national

banks (the Bank of China, the China Construction Bank, the Industrial and Commercial Bank of China, and the Agricultural Bank of China) into universal banks, endowed the four specialized banks with broader financial strength to

collect social funds to support production construction by way of bank loans through their diverse operations.

The four banks all wanted to win a favor from local Party and government

departments by credit loans, so they competed to issue loans, which caused a credit boom. Moreover, the two-way countermeasures which boasted of

both controlling the balance of new loans and limiting the fixed-asset loan disbursement, were less effective than expected. In fact, neither the planning

department nor the central bank devoted to monitoring the real data of the annual fixed-asset loan disbursement in the four banks, and even bank statistics, showed

no information on loan disbursement size. A more serious problem was that the Chinese central government once agreed to leave the financial funds of certain

provinces and cities to local projects as a favorable policy to the local governments,

which in fact was equal to increasing a credit quota for the local area, but gradually evolved into an unwritten principle of “local funds to be used for local projects.” In

reality, this action encouraged the financial separation between different provincial governments and, to a larger extent, indulged the excessive growth and the blindness of investment.

Any economic reform would inevitably bring about the dispersion of capital

and thus urge government departments, local governments, and enterprises to

raise funds for long-term investment, since the reform was aimed at arousing the

enthusiasm of the above-mentioned parties and increasing their financial capability and vitality. The financing boom induced by the financial reform between 1987

and 1988, the investment fever of trust companies, financial craze caused by local

governments striving to run financial institutions and the emergence of more than

700 financial companies, all contributed to the high growth of investment. Between 1992 and 1993, when Deng Xiaoping visited southern China, he said “development

is the absolute principle,” which motivated all positive factors in construction and development and attracted the growth of various investments from outside the

government structure. In the aforementioned two times of investment booms, the primary investors were state-owned enterprises, and government departments

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and local government played leading functions. This reflected the impact on the

rigid planned economic system and the inability of the old system to adapt to market disciplines during the economic transition when government departments, local governments, enterprises, and banks, made use of the financial products

and instruments borrowed from the mature market economy, in the pursuit of motivations for construction and development.

Those investment booms were almost all accompanied by rises in inflation

which were finally solved by implementing tight financial policies to control the

investment scale and take the economy back on a healthy track. The investment

craze between 1992 and 1993 exposed many defects in the transitional reform policies of department responsibility contracts, local fiscal responsibility contracts,

and state appropriation for bank loans. After the adjustment by financial macrocontrol in 1993, a series of reforms were carried out, which gave birth to the tax-

sharing system, modern enterprise system, foreign exchange settlement system, the separation between commercial banks and policy banks, as well as securities

and insurance markets, and it thus further promoted the innovation of the capital formation mechanism.

The economic reforms of a socialist society also have their merits, that is, the

market-oriented reforms can motivate all the positive factors. These reforms, however, demanded that the planning department, the financial department, the

central bank, and other comprehensive departments accommodate the changes,

harness the reform by using the economic levers, and lead all kinds of financial

resources mobilized by various reform measures in the right investment direction. On the contrary, if the comprehensive departments cannot adapt to the reform

policies, foresee the potential power of all positive factors, make the best of the favorable environment to practice the powerful macro-control system and

measures, skillfully utilize various economic levers to promote the beneficial and abolish the harmful, and lead the enthusiasm towards investment in the right

direction, it would lead to the deviation from the reforms and create the blindness of arbitrary capital expansion.

Prelude to a Market Economy: Financial Macro-Control and Tax Reform At the beginning of 1992, Deng Xiaoping put forward a series of visions to speed up the reform and opening up and develop a socialist market economy, which

was a major breakthrough compared with the planned commodity economy

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12 years earlier. In October of the same year, the 14th National Congress of the

CPC proposed the establishment of a socialist market economic system, which completely solved the long-term ideological misunderstanding towards a market

economy since the reform and opening up. Decision of the Central Committee of the

Chinese Communist Party on Setting Up the Socialist Market Economic System made during the Third Plenary Session of the 14th Central Committee of the CPC in

November 1993, pointed out that to build a socialist market economic system was to make the market play a basic role in resource allocation under the state macro-

regulation. Since then, the relationship between government and the market came

into public notice, which provided a theoretic foundation for the reform towards a market economy in 1993 and 1994. China’s reform towards a socialist market

economy started under very tough conditions. It first met with the overheated economy and inflation in 1993 and dispersed capital resulting from the previous policies of decentralizing power and transferring profits downwards and various

contract systems. At that time, Zhu Rongji was the executive vice-premier of the

State Council. He had to deal with the inflation and dispersed capital first, which was a necessary preparation for the economic transition. And then in 1994, Zhu Rongji carried out a series of radical policies, including the tax-sharing system, modern corporate system reform of state-owned enterprises, foreign exchange

settlement and sale system reform, and the separation between policy banks and commercial banks, on the basis of the strengthening of financial macro-control in

1993, which started the transition towards a socialist market economic system in the financial area.

The first task of the preparation for an economic transition was to control

inflation, or to be more precise, to reinforce financial macro-control, bring down inflation and eliminate economic overheating. It dated back to 1992 when the southern tour speech by Deng Xiaoping aroused people’s enthusiasm to pursue economic construction and development which also was accompanied by the

blind growth of various extra-budgetary funds. The stock craze, real estate craze, and development zone craze emerged in the second half of 1992. In 1993, the total fixed assets investment rose by 61.8% and the investment rate was as high as 43.3%. The rapid growth of total social demand created a tension in the

infrastructure and basic industry, the gap between demand and the supply of electricity, petroleum products, and building materials was growing larger and

larger, and the railway carrying capacity of important trunks could only satisfy

40% demand. The overheated economy caused serious inflation. In 1993 and 1994,

retail price increased by 13.2% and 21.7%, respectively, the fastest and highest

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rising rates since the reform and opening up. Meanwhile, there were also problems of excessive input of currency and financial disorder. In the first half of 1993, M1

and M2 rose by 36.5% and 54.1%, respectively, displacing an unusual growth rate

of money supply. The currency issuance was RMB55billion more than the number of the same period of the previous year, and RMB44 billion more than that of the inflated 1988. The phenomena of indiscriminate collection of funds, unselective

inter-banking lending, and arbitrary increase of interest rates became increasingly severe. The bank deposits growth showed a declining trend, and the four major banks illegally issued short-term loans, most of which flew to the real estate industry and stock markets.

In view of the overheated economy and increasingly high inflation rate, the

central government sent 13 ministers to conduct investigations in 26 provinces and

cities, which resulted in 13 articles that were to be discussed in the State Council. Zhu Rongji was the executive vice-premier responsible for national economic works and he said in a joking way: “13 is not a lucky number, we should add

a few more articles.” This was the No. 6 document (also known as “16 articles document”) released by the CCP Central Committee and the State Council in June 1993 about improving the economic situation, with the primary tasks being

to intensify the financial macro-control, combat inflation, and eliminate economic overheating.

The implementation was not successful at the very beginning. In order to

put the “16 articles document” into practice, Zhu Rongji assumed the position of Governor of the People’s Bank of China in June 1993, to enhance economic

macro-control via financial means with the rectifying of financial order as a

breakthrough. He announced the following measures: 1. To resolutely investigate and punish the illegal activities, such as the indiscriminate collection of funds,

unselective inter-banking lending, and arbitrary increase of interest rates in order to block the illegal channel for capital loss; 2. Under the principle of a

tight loan supply, to secure the necessary funds for state-owned enterprises, key construction projects, and agricultural development; 3. To raise the lending and deposit rates successively in May and July 1993, reopen the business of

inflation proof savings deposits in order to speed up capital withdrawal and stabilize citizens’ expectation. In July 1993, the central bank took back the loan

size adjustment right up to 7% from provincial branches and centralized the allocation and relending rights of credit loans, the formulating and adjusting

rights of the benchmark interest rate, as well as the issuing power of money and gave these rights to the head office of the People’s Bank of China. These measures

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effectively controlled the economic and financial disorder. In 1994, the central

bank suddenly stopped making an overdraft for the government and offering special-purpose loans. It should be said that the reinforcement of economic micro-

control and the rectification of financial order in 1993 laid a good foundation for the comprehensive economic reform in 1994.

The second task of the preparation of an overall economic reform was to deal

with the dispersed capital, namely, under the circumstances of the sharp decline in central fiscal revenue and extremely dispersed capital, the central government

reformed the tax system by implementing a tax-sharing system, regulated the

allocation relationship between the central government and local government, created a fair competitive environment for enterprises, centralized more financial

resources for the central financial department, and strengthened the capability and function of the central government in regulating the economy.

It was said in the above, under a planned economic system of state-

monopolized revenue and expenditure, all income of an enterprise would be

turned over to the state in the forms of tax and profits, and the national financial resources were highly centralized in the hands of the central government. The reform and opening up set the keynote of decentralizing power and transferring

profits to enterprises, expanded the autonomy of enterprises with a gradual

implementation of various management contract responsibility system and tax

farming system, and transferred the financial system from “a separated revenue and expenditure between the central and the local governments” to “an all-round fiscal contract system,” which played a huge role in promoting the enthusiasm

of local government and accelerating the economic development. However,

since the contract system fixed the revenue to be handed over to the central

authority, the proportion of the central fiscal revenue to the total fiscal revenue decreased constantly, from the 40.5% of 1984 to the 22% of 1993. The increasingly

small amount of central fiscal revenue forced the central government to borrow money from local government or overdraw from banks. The contract system also reinforced a fragmented economy with regional closure and segmentation. Meanwhile, uneven burdens on different enterprises also impeded the further

development of independent management of and fair competition between enterprises. Therefore, to completely change the contract system, reform tax and

fiscal systems, and straighten out the relationships among the state, enterprises,

the central financial department and local financial departments, became objective requirements for developing a socialist market economic system.

In 1994, on the basis of strengthening the financial macro-control, the

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state carried out a large-scale tax reform. This reform clarified the confused

relationship between tax and interest in the previous policy of tax for interest, and

distinguished between the responsibility of government as a social administrator and that as state-asset owner by separating profits from tax. The new tax reform formed a modern turnover tax with added-value tax as the main part and

consumption tax and business tax as the supplement. State-owned enterprises took 35% of total profits to pay income tax, and the contract responsibility system and tax-contracting system were abolished. Meanwhile, in consideration of the

tax reform, state-owned enterprises introduced new enterprise financial rules and accounting standards, established the state assets investment income distribution

measures of sharing profits according to contributions and leaving the profit after tax to enterprises, and adopted an international financial statement system.

This reform played a positive role in regulating the profit distribution method, rationalizing the income distribution relationship between the government and

enterprises, guaranteeing a stable growth of national revenue, and creating the level playing field required by the development of a socialist market economy for enterprises.

In 1994, the fiscal management system of a tax-sharing system between the

central and local governments was implemented. The main point of this system

was “three divisions and one return,” namely, to divide central tax from the local tax (divided into Central Tax, Local Tax, and Shared Tax between central and

local governments in terms of tax categories), divide the scopes of administrative

power and expenditure between the central and the local parts, divide the central

administrative organs from the local ones, and establish the tax return system from

the central to the local governments. The tax-sharing system was the largest tax reform since the founding of New China, and a breakthrough of the traditional thinking of “decentralizing power and transferring of profits.” It regulated the

financial relationship among different governments, promoted the annual growth of the two proportions (the proportion of fiscal revenue in GDP and that of the

central fiscal revenue in the national fiscal revenue), and effectively facilitated

the establishment of a socialist market economy by motivating governments of

various levels to participate in financial affairs and boost the growth rate of the central financial income. In the first year of the new tax system, the direct income

of the central government accounted for 55.7% of total government revenue, 27.6 percentage points higher than the number in 1992.

According to Xiang Huaicheng, the Executive Vice-Premier Zhu Rongji

personally led a team of government officials from relevant departments to work

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out accounts face-to-face with 13 provincial governments for more than two

months during the tax-sharing reform, and Xiang Huaicheng followed the team to visit most of the provinces, excluding Guangdong and Hainan provinces. The two-month visits were by no means easy trips, and working overtime or even

overnight frequently happened. Zhu Rongji said jokingly afterwards that “during that period, we travelled all around, and tried our best to convince the local

governments and enterprises. Sometimes, we have to eat humble pie, and at other times, we may employ both hard and soft tactics. The task was finally done, but I lost almost 5 pounds of weight.”

The tax-sharing system focused on the establishment of a decentralized tax-

sharing system to solve the problems of weak financial strength, the disordered

fiscal system, and the seriously inadequate financial regulation ability of the central government, which were formed in the 15 years before the reform and opening up

under a fragmented administrative relationship. The system also correctly handled

the two basic relationships between governments and enterprises, and between the central government and the local government, and laid a foundation for both the transition of financial functions in order to adapt to a market economy and

the deepened overall reform with a proper relationship between the government and market. The most obvious merits of this reform were that under the financial

constraints of the central government, a vast majority of capital could be centralized in the hands of the central government who was no longer at the mercy

of local governments by gaining the right to allocate funds. When talking about the tax-sharing reform of 1994, many people considered this tax reform as a great leap in the financial system.

When dealing with inflation and dispersed capital, the central government

also carried out a reform in financial system by separating policy banks from commercial banks, and using credit policies to adjust the economic structure. In 1994, the state built three policy banks in succession — China Development Bank,

Agricultural Development Bank of China, and the Export and Import Bank of China — and thus changed the money supply mechanism of commercial banks

forcing the central bank to issue money. In the following year, the central bank insisted on an appropriately tight monetary policy and practiced a series of

financial macro-control measures conforming to the market rules to fundamentally

resolve the financial problems. Besides, in view of the situations of a sharp decline of foreign capital, a decreasing trend of foreign trade, and a severe shortage of

foreign exchange reserve in 1994 (the trade deficit in 1994 was USD12.2 billion, while the foreign exchange reserve in 1993 was just USD21 billion, unable to

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sustain the two-year trade deficit) , the central government implemented a system of selling and purchasing of foreign exchange through banks in the foreign exchange receipts and payments of domestic institutions. Under the collective action of this practice and other policies, like export rebates, China’s trade surplus and foreign exchange reserve increased year by year.

The Transformation of Operation Mechanism in State-Owned Enterprises: To Build a Modern Corporate System To build a modern corporate system was the direction for reforming stateowned enterprises indicated by the CPC during the Third Plenary Session of the 14th Central committee of the Party, but since the state-owned enterprises had developed under a planned economic system, this reform was a complete change. The theoretical basis for the state enterprises management under a planned economy was The State and Revolution written by Lenin — Once the proletariat seized power, the state should manage the whole society by deeming it as a plant and a management office. The management method by each government department towards the state-owned enterprises under a planned economy was basically as follows: The State Development Planning Commission (SDPC) approves projects, the financial department appropriates funds, the banks act as cashiers, the industrial sector takes charge of production, the material and commercial sectors control the supply of raw materials and the products sale, and the personnel department manages personnel changes. Moreover, the state-owned enterprises under a planned economy, especially the large state-owned enterprises (such as, large steel mills, automobile plants, logging plants, and mining and oil fields), assumed almost every social function by acting as public security organs and funding schools and hospitals, in addition to production works. The state’s governance towards enterprises was a kind of decentralized management of each department responsible for a certain part. This was a typical bureaucratic style of work. It resulted in not only a separation of power and the checking of interests among different departments, but also weak communication and buckpassing between them. Since property rights cannot be transferred, the suspension of operation or the merger and acquisition of enterprises had to get the state’s approval, which involved the interests of managers and operators and thus could not be easily given. After the reform and opening up, the Chinese government implemented a

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planned commodity economy and successively carried out a series of reform

policies: In 1979, pilot projects of expanding enterprise autonomy were conducted in Shougang Corporation and another seven state-owned enterprises, which

denoted the beginning of the state-owned enterprises reform; in 1979, reforms of

“loans for fiscal allocations” and “replacement of profit delivery by tax payment” were put into practice; in 1981, the government smashed the “two iron rice bowls”

(i.e., industrial enterprises eating from the rice bowl of the state and the workers from the rice bowl of enterprises) by practicing an economic responsibility system; in 1984 the central government narrowed the scope of mandatory planning

while it gave more space for instructive planning and market forces; and after 1987, contracted managerial responsibility system was promoted nationwide.

Between 1981 and 1984, the Chinese government allowed some overproduced products and a certain proportion of other products prescribed by the state to

be sold through the enterprises’ own channels at market prices instead of stateset prices, which was called a “double-track pricing system.” In 1992 some pilot

enterprises of sharing-holding reform were successively listed on the stock market at home and abroad. The reform of decentralizing power and transferring profits

to enterprises enlarged the autonomy of enterprises, but the enterprises were still

acknowledged as relatively independent commodity producers. The rights of

enterprises, however, had not been expanded much during the reform. Although enterprises could directly arrange production, supply and marketing, and dispose

of the overproduced products and budget surplus, they had to repay capital with interests after the reform replaced fiscal allocations with loans, and pay taxes as

a substitute for profits delivered to the state. There was no exception for jointstock enterprises and listed companies. It seemed that the listed companies were subject to market competition, but in fact not only the competitive enterprises but also the uncompetitive ones could not be weeded out through competition. The management mechanism was still based on a bureaucratic administration,

incompatible with the market rules. After all, although the Chinese government all

the time talked about public ownership, the government did not truly understand the concept or know how to be a shareholder.

In 1994, when Zhu Rongji announced the reform of state-owned enterprises,

he faced two major challenges: Excessive debts of enterprises, and heavy social

responsibilities of enterprises resulting from “enterprises performing social functions.” Therefore, the central government had to take several years to first lighten the heavy social burdens and reduce excessive debts. There were mainly four tasks for the state-owned enterprises.

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To help out with the excessive debts of the state-owned enterprises In 1994, the Company Law of China officially came into effect and it required the building of a modern corporate system featuring “clearly established

ownership, well defined power and responsibility, separation of enterprise from administration, and scientific management.” The first problem concerning

the property rights was how to get the state-owned enterprises out of overindebtedness. Actually, this problem was a result of the confusion between debt and equity during the reform of replacing fiscal appropriation with bank loans. The own capital (equity capital) which should be appropriated by the state was

obtained through loans. Consequently, a large number of state-owned enterprises were running under heavy debts in the absence of equity capital. In 1995, many

articles pointed out that the problem in the state-owned enterprise reform was the

ambiguous property right. I said at that time that “to talk about ownership and property rights, we have to first make clear the capital relationship. Who offers the

funds? How much would the contributor offer? Without capital, what is the point

of talking about property rights? If the capital is not replenished, how to clarify property rights?” In fact, higher authorities understood the situation. When Zhu

Rongji initiated the reform of state-owned enterprise in 1994, he decided to pilot the “optimization of the capital structure” in 18 industrial cities (later expanded to 100 cities), and the main target was to ease the heavy debts by transferring

debts into investment capital. It was the premise for building a modern corporate system by clarifying equity ownership. According to the accounts of 1995, to

reduce the debt ratio by 20 percentage points required an injection of RMB850 billion government capital, but the financial embarrassment made it difficult to

replenish the state-owned capital. From 1994 to 1998, despite the fact that the central government took several years to encourage enterprise mergers, regulate

bankruptcy procedures, suspend repayment of bank loans and interests, write off bad debts and give subsidized loans for technological transformation projects,

these measures could not fundamentally get the enterprises out of trouble. On the contrary, the over-indebted enterprises increasingly lacked capital funds. Their

deficits expanded year by year and finally a comprehensive loss occurred in 1996. Until the end of 1997, the central government confirmed the three-year reform and trouble-shooting targets of state-owned enterprises. In August of 1999, the

government determined to implement the “debt-to-equity swap.” After five years of practice, the reversed relationship between debt and equity was eventually set right.

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To separate between major and auxiliary businesses, downsize staffs to improve efficiency, and reduce the social responsibility of enterprises The state-owned enterprises undertook complicated and extensive major and auxiliary businesses, and were burdened with heavy social responsibilities. The irrational corporate structure of “being all-inclusive whether being large or small,” has always been an obstacle for the state-owned enterprises to participate in market competition. The enterprises launched the nationwide movement of “breaking the three-irons” (the iron rice bowl, the iron wages, and the iron chair of the cadre),14 and ushered in the three reforms of the employment system,

the income distribution system, and the cadre and personnel system in order to facilitate the employment and dismissal of staff members, the increase and deduction of pay, and the promotion and demotion of higher management officers, whereas the central authorities gradually discovered that the complicated and extensive major and auxiliary businesses were the root causes for the redundant personnel and low efficiency of state-owned enterprises. Therefore, a major step for the reform of the state-owned enterprises was to separate major and auxiliary businesses, and detach the auxiliary social responsibilities from the major production business in order to lessen the burdens of the state-owned enterprises. After this reform, catering, entertainment, trade and commercial institutions, as well as other service organizations, which had been originally attached to the state-owned enterprises, were separated out, and hospitals, vocational schools, property management offices, and other social service units became independent. According to later incomplete statistics, more than 4,000 enterprise-backed primary and secondary schools, over 400 public security organs, and more than 2,000 hospitals were detached from enterprises. In this way, both enterprises and government were back to their prescribed roles and the property right of auxiliary institutions became clear after this reform. Some sources said that more than 90% of sideline institutions were turned into non-state-owned holding companies, in which staff shares accounted for 57% of total equity. Clear property rights pushed the operational mechanism of enterprises through profound changes, and the employees’ consciousness of market competition and surviving the crisis were greatly enhanced. Some enterprises took advantage of the property rights exchange market during the separation of subsidiary business for major business to bring in competent investors, which added fuel to the further development of the enterprises. After the reform, the structure of state-owned enterprises was adjusted and optimized, so the enterprises could divert more material

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and financial resources and energy to main businesses in order to achieve high

efficiency. Later, in order to highlight core business, the reform of “downsizing for efficiency” was put into practice. During this period, the staff of the state-

owned enterprises decreased from as much as 70 million to 40 million, a drop of 40%. This downsizing significantly improved the labor productivity, promoted the

transformation of employment and income distribution mechanisms, and created

conditions for enterprises to grow larger and stronger and increase their market

competitiveness. The largest problem brought along with the reform of downsizing for efficiency, however, was that when the state-owned enterprises buy off the

employee service years and get their employees laid off, these jobless employees could not receive sufficient compensation and social security. Although later on

the central government carried out the re-employment project as a remedy, a large

number of employees were left at the bottom of society due to the lack of property

placement and necessary social security. Zhu Rongji revealed in a speech in 2002 that the number of laid-off workers between 1998 and 2000 was 25.5 million.

To reorganize and upgrade small- and medium-sized state-owned enterprises In the reform of state-owned enterprises, how to pull tens of thousands of enterprises out of the over-indebtedness was a big problem. It has to be mentioned, the Decision on Some Issues concerning the Improvement of the Socialist

Market Economy announced in the Third Plenary Session of the Fourteenth Central

Committee of the CPC in 1993 pointed out that for the general small state-owned enterprises, some could implement contract operation or leasing management,

while others could be transformed into joint-stock companies or even sold to other organizations or individuals. How could these enterprises dig themselves out of excessive debts and losses under the circumstance that state-owned enterprises

operated on borrowings due to a lack of capital and were constantly burdened with high interest rates? Quanzhou City was overwhelmed by the heavy burdens

and became the first to sell dozens of local enterprises to the China Strategic

Holdings, a Hong Kong company headed by Oei Hong Leong. In fact, it was debt

restructuring and there was no such a problem of the loss of state assets. But to sell state-owned enterprises and state assets was a sensitive topic for the Chinese people. Under the influence of a public ownership for over 40 years, some people criticized this sale by Quanzhou as a squandering action. Later, the overseas listing of the China Strategic Holdings aroused a “China Strategic Crisis” (which will

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be detailed in Chapter 16). It was also in the year of 1993, when Chen Guang, the Municipal Party Secretary of Zhucheng, Shandong Province, reformed 288 local

enterprises above the county level by selling out the net assets to employees and up until July 1994, 272 enterprises had completed the reform. Some people satirized Chen Guang by calling him “Chen Sold-Out.” In July 1995, when the Shandong

provincial government held a provincial meeting on the reform of the countylevel enterprises in Zhucheng City, the Zhucheng reform model was justified. But the criticism towards Chen Guang from certain Beijing leftist magazines made the

relevant departments soon change their mind by saying that “to sell out is not a

panacea for all.” Of course, you could choose not to sell, but you have to be always burdened with a deficit. Here, I have to explain the “ice cream principle.” It is said

that the property of state-owned enterprises is just like ice cream, you have to sell it as quickly as possible lest it will melt. But now another “ice cream principle” comes out: One would rather hold an ice cream and see it melt before one’s eyes

than sell it to others. The reality is that if you sell five Yuan worth of ice cream at a price of three Yuan, some people will criticize you for creating the erosion of state

assets; if you keep the ice cream until it melts and the nation’s asset is indeed lost, no one will criticize you for anything. It indicates that some people do not actually care about the loss of state assets and are willing to be misers holding the melting ice cream instead of selling it. These people cannot get rid of the ideological

constraints. In 1996, Hong Hu, the Deputy-Director of the State Commission for Restructuring the Economic System, conducted an investigation in Zhucheng City and made the conclusion that the reform orientation was correct, the reform

measures were powerful, the effects were remarkable and the public was satisfied. In March of the same year, Zhu Rongji, Vice Premier of the State Council and member of the CPC Central Committee Political Bureau Standing Committee, led

officials from the nine ministries to Zhucheng City for another investigation. Zhu Rongji appraised the corporate reform of Zhucheng in a meeting in Qingdao and asserted that there was no loss of state assets in Zhucheng.

In September 1995, the Fifth Plenary Session of the 14th CPC Central

Committee passed the Suggestions on the Formulation of the Ninth Five-Year Plan for the National Socio-Economy Development and the Long-Term Objectives by 2010 (hereinafter referred to as the Suggestions). The Suggestions put forward a new idea of “invigorating large enterprises while relaxing control over small ones,”

and pointed out that the government should “focus on building the entire state

economy, and implement a strategic reorganization of state-owned enterprises

through the flowing and restructuring of stock assets.” The reorganization should

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orientate towards market and industrial policies, invigorate major enterprises while allowing more flexibility for minor ones, integrate the optimization of stateowned assets distribution structure and corporate organizational structure with

that of the investment structure, and form mechanisms of mergers, bankruptcies, and the downsizing of staff for efficiency in order to prevent the loss of state assets. The government should discriminate between different occasions, and

accelerate the reform and restructuring of small state-owned enterprises, through reorganization, combination, merger, stock cooperative system, lease, contract management, sale, and many other forms.

In the reform of state-owned enterprises, although small- and middle-

sized enterprises were in the majority, their small total assets facilitated the reorganization. After the Suggestions of the CPC Central Committee were

announced, there were constant ideological struggles, and the local government also faced the severe reality of having no money to either replenish capital or

cover the deficit and repay bank loans, thus the practices of “selling the whole enterprise,” “operators and workers holding shares,” and even “transferring enterprises with no asset” were promoted throughout the country. In 2003,

Li Rongrong wrote in an article that “a great variety of means were used to

loosen control over and enliven small state-owned enterprises, and 86.1% of the small enterprises had completed the reform. Through the policy of bankruptcy

and closedown, a large number of loss-making and insolvent enterprises and exhausted mines withdrew from the market, which directly promoted the

strategic reorganization of the state-owned economy and the establishment of the mechanism for survival of the fittest.” There was a report in 2008 which said that

the property rights reform of small- and medium-sized enterprises around the country was basically put into place, and the majority of enterprises in Sichuan, Chongqing, and Shaanxi had completed the reorganization. Taking Sichuan

Province as an example, the number of small- and medium-sized state-owned enterprises dropped from 14,000 to 820, a decrease of 94%, between 1998 and 2005.

To pilot the modern corporate system in large state-owned enterprises In November 1994, the State Council approved the pilot projects of the modern

corporate system in more than a hundred enterprises. It signified that the state-

owned enterprise reform transferred from the temporary solution of decentralizing

power and transferring profits to system innovation in order to shape a basis for

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the development of the socialist market economy. The Suggestions of 1995 came

up with the idea of “focusing on a batch of enterprises and business groups, and by taking capital as a link, uniting and leading a number of the enterprises

to transformation and development, in order to form economies of scale and give full play to the leading role of the enterprises in the national economy.” However, since the relationship between a modern corporate system or a joint-

stock system and diversified investment subjects was unclear during that period of time, the pilot enterprises failed to attract or organize more private capital

through the shareholding system and other organizational forms. As a result, the investment subject was single and 80% of the enterprises were transformed into solely state-owned corporations. The pilot projects “were not very successful”

and “government functions were mixed up with enterprise management” (Zhang

Zhuoyuan, 1999). Until 1996, the central government proposed the “three reforms and one strengthening” in order to reform, reorganize, restructure and strengthen the management of the state-owned enterprises. In 1997, the report of the 15th

Party Congress stated that “We shall cultivate and develop a diversity of investors in order to push the separation of administrative functions from enterprise

management and change the way enterprises operate,” “readjust and improve the ownership structure” and explore multiple forms of public ownership in its

realization.15 Later the reform of enterprise through stock system was gradually

promoted. More than 2,000 state-owned large- and medium-size enterprises successively undertook the pilot projects of the modern corporate system, and a

substantial part of enterprises formed business conglomerates with international competitiveness. In 1999, the state decided to put into practice a strategic

adjustment of state-owned economy. After 2000, when enterprise management

was detached from government functions and the reforms were accelerated, China made larger steps in the reform towards the modern corporate system. It was

not until several rounds of integrations and reorganizations of large state-owned enterprises that 123 large central enterprises were finally formed under the Stateowned Assets Supervision and Administration Commission.

If we analyze deeper, we could find that the solution to the difficulties in the

reform of state-owned enterprises towards the modern corporate system was to shift

the operation mechanism. First, to accommodate business operation to the market. An inherent weakness of Chinese enterprises was being small and scattered, and the enterprises were inexperienced in operating in the capital market since they had been

brought to life under the planned economy free from market competition. Once the planned economy was transformed into a market economy, every enterprise would

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regard itself as an independent cell of the market economy. At first, the state-owned enterprises were short-sighted, and only paid attention to the small market. Their

“market infantilism” would inevitably make the enterprises treat their partners from upstream and downstream businesses as competitors, which would hinder industrial

consolidation and the centralized management of business groups. Every enterprise wants to be the leader and thus both upstream and downstream enterprises focus on

their own development, which will definitely result in scattered forces and a loss of advantages. This situation was common at that time and the most typical one was

the “four petrochemical enterprises of Nanjing” widely reported in 1997. The four enterprises were Yangzi Petrochemical Company, Yizheng Chemical Fibre Company,

Jinling Petrochemical Corporation, and Nanjing Chemical Corporation, which were respectively affiliated to China Petro-Chemical Corporation, Ministry of Chemical

Industry, Ministry of Textile Industry, and Nanjing Municipal Government. Since

the four petrochemical enterprises operated under separate authorities in the old administrative system, they could hardly overcome their narrow vision of the small market and only focused on self-development by finding overseas partners

to expand their business. Just as the media described, these enterprises were about

to “fight an international war in the domestic market.” On the eve of the 15th

National Congress of the CPC, after the intervention by the central government,

the State Council decided to reform these four petrochemical enterprises into large ones with the economies of scale, and consolidate them into leading conglomerates with international competitiveness in major industries to serve as a sample of win-

win partnerships and being industry pacesetters. Although this forming of large enterprise groups was not a result of market forces, a major breakthrough was to

remove the institutional and managerial barriers in enterprise organization. Under such a fragmented and segmentary system, the mergers and acquisitions of large enterprises could not be realized without the intervention by the central government.

Second, to establish an effective incentive mechanism for enterprise managers

and to be able to efficiently select and secure capable managers. The competition in the modern market economy comes down to talent competition. This competition does not exist among general staff but high-level management professionals and “a good general is usually harder to find than an army of one thousand.” The

keys are two words: Appointment and reward. The later reflects the value of the former. China’s enterprises follow the thinking of official rank standard, and when

a company selects its top managers, seniority must be given top priority. Thus, the

young talents cannot be promoted and the outstanding senior managers, especially entrepreneurs, cannot be remunerated generously. For a long time, the Chinese

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people did not consider the opportunity cost in talent deployment and were not good at placing the capable person at a suitable post. The opportunity cost resulting from the poor personnel arrangement is far larger than the loss of state

assets. Of course, there is a problem of “talents being difficult to be controlled.”

Some leaders are accustomed to the submissive and flattery subordinates and therefore cannot tolerate the obstinate and unruly talents.

The key to the talent deployment is to discard the prejudice of equalitarianism,

and establish an incentive mechanism. When Longping High-tech Agriculture Corporation was listed, some people talked about the tens of millions of shares held

by the founder, Yuan Longping in a jealous way; when Stone Group Corporation carried out management buy-outs, people again guessed the market value of the stocks in the hands of its Chairman, Duan Yongji; when Sina, Sohu, Netease

were listed in the U.S. stock market, someone discussed about the wealth of the respective leaders of Wang Zhidong, Zhang Zhaoyang, and Ding Lei. It was obvious that others were envious of the above talents. Although management buy-

outs and a share option plan have certain risks, there will always be one who is brave enough to take the risk if the reward offered is attractive enough. However, only the bravest one can get the huge reward, and without either great efforts or outstanding achievements, one will be unable to receive the generous reward. People who get used to the traditional system of state-owned enterprises, tend to

consider share option as a kind of costless welfare and right, and believe that as long as one is assigned by higher authorities, even if the person is good for nothing, he can enjoy the fruits of others’ work. Consequently, quite a number of state-

owned or state-controlled enterprises under the old system, as well as a group of inappropriately reformed listed state-controlled companies which still followed the

old system, displayed a situation of “rich leader but poor group.” These enterprises can hardly build “generally wealthy teams” as leading private firms can.

Speaking of “rich leader but poor group,” we have to mention the famous

case of the “Tobacco King” of Yunnan, Chu Shijian, who embezzled public funds

after invigorating Yuxi Hongta Tobacco Group. Yuxi Hongta Tobacco Group was

a local state-owned enterprise in Yunnan Province and known as Yuxi Cigarette Factory before being reformed. When Chu Shijian served as the Factory Director in

1979, the factory was just a semi-mechanized workshop only with a fixed asset of RMB10.65 million and an annual output of 275,000 boxes of cigarettes. Chu Shijian had worked as Factory Director for three years and carried out three major reform policies. The first one was to renovate the income distribution system. In 1982, Yuxi

Cigarette Factory promoted a system of “contracted performance-linked salary

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and bonus” by relating the workers’ salary and bonus to the production volume in order to completely abolish equalitarianism in distribution. Second, to change

the system of tobacco planting being administered by the agricultural sector, tobacco purchasing price being set by the Price Bureau, and cigarette sale being monopolized by the Tobacco Bureau.

In 1985, Chu concurrently held the posts of Factory Director of the Yuxi Cigarette

Factory, Manager of the Yuxi Tobacco Branch Company, and General Director of Yuxi

Area Tobacco Monopoly Bureau. He established the famous mode of “three-in-one” by consolidating the above-mentioned three organizations into one and opened a

“high-quality tobacco production base” to directly guide the tobacco cultivation. This action connected every link in the tobacco industry from tobacco cultivation, tobacco

production to sales, and utilized the profits from the cigarette factory to support

tobacco planting, so that farmers could benefit directly. In 1988, a major earthquake struck Yunnan. To immediately improve the economic situation of Yunnan, the

central government gave special approval to the city for the development of the

tobacco industry and clearly stated that others could also try the “three-in-one” mode invented by Chu Shijian. As a result, Chu undertook a large scale of mergers and acquisitions of tobacco factories in Yunnan to expand the production capacity,

and opened exclusive stores to sell the products, which turned Chu Shijian from an entrepreneur into an industrial magnate. Third, to introduce advanced equipment.

The cigarette factory purchased cigarette units from Molins Tobacco Machinery Group of the U.K. in 1981, and later continuously introduced 89 sets of the world’s leading equipment from the U.K., Germany, Italy, Japan, and the Netherlands.

Within just 17 years when Chu Shijian was acting as the Factory Director,

he turned a small local tobacco factory into the first in Asia and third in the

world cigarette group. The factory was also a nationally well-known enterprise

and financial pillar for the local government. By 1994, one of its famous brands,

Hongtashan, had opened 12,000 exclusive shops, and could annually produce 2.18 million boxes of cigarettes and generate profits and tax revenue of as much as RMB20 billion. Yuxi Cigarette Factory was rated as a first-class national enterprise,

and Chu Shijian won the title of “National Outstanding Entrepreneur” and “Top Ten Man of National Reforms,” and the lifelong honor of “Golden Ball,” among many others.

Surprisingly, in February 1995, the Central Commission for Discipline

Inspection of the CPC received an anonymous report about one of Chu Shijian’s

relatives getting involved in a bribery case. In July 1995, Yunnan provincial government appointed a new Chairman of the Yuxi Hongta Tobacco Group and

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Chu Shijian was arrested for a trial in 1997. In January 1998, the Xinhua News

Agency carried a report about the serious economic crimes committed by the

former Chairman of the Yuxi Hongta Tobacco group, and Chu Shijian was accused of embezzling public funds of about USD3.55 million with other leaders of the

group (Chu received USD1.74 billion). It was reported that Chu Shijian confessed

to the procuratorial personnel: “The new chairman will take over the group in July 1995, and I thought I have to transfer the signing authority to the new chairman

then. I have devoted my whole life to the group and have to think about the rest

of my life. I cannot have suffered for nothing, so I decided to embezzle over USD3 million and told other group leaders that it was enough for our latter lives.” Many

people in the Yuxi Hongta Tobacco Group thought that Chu had taken the money he deserved at the time when he should not have.

Chu’s candid confession to the procuratorate aroused a wide discussion

around the country. Chu Shijian made a huge contribution to the Yuxi Cigarette

Factory when he was in power for the last 10 years. The factory created RMB99.1

billion in profits and tax revenue for the state, achieved a brand value of RMB39.8 billion, and solved the employment of half the population of Yunnan Province.

Finally, the central leadership decided that his merit cannot offset his faults, while

his defects cannot obscure his virtues. In 1999, Chu Shijian was sentenced to life in

prison. Two years later, Chu’s sentence was commuted to 17 years’ imprisonment. In 2002, he was approved for medical parole due to severe diabetes.

In 1997 when Chu Shijian was arrested, the State Tobacco Monopoly Bureau

issued a “double control” policy which withdrew the “three-in-one” mode and closed Hongta exclusive shops. According to statistics, since 1999, the output of

flue-cured tobacco in Yunan Province was reduced from 2.3 million to 1.1 million within three consecutive years, and the annual sales volume of Hongtashan dropped sharply from its peak of 900,000 boxes to 300,000 boxes.

Ma Jun, the defense lawyer for Chu Shijian, did the math for Chu Shijian:

During the 17 years when Chu acted as the Factory Director, he created a total of

RMB80 billion profits and tax revenue for the state, but his total personal income was only RMB800, 000. Ma Jun believed that the objective reality which aroused

the feeling of unfairness in Chu, apart from subjective factors, led to Chu’s crime. Ma Jun had a famous saying that “the annual income of such a contributive

leader of a state-owned enterprise can hardly compete with the pay for a single performance of a singer!”

Ma Jun said: “In China’s fights against corruption, the government focused

more on the entrepreneurs who made a fortune by trashing their enterprises,

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namely the so-called ‘rich leader but poor group.’ The state-owned enterprises reform and economic development aimed to eliminate the situation of ‘rich leader but poor group’ and create more and more ‘rich leaders and rich groups.’ Chu Shijian has committed a crime and should face legal consequences, but his crime was after all different from that of a rich leader of a poor group. Chu turned not only his little group but also the large group (the province or even the state) into rich ones. When he intended to also enrich his own family by moving some wealth from his little group, he was caught by others.” Ma Jun further expanded his idea by borrowing the “cat theory” from Deng Xiaoping: “The defendant Chu Shijian resembles the cat which is good at catching mice but steals fish on special occasions. Compared with the cat which also catches mice but frequently steals fish or which does not catch a mouse but usually steals fish, Chu shijian was totally different. Why cannot we give the capable cat some fish before the cat steals fish?” Of course, the embezzlement of more than USD30 billion by Chu Shijian was indeed a case of corruption and negligence and Chu’s merit could not offset his faults. However, from his case we can see that the establishment of an effective incentive mechanism was very important.

Counterfeit Short-Term Lending and Loans Beyond the Credit Ceiling: The Last Contest between Market Economy and Planned Economy in Currency Field After the reform and opening up, along with the financial reform and the involvement of credit in investment, the central bank imposed a credit ceiling with a view to leading and regulating the support of bank credit to economic development, controlling money flow, and establishing a normal financial order. Meanwhile, in some coastal cities and areas where the market economy and non-state economy developed rapidly and vigorously, capital was increasingly in great demand and normal credit funds could not satisfy the financial needs. Consequently, counterfeit short-term lending (namely, to use short-term loans for long-term investment) and loans above the credit ceiling emerged to meet the financial demand for operation, which created for a time investment expansion. In 1993, when the Vice Premier Zhu Rongji rectified the financial order, he focused on cleaning up illegal lending, fake trust, and loans above the credit ceiling in order to get tens of millions of capital back into normal production and circulation channels in the speculation market. The illegal activities of counterfeit

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short-term lending and loans bypassing the credit ceiling continued despite

repeated prohibitions. In 1995, Zhu Rongji decided to impose severe punishment

on several typical violations as a warning to others. I was working for the China

Construction Bank at that time, and after making investigations on the loans above the credit ceiling in Zhejiang Province, I found that the problems of counterfeit

short-term lending and loans bypassing the credit ceiling were very complex there and closely related to the policy of local government to enliven its economy, the

defects in credit control system and the non-market interest rates, not just a matter of operational violation.

According to my findings, the once popular illegal activities of counterfeit

short-term lending, fake trust, and loans above the credit ceiling in coastal cities

appeared as early as the mid-1980s. They were financial pillars for the impressive

growth of the non-state economy in these areas and in reality breakthroughs in the initial credit control system. At that time, since there was no real estate market

and securities market, the loans beyond the credit ceiling did not get involved in speculation, so I called it a “special case” in the capital formation mechanism

and believed this “special case” was a real reflection of the last contest between a market economy and a planned economy in the currency field.

The problem originated from the credit control system. The system was

initially an instructive plan for the financial field and a guidepost for controlling

the year-end bank loan balance. Back in 1983–1984, the financial revenue and

expenditure were tight, and the investment in capital construction was cut down.

The central bank complained about the deformed pattern of “large public finance but small banking system,” and there was a proposal of “linking deposits with

loans, and more deposits, more loans” in financial reform. As a result, banks in different areas started to provide a large number of fixed-asset loans to support

capital construction and technical innovation. As a result, the credit loans ran out of control at the end of 1984. From 1985 on, the state demanded the carrying out

of dual-track control over the scale of fixed-asset investment and credit loans, but the implementation was difficult. The reasons were that the credit ceiling only

limited the year-end loan balance but could not control the “excessive loans in the middle of the year,” and technical renovation loans could be reloaned after

being withdrawn. In fact, these loans were not subject to the fixed-asset loan ceiling. According to the survey of the Bureau of Statistics, many banks possessed

a considerable amount of “other investment loans” which were not calculated in the fixed-asset loan size. Therefore, although the government called for the control

over the investment scale of fixed assets between 1985 and 1988, the investment

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quota was exceeded every year.

Despite a less stringent credit control system in the initial implementation, the

system greatly limited the bank loans in the coastal provinces and cities where the market economy enjoyed a rapid development. At that time, in the Guangdong

and Fujian provinces, and later in Shanghai, due to a lack of construction funds,

the local governments asked for approval from the central government for a policy

of “local funds for local use,” which was a breakthrough in the credit control system and in reality created a favorable regional policy of “more deposits and

more loans.” This practice aroused attention from cities with prosperous market economies (especially Jiangsu and Zhejiang Provinces), but those cities without

the favorable policy could not follow suit. These local governments thus made every endeavor to search for funds in order to develop the economy. “Financing fever,” and then “bonds fever,” and “financial fever” occurred successively. The

local governments first issued municipal bonds to raise funds and then turned to run trust companies and various financial companies for collecting a portion of

funds to support local construction after the central authorities banned the issuing

of local bonds. During the rectification in 1989, more than 300 trust and investment

companies utilized short-term lending capital to support long-term investment, which was a prototype of loans beyond the credit ceiling.

In Jiangsu, Zhejiang, and other places where a market economy and a non-

state economy grew prosperously and financial awareness was awakened comparatively early, the credit control system in fact played a role of restricting the

development of the market economy and production. In those cities, the economic development was based on the non-state economy (the proportion of the non-

state economy accounted for two-thirds of the economy in Zhejiang and Jiangsu provinces) and markets (Zhejiang owned over 4,000 large markets out of 8,000

around the country), and so was the growth of bank deposits. However, the credit

quota was decided on the basis of the “base-plus-growth” method, and the credit control system complied with the patterns of a planned economy and a stateowned economy rather than those of a non-state-economy and a market economy.

As long as there were no large projects and large enterprises, there would be no sufficient loans. Even though the size of loans increased a little bit, it was far from enough to satisfy just state-owned enterprises, let alone non-state and market

economies. Those cities held little hope for the increase of loan quota. The deposits grew quickly in those cities while the loan quota lagged behind, so the banks in

those cities usually transferred their deposit surplus to the bank branches in other

cities to support loan projects. Thus, the local Party and government officials in the

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former cities were not pleased.

Due to the rapid development of the market economy in coastal areas, local

governments, enterprises, and banks found opportunities in market supply and demand, and proposed some projects which suited the practical requirements

of the market. At this point, owing to the insufficiency of loan quota, the urgent need of local governments and banks to use deposits to support local economic development gave rise to the emergence of counterfeit short-term lending, fake trust, and other kinds of loans to bypass the credit ceiling.

What is the definition of a loan beyond the credit ceiling? It is a loan which is

issued through bypassing the credit limit. It should be said that the credit control system imposed on the state-owned commercial banks, as a major monetary means, played a certain role in macro-financial control. The system could control

the total amount of credit and suppress the overheated economy for one thing,

and ensure the concentration of funds on important projects and promote the

healthy development of the economy for another, at the earlier stage of economic reform when the state-owned economy was at the dominant place, and financial institutions were not in a great number and offered just simple financial products.

In the mid-1990s, the central government advocated “a socialist market

economy,” which incurred huge changes in the economic and financial areas. I concluded these changes as methods of “breaking the four kinds of dominance”

in the financial field: 1. Breaking the dominant place of the non-state economy

by encouraging the growth of the non-state economy which accounted for onethird of the total economy nationwide, and two-thirds in coastal areas; 2. Breaking

the dominant place of state banks, as the medium- and small-sized commercial banks, urban credit cooperatives, and non-bank financial institutions sprang up

and contributed 30% of the total new loans in 1994; 3. Breaking the dominance of indirect financing between banks by the development of the capital market,

bonds, stocks, funds, and other kinds of direct finance; 4. Breaking the dominance of deposits and loans through the diversified development of financial products.

In 1994, the financial assets except loans in China’s four major specialized banks accounted for 46% of the total newly increased assets, owing to the diversified

business development of banks. The “breaking of the four kinds of dominance” increasingly reduced the function of the credit control system as a monetary policy

tool, and gradually turned the system into an obstacle to the market economy.

A great variety of conflicts thus occurred, and the credit control system was increasingly unable to meet the needs of the market economy and financial reform.

To lend out loans beyond the credit ceiling mainly happened in the state-

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owned banks, where there was a huge gap between deposits and loans, through basically two ways. The first way is that banks will lend the funds to the subsidiary companies of county- or city-level financial departments who will then entrust banks to make loans to enterprises. The other way is that when enterprises demand a higher deposit rate (for example, a monthly interest of 12 ‰), which cannot be satisfied by banks due to the interest rate control, the banks will resort

to fake trusts who will organize tripartite trust agreements to be signed among depositors, banks, and loan customers, and banks will ensure the depositors that

all the risks incurred by the entrusted loans will be solely borne by the banks. But

the practice of “lending out excessive loans in the middle of the year (quarter) but suppressing the loans back to the credit limit at the end of the year (quarter)” was regarded as a normal operation rather than an illegal activity. Sometimes, when

enterprises could not repay their loans, the outstanding bank loans would surpass the credit quota, and banks would stagger the time for calculating the credit size and reduce the loan amount by dispatching loan balance.

To lend out loans by bypassing the credit ceiling reflected various conflicts

inside and outside banks caused by the credit control system under the socialist market economy.

First, the pressure from local government. Many local governments demanded

the launching of some new projects to meet the market demand based on the

development of the local market economy, and emphasized the principle of “local

funds for local use” to prohibit local banks from funding the projects of other provinces. Some other local governments publicly called for a narrowing of the

huge gap between deposits and loans in banks, which would have meant to make full use of the deposit surplus to prevent banks at a higher level from transferring

the money to other areas. At that time, the China Construction Bank had the largest deposit-loan gap among other state-owned banks and was most frequently

asked to transfer money to the bank branches in other places. Several counties and

cities even called on local enterprises to not save money at the China Construction Banks for fear that money from local enterprises would be transferred to other

places. Many counties and cities supported the establishment of foundations and encouraged enterprises to independently raise funds. It was said that the capital

raised by enterprises amounted to RMB4 billion in Zhejiang Province in the first

quarter of 1993. Some counties and cities issued a document which said the raised funds with a monthly interest rate lower than 15‰ can be included in costs. Until 1995, certain counties and cities still urged local banks to ask for loans, including

loans beyond the credit ceiling, from upper-level banks by means of a government

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bonus: According to the amount of newly increased loans, fixed-asset loans will be rewarded with a 5‰ bonus, and working capital loans will be rewarded with a 2‰ bonus; the bonus will be included in the costs of borrowing enterprises.

Second, various financial institutions sprang up and fiercely competed with

each other. The support from local governments to run financial institutions was regarded as a way out for local construction companies by centralizing social funds. Urban credit cooperatives and trust companies were first set up, and then branch

institutions of commercial banks other than specialized banks were established, owing to the efforts of various parties, in order to divert deposits from specialized

banks, link loans to deposits, absorb social funds, and support production and construction. The increase of financial institutions was an achievement of financial reform, but unfair competition existed among financial institutions. The core issues for the competition were loan size and interest rate. Small- and medium-sized banks imposed no credit quota and were regulated through the asset-liability ratio, and for these banks, more deposits means more loans. The deposit and loan interest

rates in credit cooperatives can fluctuate. In fact, it was not a secret that many financial institutions used abnormal means to win customers, stirred up a war of interest rates, and expanded their financial shares.

Third, financial consciousness of enterprises was awakened and enterprises

started to pursue a market-oriented interest rate. They usually demanded from

deposits a portion of additional income (called “handling charges”), larger than the general interest rate. This pushed the banks to undertake entrusted loans which bypassed the credit ceiling in order to adapt to the increasingly high interest rates.

Fourth, banks also have the demand to increase loans out of their own

interests. There were three reasons: 1. To issue more working capital loans, especially to those clients who often possessed comparatively large deposits,

which was an important requirement for stabilizing primary customers. Among the state-owned banks, the China Construction Banks had a small proposition of liquidity loans and thus were greatly in need of such a kind of loans; 2. To

stabilize the banks’ connection with their clients by means of higher interest rates of entrusted deposits; 3. To increase the earnings of banks and their employees,

improve working conditions, and implement electronic management by making use of the handling charge (or interest margin) of entrusted loans.

After all, the rapid development of the market economy in coastal cities

objectively required the increase of loan funds and these loan yields in reality

had the possibility to outnumber the average rate of profit. This was the most important objective condition. Moreover, the pressure from government, the

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requirements16 from upper level banks to basic level banks during the transition

of specialized banks to commercial banks, and the practice of small- and mediumsized commercial banks implementing an asset-liability ratio management, all became a kind of catalyst for the emergence of loans beyond the credit ceiling.

In 1995, when I conducted an investigation of Zhejiang Province, some

counties and cities there allowed a certain proportion of working capital loans

over the credit limit, after the central bank abolished the monthly monitoring of

the quarterly loan size, so the deposits grew substantially. One bank branch in a county-level city implemented an asset-liability ratio management method, after getting the approval from the provincial bank branch. The county-level bank branch was allowed to issue the working capital loans amounting to 40% of the newly increased deposits, and thus deposits soared and almost doubled. It was learned that the loans bypassing the credit ceiling in many cities mainly aimed

to support the non-state economy and market economy, and the loan type was

mainly working capital loans, usually accompanied by collateral or guarantee. Many bank branches believed that individuals would incur the least risks to

banks, followed by collectives, while the state-owned enterprises were most likely

to pose risks. At that time, the overdue rate of the whole Construction Bank system in Zhejiang Province was only 2.41%, and the quality of credit assets of Zhejiang Province ranked the first around the country.

Through my survey in Zhejiang, I also found that the problem of issuing

loans over the credit limit was a historical holdover. The financial rectification

in 1993 cleaned up the illegal short-term loans and called back the speculative funds in the real estate and stock markets, but a large number of loans over the credit limit issued to the enterprises with insufficient working capital became a part of operating funds which participated in the normal turnover of those

enterprises. Although the central authorities said that banks would not be blamed

for the excessive loans issued in the past, the authorities did not increase the loan quota by making allowances for this portion of loans. Therefore, the lower bank

branches continued the practice of lending out loans beyond the credit ceiling

and the indebted enterprises had to borrow new loans to repay their old debts which could not be gotten back at once. The fundamental solution to the problem

of loans beyond the credit ceiling, a solution believed in by the banks around the

country, was to reform the credit control system and implement an asset-liability management system.

When Zhu Rongji rectified the financial order in July 1993, he ordered the

dismissal of the directors of banks which had lent out loans beyond the credit

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ceiling. But the actual situation of the excessive loans was very complicated,

especially in Zhejiang and Jiangsu provinces and other economically developed areas, where the local governments, local financial institutions, and central bank branches had usually approved or given tacit permission to the lending activities. In some areas, the bank loans beyond the credit ceiling were made after the local

Party and government organs coordinated with the financial sector, central bank, and audit offices. It was ironic that an illegal business won favor from almost all the departments and authorities, except the policy-makers. It also indicated that the credit control system was divorced from reality, the market, and the general people.

It is clear now that the problems of “loans bypassing the credit ceiling” and

“counterfeit short-term lending” seemed to lie in the banks, but in fact they resulted from local governments deliberately breaking the investment and loans limits set by the Planning and Economic Committee through manipulating the

financial sector and banks in order to develop market economy and expand

capital. But, if we only consider the financial operation, to issue securities, raise

funds, run financial institutions, lend out loans bypassing the credit ceiling, and undertake counterfeit short-term loans, all were innovations in the capital

formation mechanism. It also indicates that there is but one step from innovation to violation and from truth to absurdity. The problem is that the financial administrative authority cannot see the root cause and may cut the wrong tree down by just punishing the cadres. At that time, Wang Qishan was the president of

the China Construction Bank, and he repeatedly stressed: “We should be practical and realistic in investigating the illegal loans and find out the cause for loans

beyond the credit ceiling and counterfeit short-term loans.” Later, Zhu Rongji listened to Wang’s report and finally agreed to legalize the loans over the credit

ceiling issued in the past, and replace the credit control system with the asset-

liability management, which solved the problem by a system reform and propelled the healthy development of economy and finance.

The Proactive Fiscal Policy between 1998 and 2004: State Intervention to Fight Deflation In 1997, the inflation rate of China dropped to 0.8%, and China’s economy

achieved a soft landing in preparation for take-off. A financial crisis, however, suddenly occurred in Southeast Asia, and the deteriorating external environment brought about deflation in China in 1998. This was the first deflation to occur during China’s transition into a socialist economy.

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It should be said that when the Southeast Asian financial crisis affected China

during the latter half of 1997, the crisis did not receive sufficient attention. In March 1998, the National People’s Congress and the Chinese Political Consultative Conference were convened. At that time, the fiscal deficit occurred year after year, and various parties advocated for deficit reduction, so the two meetings decided

a moderately tight fiscal policy. But shortly after the two meetings, the impacts of the Southeast Asian financial crisis spread wider and wider. China promised to

not devaluate its currency in order to stabilize the global financial market and the international monetary system, which further weakened the commodity prices,

increased the unemployment rate, frustrated the exporting of products, and brought

about sluggish economic growth in China. Two month later, in May 1998, China’s fiscal policy had to undertake an adjustment and reform. When the monetary

policy could hardly play any role, the central government turned to implement a proactive fiscal policy in order to stimulate domestic demand and boost economic growth. In June 1998, the Standing Committee of the National People’s Congress

passed the budget adjustment proposal and officially declared the transition from

a moderately tight fiscal policy to a proactive one. This decision actually restarted the state intervention by using fiscal policies as the means of regulation and it made the state investment restore the leading role in the formation mechanism of core social capital, after the central government advocated the policy of “construction relies on banks, and meals on finance” and the finance department retreated from

economic construction in the mid-1980s. The state intervention of this time was

different from the previous ones. The state was faced with a great variety of savings and investment subjects under a socialist market economy, and the financial

regulation was intended to activate demand and consumption and promote exports and investment through various regulatory measures including more financial

investment. One way was to increase the financial deficits by RMB100 billion. At that time, the central bank issued RMB100 billion more long-term treasury bonds

for construction and the central government used the “national debt projects”

invested in by the state to stimulate investment demand and promote the capital

input from all parties of society. Proactive fiscal policy and prudent monetary policy, thus, came into being and lasted for as long as seven years.

Of course, the implementation of the proactive fiscal policy was not smooth

all the way. The actual situation at that time was: An excess of industrial products,

inadequate effective demand, a declining average profit rate of industrial enterprises, a lack of new investment opportunities, prudent investment and

loans by enterprises and banks, and an obstacle in the transition of savings to

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investment. In the face of these unprecedented problems, the response measures

of the government seemed relatively inadequate. Moreover, for a long period

of time from the founding of New China until the reform and opening up, the macro-regulation towards investment by the government mainly focused on the control of investment scale and the prevention of investment overheating. And

since the state leaders stressed “construction relies on banks” in the mid-1980s, the central government stuck into a predicament of “meals on finance,” which

further weakened the regulatory function of finance in the national economy. The 40 years of shortage economy taught the China’s government how to deal with

shortage and control demand inflation, but the government did not know how to handle surplus and initiate demand, especially how to make corresponding policy

preparations. In 1998, China started to carry out a proactive fiscal policy, mainly to increase the issuance of treasury bonds and transfer savings into investment.

Then, the government directly invested fiscal appropriations in non-profit, largescale hydraulic projects, infrastructure projects, and public works, as a replacement

for the shrinking enterprise and private investment, in order to strengthen the intervention in the economy. At that time, some scholars worried that the projects funded by the national debts would force out private investment, but this worry

was unnecessary. The reality was that enterprises made no investment and banks lent out no money, and thereby the national debts projects emerged to fill the vacancy in the capital formation mechanism. While implementing a proactive

fiscal policy, the government also adopted a series of supplementary measures, mainly including the following measures:

1. To let the China Development Bank issue financial bonds and increase policy

loans.

2. To use financial discounts as a lever to start huge bank loans. The

government gave discount government loans to some enterprises which needed support during their renovation and reformation projects, and intended to use

a small portion of interest subsidies to stimulate a large amount of investment

and loan demands. Among the newly issued treasury bonds, RMB9 billion were used for discount loans for technological upgrading. It was estimated that the RMB9 billion bonds could stimulate RMB180 billion investments for technical transformation.

3. To standardize government procurement. During the past shortage period,

the government emphasized control over institutional purchasing power and

government expenditure to ensure market supply. But now, the government had

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to give full play to the positive role of government procurement in expanding domestic demand. This measure would not only cut down expenses, but also bring into play the size effect of the government market purchasing behavior.

4. To establish financial credit guarantee fund. Some local governments

regarded fiscal revolving funds as financial credit guarantee funds, in order to promote enterprise investments and bank loans. This could further activate the economic leverage in establishing a financial guarantee system for small- and medium-sized enterprises and promoting the development of high-tech industry.

5. To refund export taxes and reduce or remit taxes in order to encourage

investment.

6. To adjust the depreciation policy. To allow the accelerated depreciation of

new equipment, and thus to stimulate investment by increasing the depreciation rates or shortening the depreciation life.

7. To make use of the government-invested companies and industrial state-

holding corporations, and undertake capital operation during the joint-stock reform of state-owned enterprises, the listing of companies, the transfer and expansion of public shares by using capital as the linkage.

After 1998, the government enlarged the financial input by means of national

debts, and fueled economic growth by using state investment to drive private investment. Examples are as follows:

1. To increase the investment in highway and railway construction and the development of small towns along the traffic routes in order to promote the

economic development along the traffic lines. However, the total length of china’s railways was just 62,000 kilometers in 1998, and the Ministry of Railways

planned to invest RMB230 billion before 2000 to extend the railways to 68,000 kilometers. Statistics said that between 1998 and 2001, the Chinese government

built or started building a large number of key infrastructure projects, including

new railway lines of 4,000 kilometers and double-track railways of 1,988 kilometers. Meanwhile, during those four years, the government also increased

25,500 kilometers of highway mileage, strengthened more than 30,000 kilometers

of embankments of large rivers and lakes, and relocated over 2 million populations living along the Yangtze River. Here I only want to explain that with the construction of highways and railways, to invest more money in the

construction of small towns along the traffic routes will boost the agricultural industrialization in different regions and facilitate the transfer and employment

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of a group of agricultural surplus laborers. This will provide a bridge to absorb the rural labor force and organize and lead the industrialization of agriculture, which will finally become a new economic growth point in China. According to the 2004 statistical bulletin, under the support of the central government, 150,000 kilometers of inter-county and rural highways were reconstructed and the drinking water problem of 50.2 million people was solved. A report in 1998 about the construction of the Beijing-Kowloon railway said that this railway, which stretched over 2,381 kilometers, consumed an investment of around RMB40 billion. Since its construction was started in 1993, the urbanization in the areas along the railway had geared up. In 1996, the average GDP growth rate of major cities along the railway was 2.9 percentage points higher than that of the whole country and 6.4 percentage points higher than that of the provinces along the railway, and the revenue of these cities grew by 28.7%. The average per capita net income of the rural residents in the villages along the railway was RMB2,167, RMB267 more than that of the national average, and increased by 18% by vertical comparison (price factor has been removed). The per capital net income of urban residents living in the cities along the railway reached RMB4,872, RMB492 higher than that of the national average, and grew by 16.2% by vertical comparison. Compared to the average growth rate of the per capita net income of urban residents and that of rural residents in the areas along the railway, the national average growth rates were 9% and 3.4% lower, respectively. The statistics of the Beijing-Kowloon railway provided powerful evidence for the need to increase investment in highways and railways, as well as proof of the expansion of domestic needs.

2. To increase the investment in urban infrastructure construction. The urbanization in China lagged behind its industrialization, and the relationship between industrial construction and urban construction was not properly dealt with for a long period of time. After the reform and opening up, many new cities were built and deficiencies in urban roads, water supply, and drainage facilities and public transportation facilities existed in these cities. The expansion of investment in the public projects, including urban highways, water, power, gas, communications, and public transportations, would not only stimulate urban consumption, but also increase the employment and reemployment in urban areas. The best example was the power supply. At that time, many power distribution and substation facilities for urban residents were made in accordance with the comparatively low power load standard of public building design between the 1950s and 1980s, which impeded the

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consumption of high-power household appliances. It was not uncommon that many urban residents bought air conditioners and microwave ovens, but could not use them. Later on, investment was made in the renovation of the power supply system and power distribution and substation facilities to transform low-voltage grid and substation facilities, and update old housing wires. This action not only employed a group of electrical workers, but also expanded the market for high-power household appliances. The sales of household appliances and the income from power supply were increased, which correspondingly enlarged the state’s revenue from the two activities. 3. To enlarge the investment in water conservancy construction and afforestation, along with the post-flood reconstruction, in order to make great progress in returning the grain plots to forestry, afforesting the barren hills and wasteland suitable for afforestation suitable for afforestation, and constructing other ecological projects. The government combined investment growth, the welfareto-work program, and the depletion of inventory together in order to expand domestic demand. 4. To increase educational investment represented the state’s support for public works and was also an effective intervention measure. At that time, the high school graduates of China numbered 3 million per year, but only 1 million could be admitted to universities since there were not enough universities. After 1998, the investment in education was increased and the mode of privately-run universities with government subsidies was advocated, which not only attracted private investment in education but also increased employment. The newly built universities and colleges provided education for hundreds of thousands of students and postponed the employment start time of these students, which eased the employment pressure on hundreds of thousands of people and enhanced the quality of the reserve labor force. From 1998 to 2004, China’s central bank issued RMB910 billion in long-term treasury bonds for construction in seven consecutive years, which effectively

boosted domestic needs and promoted the healthy and stable operation of the national economy. The price of commodities was relatively stable, employment rates grew substantially, the balance of payments recorded a “double surplus” within several consecutive years, and the economy continued to maintain near doubledigit growth. Some people, therefore, said that the seven-year implementation of the proactive fiscal policy was a period of China’s rapid economic and stable development. The achievements of the proactive fiscal policy were as follows:

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1. Maintained sustained and rapid economic development. According to the

data from the National Bureau of Statistics in 2005, the economic growth rates between 1998 and 2004 were 7.8%, 7.2%, 8.4%, 7.2%, 9.9%, 10.7%, and 9.9%,

respectively (at constant prices). The most direct benefit was to drive GDP growth by 1–2 percentage points. Statistics indicated that the national bonds contributed 2% to the economic growth rate of 7.8% in 1998, 1.5% to the growth

rate of 7.2% in 1999, and 1% to the growth rate of 8.4% in 2000. No matter how much the contribution of the treasury bonds was, to drive the GDP growth under inflation was an accomplishment of the proactive fiscal policy.

2. Increased the resident income and stimulated consumption. Since 1999, the

Chinese government raised the salaries of employees in the government and public sectors and increased pensions to retirees, scaled up the fiscal transfer

to the central and western regions, and established an allowance system for

remote areas. The household consumption rate increased by 6.54%, 9.1%, and 10.1% between 1999 and 2001, and by 13.3% in 2004 (10.2% in real terms).

3. Maintained a steady growth in imports and exports. Ever since 1998, the

Chinese government gradually increased the export rebate rates of certain commodities and made the average export rebate rate reach 15%. Meanwhile,

the improvement in management of processing trade and the expanding of the import and export rights of manufacturing enterprises effectively stimulated exports.

4. Promoted the optimization of economic structure. First, to support the technological innovation and the development of high-tech industries which

conformed with the orientation of industrial policies, through tax relief, discount government loans, and other preferential policies. Second, the central

government invested more money in the infrastructure construction and ecological environment construction in central and western areas. For instance,

in 2000, the investment in central and western China increased by 13.8% and 14.4%, 5.5 and 6.1 percentage points higher than the national average. In 2004,

the growth rates of investment in the central and western areas were 30.2% and 26.6%, 4.4 and 0.8 percentage points higher than the national average.

Statistics said that from 1998 to 2001, through the efforts of the use of

government bond funds to leverage the inflow of supporting funds, the volume

of total investment in the 8,600 government bond-financed projects reached nearly RMB3 trillion, and thereby a group of important projects were finished,

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and the economic growth potential was enhanced with the economic growth

rate maintained above 7% for several consecutive years. Now, the Qinghai-Tibet

railway was opened to traffic and the west-east natural gas transmission project was officially put into operation. To consider the overall net effect of the proactive fiscal policy in fiscal expansion and tax reduction, the policy raised the economic

growth by 2.0, 2.8, 3.2, 0.5, 0.6, and 0.9 percentage points between 1998 and 2003.

This indicated that in the later years of the proactive fiscal policy, due to the significant increase in fiscal revenue, the net effect was comparatively weak. It

also reflected that with the gradual recovery of social investment and the growing

internal dynamism in economic development, the dependence on the proactive fiscal policy declined. Therefore, to alter the orientation and strength of the fiscal

policy in 2004 and to move towards a prudent fiscal policy in 2005 were proved to be entirely correct methods.

When the government implemented a proactive fiscal policy, people worried

most that the government bond-financed projects would exert a crowding-out

effect on private investment, and thus there were always voices to advocate putting an end to the proactive fiscal policy. It now appears that the seven-year proactive fiscal policy had little impact on private investment. For me, I think the crowdingout effect mainly existed in the capital market. The proactive fiscal policy indeed

eased the deflation to a large extent by taking advantage of the government bondfinanced infrastructure constructions and the western development which were

worth hundreds of billions to leverage several trillion in supporting loans, when

banks faced limited credit quotas and dared not to easily lend out money in order to control risks. The biggest flaws of the proactive fiscal policy, however, were

to make the financial authorities have a misunderstanding over the temporarily

narrowed gap between loans and deposits, and cause the authorities to relax the construction of the bill market, bond market, investment funds market, futures market, and other financial markets. In general, the proactive fiscal policy made

a great contribution in fighting deflation while the prudent monetary policy was inadequate in building a healthy economy. Thus, the latter policy left some regrets

in both the development of the fictitious economy and the capital market and the perfection of the financial market structure.

In order to harness the deflation in 1998, the central government carried out

a series of reforms in the institutional consumption system, including salary,

housing, health care, education of employees. We knew that under the planned

economy, employees received low salaries and maintained low consumption, and

the housing, health care and education expenses of employees were all shouldered

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by the state based on a low standard. After the transition to a market economy, the control over the income distribution system of wages and bonuses was gradually relaxed and the income of workers increased significantly (of course, a

large income gap existed among workers, due to the big difference in corporate profits). The lagged reform in the housing, health care, and education systems of

employees was also an important factor in restricting consumption and fostering deflation. A significant measure in controlling deflation taken by Zhu Rongji in

1998 was to speed up the reform in housing, health care, and education systems and lead the transition of investment by enterprises and public institutions and institutional consumption to private investment and consumption. Since

the reform and opening up, Chinese residents earned more and more and their demand to upgrade the consumption structure was great, especially in terms of housing consumption. In 1998, the State Council ordered Party and government

organizations to put an end to the 40-year welfare housing distribution system and advocated the monetization of housing distribution, which brought about the

real estate boom which continued for the next 10 years. This played a huge role in stimulating housing consumption. Due to the fact that there may be problems

of overly depending on the market in the reform of housing, health care, and education systems, the central government stressed the establishment of people-

orientated policies to improve people’s livelihoods and the construction of housing and health care systems in order to ease over-marketization. But generally speaking, the reforms were more helpful than harmful. It should be said that these reforms were necessary. They played a huge role in adapting to marketization, increasing workers’ income, leading the transition of the institutional investment

and consumption to private investment and consumption, releasing various

demands and motivations of the formerly restrained private investment and consumption, and getting the deflation under control.

There was one thing special in the deflation of 1998, that is, the excessive debts

of state-owned enterprises discouraged banks from offering loans to distressed enterprises. Although advocating the encouragement of mergers and the

standardization of bankruptcy procedures, the central government was reluctant

to implement debt-to-equity swaps and thus the deflation was further intensified. Until the latter half of 1999, the central government decided to found four financial asset management companies and applied debt-to-equity swaps to the overdue

loans (namely, the non-performing loans of banks) of a considerable part of overly indebted large- and medium-sized state-owned enterprises, which not only solved the excessive debts of the enterprises, but also optimized the enterprise capital

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structure. The debt-to-equity swap would in turn enhance the debt-paying ability

of enterprises and became a major force in increasing bank loans and controlling deflation. The topic of debt-to-equity swaps will be discussed in Chapter 7.

Strategic Adjustment of the State-Owned Economy and State-Owned Enterprises Reform After the reform and opening up, China started its reform in the state-owned

economy. In general, the reform was a complex and arduous process and it went through four stages after 1979.

The first stage was the “decentralization of power and the transfer of profits”

between 1979 and 1984. This reform, mainly through enlarging the autonomy of

enterprises, put into practice the measures of profit retention and profit contracts

to encourage enterprises to meet targets and realize production and revenue increases on the basis of the replacement of profit delivery by tax payment.

The second stage was the separation of ownership and control between 1985

and 1993. Through the implementation of a contracted managerial responsibility

system, enterprise management was separated from government administration,

and ownership was separated from management power and, therefore, state-run enterprises would become state-owned ones. Meanwhile, the policy of “loans for fiscal allocations” was fully implemented and a group of state-owned enterprises was transformed and listed through the pilot program of a joint-stock system.

After the first two stages of reform, the state-owned enterprises obtained, to a certain extent, the financial resources and vitality in undertaking self-renovation,

self-accumulation, and self-development, in comparison with their pervious situations under the highly centralized management.

Between 1994 and 1999, the state-owned enterprises reform entered into the

third stage of a clearly defined ownership.

Since 1999, the reform moved into the fourth stage, namely, strategic

adjustment of the state-owned economy. The central government put forward the

need to implement strategic adjustment in the layout of the state-owned economy, and concentrated the state capital in the fields related to national security and

the lifelines of the national economy in order to enhance the controlling power,

influence, and leading role of the state sector. The adjustments were made

according to the principle of “refraining from doing some things in order to

accomplish other things.” The reason why the central government proposed the strategic adjustment was because state capital was insufficient in major industries

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and key fields while it was widely spread in other sectors.

The unreasonable allocation of resources forced the government to redirect

investments of state capital to ensure the rational flow. The fundamental targets

were to concentrate the state-owned capital in the fields related to national security and lifelines of the national economy, by withdrawing government capital from

certain industries and fields, and at the same time to make room for the injection of private capital. So the focus of the adjustments was to first reduce the investment of state capital in some sector before making full use of it in others.

The state-owned enterprises reform focused on the withdrawal of the state

capital from certain sectors, but how to retreat? The inevitable question was that

during the withdrawal of state capital and the introduction of private capital in some sectors, there would be a problem of transferring a group of state-owned enterprises and state capital to private enterprises. Although it was not explicitly stated, the

reform was intended to privatize the state-owned enterprises, as had been done by Western countries, and replace state-owned capital with private capital.

In 2003, the State-owned Assets Supervision and Administration Commission of

the State Council (SASAC) was established, and it was responsible for the strategic adjustment of the state economy and the unified management of state capital.

The founding of the SASAC represented the separation of public management

from ownership in the organization of government for the first time, identified the representatives of the state-owned assets contributors, and basically realized the

integration between asset management and the governance of personnel and work. Since then, state-owned enterprise reform entered a new phase.

To privatize state-owned enterprises, however, was not as easy in China as in

Western countries with a market economy, since China’s reform was constrained by

power, knowledge, and ideology, especially the ideological constraint which was ubiquitous. Although the higher authorities concluded that there was no loss of state

assets in the sales of small state-owned enterprises in Zhucheng City, there were still some leftist articles on this issue by 2001. The mergers and acquisitions of stateowned enterprises by private enterprises, such as the acquisition of Xinjiang Tunhe by Xinjiang D’Long Group and the acquisition of Guangdong Kelong by Shunde

Greencool, faced a similar situation. In 2004, Professor Larry Lang from the Chinese

University of Hong Kong questioned the direction of state-owned enterprises reform concerning the drain of state assets. Many non-mainstream economists

echoed his opinion and petitioned for an investigation on this problem disclosed by Professor Larry Lang. At that time, Zhang Wenkui from the Development Research

Center of the State Council firmly responded that the direction of reform cannot be

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denied in spite of the problems in the state-owned enterprises reform. Therefore, this controversy triggered by the question from Professor Larry Lang developed

into an important part of “The Third Grand Debate on Reform.” Later on, Zhao Xiao from the SASAC criticized Larry Lang for being less informed about China’s situation, and acting “as a bull in a China shop.” Professor Zhang Weiying from

Peking University responded to Professor Larry Lang by saying that “We should be kind to the people who contribute to the society.”

It was inevitable that there would be some specific contradictions and

questions in the strategic adjustment of the state economy and the privatization in certain sectors. For example, how should state investments withdraw while private

investments could step in? There was no set pattern and the government had to learn by doing. The government should let small enterprises try independently

during the strategic adjustment, and accepting both success and failure for that experience is what the government wanted. The second question was whether

the state-owned enterprises should be sold and how much should they be sold for during the privatization? The decision-making power was in the hands of

the government or the government officials. There could be a win-win situation

if the officials acted properly, but rent-seeking behaviors may also exist among different levels of officers. Another question was how to place the senior managers

in the reformed state-owned enterprises? In the acquisition of Western companies,

employees would receive a Golden Parachute by employers buying off the service years of the employees. But Chinese enterprises practiced an official rank standard

with business leaders being quasi-bureaucrats, and the process of the redemption

of state-owned enterprises was more complex and costly than the seniority buyouts in Western companies.

During the strategic adjustment of the state economy, there was also a task

of regulating privatization and protecting the enthusiasm of private capital in participating in the national economy. In the past few years, many privately-

controlled companies ran into equity disputes, which usually represented a contest between new and old systems. It was always the case that private capital was in

an inferior position. The old system side, despite its disadvantages, tried to regain

initiative through its extensive connections in the old system. So when the holders

of state shares were in a tight corner in a joint-stock company, they had to turn to their private counterparts for help. Once state shareholders were out of trouble,

however, those companies would force the private economy to step down on the

excuse of prohibiting the loss of state assets. Therefore, the government ought to regulate privatization and protect the active participation of private capital in order

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to ensure that the state asset is willing to withdraw from ownership of business while the private capital can come in as a replacement and enjoy development free from the discrimination and disruption from the force of habit.

Another implication of privatizing state-owned enterprises was to expand

equity transactions to the transactions of corporate right of control. In fact, the capital market of any country can never be called mature if no corporate right

of control is traded and transferred. Only with the flow of corporate control, can resources be really optimized, and asset restructuring, adjustment of industrial

structure, and synergy effects be truly realized. Being state-controlled is not

always the story, and the government should push forward the corporate control transactions, along with the strategic adjustment of the state economy and the

reduction of state-owned stocks, through the engagement of private enterprises, management buy-outs (MBO), and investment banks.

In November 2006, the Guiding Opinions of the SASAC about Promoting the

Adjustment of State-owned Capital and the Reorganization of State-owned Enterprises clearly stated the objectives of state capital restructuring and reorganization

of state-owned enterprises: To maintain the absolute controlling power of the

state economy in major industries and key fields related to national security and

national economic lifelines, including the military, electric fencing and electricity, petroleum and petrifaction, telecommunications, coal, civil aviation, and shipping; to enhance the leading role of the state-owned economy in basic and pillar

industries, such as equipment manufacturing and non-ferrous metals industries;

to maintain the necessary influence of the state-owned economy in commerce and trade circulation and other industries and hold dominant shares by the state in the industry pacesetter enterprises which have larger influence or special functions.

According to the article “To steadily promote the state-owned enterprises

reform on a new start” written by the former SASAC Director Li Rongrong in Seeking Truth magazine in August 2007, the accumulative sales revenue of China’s

state-owned enterprises in 2006 reached RMB16.2 trillion (RMB18 trillion in 2007),

50.9% higher than that of 2003, with an average annual average growth rate of 14.7%; the profits amounted to RMB1.2 trillion (RMB1.62 trillion in 2007), 147.3%

higher than that of 2003, with an average annual average growth rate of 35.2%;

the taxes turned over to the state added up to RMB1.4 trillion (RMB1.57 trillion in 2007), 72% higher than that of 2003, with an average annual average growth rate

of 19.8%. As of the end of 2006, the gross asset of state-owned enterprises in China totaled RMB29 trillion, 45.7% higher than that at the end of 2003, with an average annual growth rate of 13.4% (at the end of 2007, the total assets of China’s state-

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owned enterprises increased by 23.1% compared to the number of the previous year, the debt-to-assets ratio was 57.3% and the return on equity was 8.5%).

On the whole, the primary achievement of the state-owned enterprises reform

was to facilitate the concentration of state-owned capital on the major industries

and key fields essential to the national economy and state safety. In 2003, there were 150,000 state-owned enterprises, but the number was reduced to 119,000 at

the end of 2006, 31,000 less than the total number of 2003, with an average annual

decrease of 8%; however, the average assets of the state-owned enterprises reached RMB240 million, an increase of 84.6% compared to that of 2003 with an average

annual increase of 22.7%. Although the number of state-owned enterprises was

decreased, the majority of them realized an invigorated development under loose government control. The overall quality and competitiveness of the state-owned economy continuously increased and its controlling power, influence, and leading role were also greatly strengthened.

There was a clear tendency of state-owned capital concentrating in the energy,

raw materials, transportation, military, major equipment manufacturing, and

metallurgical industries, among others. In 2006, over 80% of the national assets of

central government-run enterprises were concentrated in the above-mentioned industries, and these enterprises were responsible for the country’s production of almost all the crude oil, natural gas and ethylene, and provided all the basic

telecommunications services and most value-added services. Those enterprises contributed approximately 55% of the state’s total electricity production, 82%

of the total air transportation turnover of China’s aviation industry, 89% of the national waterway cargo turnover, 48% of the total auto production, 60% of the

national production of high value-added steel, 70% of the country’s hydroelectric equipment production, and 75% of the thermal power equipment manufacturing

in China. In addition, as of the end of 2006, the country had implemented a system of policy-related bankruptcy to 4,251 long-term insolvent state-owned enterprises, solved the placement of 837 workers, and completed 80% of the workload of

policy-guided closure. In 2008, the target of policy-mandated bankruptcy was basically finished.

Another major achievement was to accelerate the joint-stock system reform of

state-owned enterprises to make the mixed ownership economy the principal form of the public ownership system. As for the corporate system reform in the central

government-run enterprises and their subsidiaries, the proportion of reformed

enterprises increased from 30.4% in 2002 to 64.2% in 2006. Since 2003, 33 central

government-run enterprises have gotten listed through IPO in overseas markets.

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Large enterprises related to petroleum and petrochemicals, telecommunications, transportation, and metallurgy were listed overseas. The joint-stock system reform

in each province, region, and city was also further geared up. During the four years between 2003 and 2006, there were successively 78 times of open recruitment of 81 senior management positions in the enterprises directly controlled by the central

government. In 2007, another 22 executive positions in the central governmentowned enterprises were offered to both domestic and overseas talents, and a

market-oriented employment mechanism complying with the modern corporate system was initially set up.

In the face of the widely distributed state-owned enterprises, China’s

government had long suggested fostering 30 to 50 large companies or groups with international competitiveness. Four years after the founding of SASAC, there were 77 central government-controlled enterprises participating in the 41 reorganization

efforts, and the number of the central government-owned enterprises was reduced from 196 in 2003 to 157 in 2006. It was said that another 80 to 100 enterprises would

be adjusted or restructured by 2010. In 2006, the number of central government-

run enterprises with a sales revenue over RMB100 trillion was 21 and that of the ones with a profit above RMB10 billion was 13, which increased by 12 and 7, respectively, compared with the number in 2003. In 2006, 13 central government-

controlled enterprises including Baosteel Group were listed in the Fortune Global

500, 7 more than in 2003. Among those enterprises, Sinopec Group, China National Petroleum Corporation (CNPC), and China Mobile Communications Corporation moved up to 23rd, 39th, and 202nd places in 2006 from 70th, 69th, and 230th in 2002, respectively.

In January 2007, Singapore’s Lianhe Zaobao published a review article by Han

Fangming and he thought that “under today’s globalization, the competition of national strength among different countries is to a large extent the long-

term business confrontation among enterprises. Large enterprises can save the market transaction costs by undertaking economy of scale or economy of scope, significantly reduce the cost of government regulation, and enhance the research

and development capabilities. In this matter, the Chinese government has

never followed the specious fallacy of ‘market fundamentalists.’ It is very wise; otherwise, if the government adopts the shock therapy to sell out overnight all the

large enterprises essential to the economic lifeline, China’s status and the future of China’s citizens will become fragile owing to the loss of economic strength.”

In September 2010, Li Rongrong stepped down as the director of SASAC. During

his seven-year tenure at SASAC, he reduced the number of the central government-

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controlled enterprises to 123 from 196. By the end of 2009, the total assets of those enterprises jumped to RMB21 trillion from RMB7 trillion, the net assets increased to RMB8.4 trillion from RMB2.9 trillion; the operation revenue reached RMB3.36 trillion; the profits grew from RMB240.5 billion in 2002 to RMB815.1 billion in 2009; the annual tax contribution exceeded RMB1 trillion; and 30 central governmentcontrolled enterprises entered the Fortune Global 500. He Liangliang from Phoenix Television commented on Li Rongrong by saying that “Li is a capable man.” Many other commentators believed Li Rongrong deserved the praise. The biggest controversy about Li Rongzi during his rule at SASAC was the seven-year policy of “the state advancing as the private sector receded” (or privatization). Some people argued that in the past seven years, the central government-owned enterprises occupied the majority of resources in national economic activities, controlled the absolute say in social economy, and gained the pricing power of the commodities pertinent to national interest and people’s livelihoods. This caused the slow development of the non-state-owned enterprises whose contribution rate to GDP was 65% and tax contribution rate was 61% (according to the data of 2008), and created an even more difficult environment for the growth of medium- and small-sized privately-owned enterprises. It was an undeniable fact that the rising dominance of China’s state-owned enterprises was at the expense of the once-vibrant private sector. This situation could harm the balance and stability of national economic ecology and seriously erode the cornerstones of the law of the market economy: Fairness and efficiency. Meanwhile, according to the report released by the China Europe International Business School, the salary at the A-share listed state-owned enterprises in China nearly doubled that at privately listed companies (including overseas-listed Chinese companies). In contrast, the listed state-owned enterprises were less efficient than the listed private enterprises, and the average return on net assets of the former accounted for only 37.7% of that of the latter. On September 5, 2009, Li Rongrong revealed that the annual increase of the profits in the central government-controlled enterprises was RMB159 billion, and the annual growth of the total compensation for the senior executives above the level of vice president in these enterprises was around RMB46 million in the “Top 500 Enterprises of China Release Conference and Corporations Summit” in Hangzhou. He believed that these increases were reasonable, but the compensation for the senior managers in the central government-owned enterprises became a topic of public controversy.

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Chapter

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Prologue: “Ghost Hunting” This chapter will focus on depreciation and also simple and expanded

reproductions as well as the crowding out of investment in the former by that of the latter. This activity recalls the “ghost hunting” activities organized by Xu

Yi, Bank President of China Construction Bank (CCB), from my time when I was working with him there.

In 1958, nine years after the founding of New China, the CCB was incorporated

in the Ministry of Finance to become an Account Division for Capital Construction,

and thus my colleagues in CCB and I had the chance to get experience with the

macro-economy. However, books were the only source for people to understand accumulation, social reproduction, and simple and expanded reproductions back

then. It was not until the leftover problems from the three years of the Great Leap Forward (1958, 1959, and 1960) had been solved that people really gained access to those macro-economic issues.

The Great Leap Forward gave birth to the over expansion of investment in

capital construction in 1958. Mao Zedong advocated setting “two targets,” the one was a must to attain and the other was one to aspire towards. The investment

quota was being increased at every lower level and, as a result, investment in

capital construction had expanded massively. In addition, during the movement, the Ministry of Finance accepted Mao’s criticism about performing purely

fiscal functions, and put forward a slogan of “more revenue, more expenditure,

more construction; much more revenue, much more expenditure, much more construction.” By 1959, the investment quota and revenue had grown while the

commodity supply was still in short supply and becoming more and more lacking.

Li Xiannian was the then Vice-Premier, responsible for finance and trade affairs, and at the same time the minister of the finance department. Li Xiannian asked the officers in the Ministry of Finance: “Currency is said to be the symbol of material

goods, isn’t it? How come money is spent, but there are no goods? There is something fishy!” He called on the department to hunt the “ghost.” The Ministry

of Finance instructed Xu Yi who was Financial Secretary of the Account Division for Capital Construction and President of the CCB to form a “ghost hunting group” responsible for researching the relationship between capital construction

investment and economic growth as well as financial revenue and expenditure. The group members included Tian Yinong, Wang Zhuo, Chen Baosen, liu Biao, Hu Jing and I, among others.

Under the leadership of Xu Yi, we carefully read Karl Marx’s Das Kapital many

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times. We found the following passage in Volume 2 of Das Kapital: On the basis of socialised production the scale must be ascertained on which those operations — which withdraw labour-power and means of production for a long time without supplying any product as a useful effect in the interim — can be carried on without injuring branches of production which not only withdraw labour-power and means of production continually, or several times a year, but also supply means of subsistence and of production.1 In another place, Marx further elaborated the scale of production when assuming a communist society: The question then comes down to the need of society to calculate beforehand how much labour, means of production, and means of subsistence it can invest, without detriment, in such lines of business as for instance the building of railways, which do not furnish any means of production or subsistence, nor produce any useful effect for a long time, a year or more, while they extract labour, means of production, and means of subsistence from the total annual production. In capitalist society however where social reason always asserts itself only post festum great disturbances may and must constantly occur.2 In Das Kapital, Marx made a thorough analysis on the great disorder caused by excessive investment in capitalist society. Similarly, in our not well-planned socialist society, over expansion of investment and long-term input without any output also brought about a great disturbance. It was the “ghost hunting” activities that made us realize the huge power of Marx’s theory about the feature of capital construction of “no output, only input” described in Das Kapital, and deeply understand that excessive monetary input in capital construction but without corresponding output would lead to economic and financial disorder. In the “ghost hunting” activities, Xu Yi led us to re-examine the relationship among industrial and agricultural output value, investment in capital construction, financial credit receipts and payments, and materials supply and demand, and came to the conclusion that the size of capital construction investment was too large, the ratio of light to heavy industry was imbalanced, a budget deficit existed instead of a budget surplus, credit expansion was supported by the issuance of money, and the national economy was seriously disproportionate. In a report to Li Xiannian, Xu Yi pointed out that the great disturbances which were caused by excessive input in capital construction without corresponding output, occurred in many aspects of the economy at that time. At last, Xu summarized: “Passion for investment is commendable while rules cannot be violated.” However, this report

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of “ghost hunting” was not revealed due to the struggle against rightist deviations in the Lushan Conference. The aggressive investment during the three-year Great Leap Forward brought about the five-year adjustment of the national economy. An important lesson learned from this investment expansion was that capital construction investment during the Great Leap Forward pursued only expanded reproduction rather than simple reproduction, resulting in massive debts in the updating of urban industrial equipment and the expansion of excavating and logging industries, and thus the government had to take out more money to compensate for simple reproduction during the adjustments after 1961. The Ministry of Finance offered RMB37 billion in total to commission CCB to solve the problems of incremental investment at every lower level and excessive investment growth left over during the Great Leap Forward. In 1962, the Party Central Committee and the State Council drew a lesson from this experience: Any works of socialist economic construction, whether to draw up plans, implement economic administration, or undertake material supply, must first focus on simple reproduction and then expanded reproduction. I tell this story because Chapter 1 said Marx discovered that the depreciation fund or sinking fund is both a compensation fund and an accumulation fund, but the expansion nature of capital made Chinese enterprises, competent departments, and officers from the State Planning Commission responsible for “conscious social regulation,” naturally apply compensation funds to accumulation, namely expanded reproduction, which frequently resulted in runaway increase in investment and great disturbances in social economy. The runaway increase in investment during the Great Leap Forward was the result of expanded reproduction crowding out simple reproduction. In the late 1979s, the double expansion of investment in both capital construction and innovation was another kind of runaway investment. The “ghost hunting” activities led by Xu Yi enlightened me in my lifelong research in investment and capital. It is also because of this “ghost hunting”

that CCB started to focus on investment scale and the cadre from the Ministry of Finance and CCB learned a profound lesson on excessive investment. The troubles made by government departments, local governments and enterprises on a micro-economic level will be solved by the Ministry of Finance and the CCB on a macro-economic level. This “ghost hunting” and the discussion on the concept of investment with the State Planning Commission made us deeply understand Marx’s words: On the basis of public ownership, society has to calculate

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beforehand how much it can invest in capital construction without detriment to existing production. It becomes the theoretical basis for my study on investment throughout my life.

Marx: The Depreciation Fund Is Also the Accumulation Fund for Expanded Reproduction Some people may question: How can we regard the depreciation fund as a new form of the accumulation fund, since the depreciation fund is just a kind of compensation fund and the stock of existing capital in the capital formation

mechanism? It is right that the depreciation fund is used to replace the portion of value gradually transferred to products through the wear and tear of fixed capital. The reason why the depreciation fund is considered as a compensation fund is because fixed assets repetitively perform the same functions in social reproduction whose value is transferred to products through wear and tear and compensated

through the selling of the products, and the depreciation fund will be used for

the renewal of fixed capital and transformed into new fixed capital which will be renewed in kind (this renewal will bring about massive moral depreciation) at the end of the useful life of old fixed assets. But this is just one side of the story.

The other side of the story is that the compensation of fixed assets in value

and those in kind are different in time. During the depreciation of capital, the depreciated capital “dies” in name only, and the use value of the remainder can

continue to function in production as long as the capital does not wear out and must be replaced; while the nominally “died” capital, i.e. depreciation allowance, can still be used for accumulation and expanded reproduction as long as it serves

for no immediate compensation. A depreciation fund is both a compensation fund and an accumulation

fund. The one who discovered this law was none other than Marx. In this way, depreciation has been incorporated into the capital culture. How did Marx find that depreciation funds are at the same time funds for compensation and accumulation? When Marx wrote Das Kapital, he had already discovered that the compensation of fixed assets in value is inconsistent with that in kind in terms of time. In his letter to Engels on August 20, 1862, he wrote:

One point about which you, as a practical man, must have the answer, is this. Let us assume that a firm’s machinery at the outset = £12,000. It wears out on an

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average in 12 years. If then £1,000 is added to the value of the goods every year, the cost of the machinery will have been paid off in 12 years. Thus far, A. Smith and all his successors. But, in fact, this is only an average calculation. Much the same applies to machinery having a life of 12 years as, say, to a horse with a life — or useful life — of 10 years. Although it would have to be replaced with a new horse after 10 years, it would in practice be wrong to say that 1/10 of it died every year. Rather, in a letter to Factory Inspectors, Mr Nasmyth observes that machinery (at least some types of machinery) runs better in the second year than in the first, at all events, in the course of those 12 years does not 1/12 of the machinery have to be replaced in natura each year? Now, what becomes of this fund, which yearly replaces 1/12 of the machinery? Is it not, in fact, an accumulation fund to extend reproduction aside from any conversion of revenue into capital? Does not the existence of this fund partly account for the very different rate at which capital accumulates in nations with advanced capitalist production and hence a great deal of capital fixe, and those where this is not the case?3 More than 10 days later, Engels replied to Marx on September 9, 1862: “Likewise the question of wear and tear is where, however, I rather suspect you have gone off the rails. Depreciation time is not, of course, the same for all machines. But more about this when I get back.”4 Unfortunately, this topic was not touched upon afterwards. Five years later, on August 24, 1867, Marx reminded Engels about this issue again: “I am again obliged to seek your advice on one point, as I did many years ago. Fixed capital only has to be replaced in natura after, say, 10 years. In the meantime, its value returns partially and gradatim, as the goods that it has produced are sold. This progressive return of the fixed capital is only required for its replacement (aside from repairs and the like) when it becomes defunct in its material form, e.g., as a machine. Prior to that, however, these successive returns are in the capitalist’s possession. Many years ago I wrote to you that it seemed to me that in this manner an accumulation fund was being built up, since in the intervening period the capitalist was of course using the returned money, before replacing the capital fixe with it. You disagreed with this somewhat superficially in a letter. I later found that MacCulloch describes this sinking fund as an accumulation fund. Being convinced that no idea of MacCulloch’s could ever be right, I let the matter drop.

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His apologetic purpose here has already been refuted by the Malthusians, but they, too, admit the fact. Now, as a manufacturer, you must know what you do with the returns on capital fixe before the time it has to be replaced in natura. And you must answer this point for me (without theorising, in purely practical terms).5 Two days later, Engels wrote back to Marx and explained: “There is no doubt

that the manufacturer is using the replacement-fund on average for 4½ years

before the machinery is worn out, or at least has it at his disposal.” He continued: ”Regarding the economic significance of the matter, I am none too clear about it, I

do not see how the manufacturer is supposed to be able to cheat the other partners

in the surplus-value, that is, the ultimate consumers, by thus falsely representing the position — in the long run.”6 Engels sent two schedules for machinery to Marx the next day and told Marx that if the depreciation rate is 10%, a capitalist could

“increase his machinery by 60% and without putting a farthing of his actual profit into the new investment.”7

Marx, thereby, concluded in Theories of Surplus Value: “The sinking fund, i.e.,

the fund for wear and tear of the fixed capital, is, in my opinion, at the same time a fund for accumulation.”8

Later, when commenting on Malthus, Marx cited the words of Malthus on

McCulloch: “Mr. McCulloch…conceives that the introduction of machines into any employment necessarily occasions on equal or greater demand for the disengaged

labourers in some other employment, …In order to prove this, he supposes that the annuity necessary to replace the value of the machine by the time it is worn out, will every year occasion an increasing demand for labour.”9 Marx then

commented: “The sinking fund itself can, indeed, be used for accumulation in the

interval when the wear and tear of the machine is shown in the books, but does not actually affect its work. But in any case, the demand for labour created in this way is much smaller than if the whole capital invested in machinery were laid out in

wages, instead of merely the annual wear and tear. MacPeter is an ass—as always.

This passage is only noteworthy, because it contains the idea that the sinking fund is itself a fund for accumulation.”10

Marx asserted: “Hence where much constant capital, and therefore also much

fixed capital, is employed, that part of the value of the product which replaces the wear and tear of the fixed capital, provides an accumulation fund, which can

be invested by the person controlling it, as new fixed capital (or also circulating

capital), without any deduction whatsoever having to be made from the surplus-

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value for this part of the accumulation (see McCulloch). This accumulation fund does not exist at levels of production and in nations where there is not much fixed capital. This is an important point, It is a fund for the continuous introduction of improvements, expansions, etc.”11

In another place, Marx added: “We have seen that where capitalist production

is developed, that is, where the productivity of labour, the constant capital and particularly that part of constant capital which consists of fixed capital are developed, the mere reproduction of fixed capital in all spheres and the parallel reproduction of the existing capital which produces fixed capital, forms an accumulation fund, that is to say, provides machinery, i.e., constant capital, for

production on an extended scale.”12 In conclusion, the sinking fund or depreciation fund is not only a compensation fund but also an accumulation fund for expanded reproduction.

Accelerated Depreciation: Speed Up Compensation for Advanced Capital Accelerated depreciation is an advancement of the capital formation mechanism. It

fully takes into account the rapid development of new technology and the possible moral wear and tear, features accelerated replacement, and aims to ensure for enterprises the renewal of fixed assets in the form of technical improvements.

At first, capitalist society will set aside depreciation funds in accordance

with the average use life of fixed assets. This method can help enterprises to

stabilize costs and make excess profits by expanding the life expectancy of machines if technological changes are minor. On the contrary, if there is a dramatic technological change, this depreciation method can no longer compensate

the moral depreciation resulting from early obsolescence of technology and equipment, and thereby expose the problems of this method of long depreciation life, low depreciation rate, and high risk.

The first industry which revealed those problems was the military industry.

During World War Two, Western countries took the initiative in speeding up depreciation and shortening the service life of equipment in military industry

enterprises, in order to encourage capitalists to make investments and production in the military industry. The Bulletin “F” in 1942 promulgated by the U.S.

government reduced the depreciation life of fixed assets in military industry

enterprises to 5 years (from 20 to 30 years). Then, during the Korean War, accelerated depreciation was again applied to the military industry enterprises by

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the U.S. government. The merit of this method is that the compensation of original capital is secured before tax payments and profit distribution. The downside,

however, is the massive loss of taxes owed to the government. Consequently, after the wars, Western governments postponed the accelerated depreciation.

After the Second World War, capitalist enterprises encountered some

outstanding problems when recovering from the effects of the war: Heavy tax

burden, excessive dividends, low depreciation rate, extended service years of equipment, huge debts from equipment replacement, and inadequate compensation

for fixed assets. In the meantime, the rapid development of science and technology

in the postwar years called for a new form of compensation investment since the low depreciation rate could hardly make up for the moral wear and tear caused

by the early obsolescence of technology and equipment. It revealed that the old depreciation system could no longer satisfy the need of the compensation fund. Since enterprises required accelerated depreciation, the government had to choose

between a low depreciation rate which would continue the heavy tax burden and bring about a persistently depressed economy or even paralyzed economy, and a high depreciation rate which would increase the compensation fund.

In 1985 when I joined the Investment Policy Seminar of the Economic Research

Center of the State Council, I studied accelerated depreciation. I found that after

the Second World War, governments in Western countries generally sped up

depreciation, and intended to use less total tax to encourage capitalists to give up

a portion of dividends for the purpose of equipment renewal or replacement. The

government made use of the increase in industrial orders in engineering, steel, and other industries to show a multiplier effect in order to beat economic recession

and achieve economic recovery. Western countries, such as the Federal Republic of Germany, Japan, France, and the United States, chose the accelerated depreciation.

At that time, Zhang Yuping from the investigation department of the CCB

compiled a book called Selected Investment Statistics of Fixed Assets of Foreign Countries (1954–1980). The book showed the proportion of the depreciation funds of fixed assets to Gross National Product (GNP) in Western countries (see Table 5.1). Table 5.1

1954 1960 1977

Proportion of depreciation funds for fixed assets to GNP in Western countries (%) U.S. 8.82 9.06 12.12

U.K. 7.83 7.61 11.26

France 9.37 8.79 11.23

Germany 8.07 8.83 11.18

Japan 7.28 10.66 13.03

Source: Investigation Department of CCB, Selected Investment Statistics of Fixed Assets of Foreign Countries (1954–1980).

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From the above table, we can see an upward trend of the proportion of

depreciation funds in Western countries. Of course, this growth may also result from the increase in the total fixed assets, but the change from low depreciation rate to accelerated depreciation must be an important reason.

The Ministry of Finance in Japan believes that accelerated depreciation is a

good way to develop financial resources. In 1986, I made an investigation into

the automobile industry in Japan. Japanese people thought that the accelerated depreciation practiced in the Japanese automobile industry substantially increased

the proportion of depreciation funds in the own capital of enterprises. The proportion was 50% in 1960, 66% in 1961, 71% in 1962 (calculated based on the

statistics of 12 factories), and 74% in 1964 (calculated based on the statistics of 15 factories), which accumulated a large number of funds for the great development of

the automobile industry in 1968. Among the investments in the Japanese automobile industry, the proportion of own capital investment was 50% in 1960s, increased to 70%–90% in the 1970s, and further raised up to 95% in the mid-1980s. This

indicates that accelerated depreciation played an indispensable role in strengthening enterprises’ financial capability in self-transformation and self-development.

The statistics of the U.S. reveal another aspect of the function of accelerated

depreciation. In 1962, the American government revised the depreciation policy

by establishing a guideline life of equipment which brought about an annual decrease of USD1.5 billion in tax payments, but the profits obtained through stimulating investment were three times as large as the tax decrease. In 1971, the

Nixon administration relaxed the depreciation policy, which would lead to a tax reduction of USD3.9 billion per year. In 1981, the Reagan administration further

shortened the depreciation period of automobiles from 3.5 to 3 years, industrial equipment from 8.6 to 5 years, and factory building from 23.8 to 15 years. The

benefit gained by enterprises from tax cuts was USD9.7 billion in 1982, USD18.8 billion in 1983, and over USD30 billion in 1984, but the government believed that accelerated replacements would bring greater economic and financial benefits to the United States.

The move from a low depreciation rate to an accelerated depreciation rate

was a breakthrough of the capital formation mechanism in speeding up the

compensation for advanced capital. It replaced the high-risk equal-annual

payment depreciation with accelerated depreciation and enabled enterprises to first compensate for initial capital before making accumulation, paying taxes, and allocating profits. It increases the compensation fund and promotes the positive

cycle of reproduction by speeding up depreciation. Of course, this compensation

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fund, as Marx has said, is not only the fund for the wear and tear of the fixed capital, but also a fund for accumulation.

Technology Transfer Fee: Mechanism for Intangible Assets Compensation and Accumulation Science and technology developed quickly after the Second World War, and Western developed countries produced a great number of scientific and

technological innovations, including new equipment, new technology, new processes, new material, and new products. The trade in technology rose along with this trend, and there were demands for the transfer of technical

achievements, production technology, know-how, software, etc. In the meanwhile, some enterprises in Western developed countries spontaneously transferred

technological achievements through technology trade and adopted technology transfer fees to compensate for the investment in the trial production of technology. The charge for technology transfer was generally composed of two parts: One

was the one-time transfer fee of technical patent, widely known as “initial down

payment,” which will be charged once the transfer agreement becomes effective; the other is the recurring technology transfer fee collected according to a certain

proportion of annual output, also known as “royalty.” This charging method was soon accepted by the society and protected by the law in the economic life of society. It becomes an important part of intellectual property protection.

This transfer of technology facilitates the technological progress. In one

aspect, the popularization of science and technology turns science and technology

into productive forces of society and brings about huge economic benefits to both society and enterprises. In the words of Alan Greenspan, the technological promotion turns what is “scarce and expensive” into something “cheap and

common.” In the other aspect, the rapid advances in the high tech field and the

substantial increases in technical experiment investment (in which intangible assets occupy a considerable proportion) require new forms of technology transfer and intangible assets compensation and accumulation mechanisms.

A technology transfer fee has, therefore, come into being. It is a compensation

system of technological investment and a supplement to the capital formation mechanism of intangible assets, and for the society a system for the establishment

and the stable operation of science and technology development funds in the

national economy. It constitutes the investment and costs of intangible assets for the enterprises which introduce new technology while an effective form for the

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compensation and accumulation of intangible assets for the enterprises which disseminate the technology.

The Detour on the Way to the Development of Depreciation Fund and Fund for Simple Reproduction Since the first five-year plan of large-scale economic construction in 1953, New

China implemented highly centralized planned economic and fiscal systems. All income of state-owned enterprises, including profits and depreciation, should be turned over to the financial department. Spending on each item by

these enterprises, whether the investment by newly-built enterprises in capital

construction or the renovation and reformation investment by long-established enterprises (including the renewal of factory buildings and equipment) had to be

reported to the state finance ministry for approval and budgetary provisions in the form of capital construction plan.

Such a highly centralized kind of management was difficult to be implemented.

Economic activities change day after day, and it is impossible to include every

investment of all enterprises in a national capital construction plan without any errors or omissions. This rigorous policy frequently met with opposition from the industrial sector since the promulgation in 1952. During the three-year Great Leap

Forward between 1958 and 1960, this system was abolished with the practice of decentralization. In this period, Mao Zedong advocated setting “two targets,” the one obligatory to attain and the other aspired for, with the investment quota was

increased at every lower level, and thus the investment in capital construction expanded massively. Moreover, in practice, people regarded capital construction investment as investment in expanded reproduction, and therefore many economic

sectors used the planned provisions for capital construction to invest in expanded

reproduction, especially in new projects. As a result, investment in simple reproduction was crowded out and could not be guaranteed and there was a huge debt from equipment replacement.

The adverse impact from the incremental investment at every lower level in

capital construction during the Great Leap Forward was revealed in the economic

adjustments in the early 1960s and mainly reflected in the inadequate investment for maintaining current production level.

First, the debt caused by equipment update in long-established enterprises was

exposed. The earliest cases were the debts from the maintenance of automobiles, industrial boilers, and diesel engines in the four major cities of Tianjin, Beijing,

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Shanghai, and Shenyang, and the outstanding renovation costs for rolling stock in

the Ministry of Railways. So the state finance ministry appropriated RMB1.3 billion for three consecutive years for repaying the debts incurred by equipment update.

In the meanwhile, many other long-established enterprises also suffered

from equipment replacement debts. At that time, Sun Yefang suggested that the central government leave depreciation funds to enterprises to ensure the simple

reproduction of fixed assets. His advice aroused a discussion on depreciation funds and simple reproduction in the economic circle, especially in the biweekly

economic symposium hosted by Red Flag magazine. I was working for the CCB

then and joined the discussion with Xu Yi, President of the bank. I organized a team to investigate the simple reproduction in dozens of sectors and provided over 10 investigation reports to the biweekly meeting.

The shortage of investment in sustaining simple reproduction also disclosed

the outstanding expenses for the expansion in excavating and logging industries.

According to the regulation of that time, building new mines and forests was a function of capital construction and the expansion of existing mines and forests was to be conducted according to the national capital construction plan. However, the capital plans usually focused on developing new mines and forests without

making proper arrangements for the expansion of old ones. So the old mines and forests lived off their past gains and created huge debts in the expansion works.

Dong Biwu then wrote a poem to describe the situation and the closing line

said “To act rashly is of no use.” In order to solve the investment for the expansion of old mines and forests, the financial department stipulated in 1962 that the

expansion expenses of coal mining and forest harvesting could be drawn from the costs of coal and wood according to a certain percentage of output as a fund

for maintaining simple reproduction, and this fund would be independently used

by competent departments instead of being approved by the state according to the national capital construction plan. It was very beneficial for regulating the

production of mines and forests. The nature of this fund was said to be the capital construction fund and it was not included in the state budget. Similarly, oilfield

maintenance costs, namely the costs for drilling injection wells around oilfields to increase pressure and thus maintain original oil extraction capacity when the

oil resources and oil productivity decreased, were also drawn from the costs of crude oil according to a certain proportion to the crude output. These measures

guaranteed the funds for simple reproduction and were necessary supplements to the capital formation mechanism during the planned economy period.

The Party Central Committee and the State Council summed up a lesson

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from this experience in the national economic adjustments in 1962: Any works of

socialist economic construction, be it plan making, economy managing, or material supplying, must put simple reproduction at the first place before undertaking expanded reproduction.

Because of this, in the capital construction plan of 1962, under the capital

construction investment target, an investment quota for maintaining simple reproduction was specially set up. It provided that “production capacity was to

be maintained, production content and investment volume should be itemized, and the fund for compensating the defunct production capacity in the investment for maintaining current production capacity should be specified.” The central

government also stipulated that when departments employed the expansion expenses of coal mining and forest harvesting and the oilfield maintenance costs in mine development and oilfield maintenance, they should make a capital

construction plan by themselves. It should be said that the separation by the state

of the simple reproduction investment in the excavating and logging industries from the capital construction investment during the economic adjustments in 1960s

practically solved the leftist impact from the Great Leap Forward. This method of

directly extracting funds for maintaining simple reproduction from the product sales revenue complied with the rule of production and was a supplement to the capital formation mechanism.

The development of fixed-asset depreciation funds was not as unsmooth

as that of funds for simple reproduction. Despite repeatedly being blamed, the

Ministry of Finance required enterprises to turn over depreciation funds to the state instead of keeping it for the update of fixed assets until 1969 (i.e. during

the Cultural Revolution). But afterwards many grassroots enterprises still could not benefit from the changed policy, since some central departments and local governments continued to use all or parts of the depreciation funds in a centralized

way. To leave the depreciation fund to enterprises was for the renewal of fixed

assets, but many central departments and local governments concentrated on the fund themselves for expanded reproduction. The survey after the reform and opening up of 1978 discovered that the debts incurred by the update of fixed assets were worse than those of the early 1960s.

The situation of fixed-asset investment after the 1970s was different from

that in the past when the depreciation fund was turned over to the financial

department or diverted to other purposes, or that during the Great Leap Forward when the fund for expanded reproduction crowded out the investment for simple

reproduction. For one thing, the State Planning Commission intended to devote the

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capital construction investment of billions to expanded reproduction projects while leaving small investment at the disposal of the finance department. For another, the

Ministry of Finance was willing to set aside a portion of money for the innovation

and renovation projects of local departments. In fact, the State Development Planning Commission and the Ministry of Finance left a large number of funds for enterprise innovations and created many capital channels for small projects and

small economic measures. Competent departments and manufacturing enterprises

welcomed these innovation funds. They are a supplement in the capital formation mechanism for small investment and innovation investment of enterprises under the circumstances of fixed-asset renewal fund being diverted to other purposes and funds for maintaining simple reproduction being not guaranteed.

In this way, many replacement investments were divorced from capital

construction and there were roughly 5 categories:

1. Special appropriations directly from financial budgets, such as innovation, renovation, and reconstruction funds, subsidies to five types of small industrial

enterprises (i.e., iron and steel plant, coal mine, chemical fertilizer plant, power station and machinery plant, later non-ferrous metals, agricultural machinery and cement plans were added to this category), mobilization subsidies for

producing deficient products or manufacturing goods for civil use by military industrial enterprises, and investment allowance for specialization and collaboration.

2. Funds extracted or retained from costs (commerce circulation costs), such as

small construction funds of simple sheds and warehouses for commercial use, food and trade departments, funds for the simple construction of retail outlets for the aforementioned departments, funds for small oil tanks.

3. Bank loans, such as small technical loans to industrial enterprises by the CCB and special loans for industrial exports to the manufacturing enterprises.

4. Local governments can impose certain fees on enterprises, for example, 49 municipal governments extracted urban construction and maintenance fees from industrial and commercial profits.

5. The foreign capital borrowed and repaid independently by enterprises could be excluded from the capital construction plan and state budget, namely, the so-called “second-front investment.”

In this way, the fixed-asset investment is divided into two parts: One was

capital construction investment; the second was the investment for innovation and

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transformation. But the investment scale of the innovation fund grew larger and

larger over a long period and was similar to that of capital construction. Moreover,

the State Planning Commission did not want to see a slight decrease in the planned capital investment and, as a result, the investment scale of fixed assets got out of control.

Great Debate on the Concept of Investment Triggered by Double Expansion of Investment In 1979, when the reform and opening up policy was first announced, there was a debate on the concept of investment in capital construction and fixed assets in the economic sphere. On one side of the debate was the State Planning Commission,

and on the other side was the CCB. The question being debated seemingly was

whether innovation investment should be included in fixed-asset investment, but the real focus was on whether the investment scale of fixed assets was too large.

The origin of this controversy lied in the definition of capital construction

investment in the early stages of New China. In 1952, China initiated the first fiveyear plan of massive economic construction. At that time, China undertook 156

major construction projects with the aid of the Soviet Union, and borrowed from

the Soviets the concept of capital investment as a replacement for the commonly

mentioned fixed-asset investment in economic life. So what is capital investment? According to the Interim Measures for Capital Construction Works promulgated by the Government Administration Council of China’s Central People’s Government in 1952, “whatever new construction, reconstruction, restoration projects of the

expanded reproduction of fixed assets or the related projects should be considered as capital construction.” The Political Economy (third edition), a textbook issued by

the Economics Institute of the Academy of Sciences of the Union of Soviet Socialist

Republics also gave a definition of capital construction: “Capital investments are the total outlays used over a particular period to create new productive and non-productive fixed funds and to reconstruct those already in existence.” 13

Based on economic common sense, social reproduction always means expanded reproduction and the expanded reproduction is always carried out under the

basis of simple reproduction, just as Marx has said: “As far as accumulation does take place, simple reproduction is always a part of it … and is an actual factor of accumulation.”14 Therefore, there is no doubt that capital investment has to comprise both expanded reproduction and simple reproduction of fixed assets.

During the socialist construction of New China, however, the aggressive leftist

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thinking always prevailed. People wondered that despite the fact that the economic

development of European capitalism extended over 300 years, could the economic

construction of a socialist society develop faster? So China put the pursuit of high speed and high growth of economic development above everything. The definition

in the Interim Measures for Capital Construction Works provided an important basis

for many economic departments equating capital construction with the expanded reproduction of fixed assets. This was also the reason why many economic departments diverted the capital investment allocated according to the state plan

to the investment of expanded reproduction, which crowded out the funds for

simple reproduction and caused debts in equipment replacement during the Great Leap Forward.

In the later period of the Cultural Revolution of the 1970s, the leftist thinking

in economic life surged and people were eager to boost the economy. It was principally manifested in the fact that the planning department pursued a fast

and high economic growth and intended to use large-scale capital investment to ensure the high target in the economic plan. It was because of this that the planning department extended the definition of expanded reproduction of

fixed assets in the Interim Measures for Capital Construction Works to an unwritten

definition: Capital investment is the state spending for changing the structure

of the national economy, rationally allocating productive forces and increasing production capacity and project benefits. This unofficial definition, in fact, became

a principle of investment allocation in real economic life for a long period of time. So the planning department regarded investment as capital construction for the

expanded reproduction of the national economy and equated capital construction with accumulation and expanded reproduction. The department allocated the

budget appropriations for capital investment to expanded reproduction projects, and the innovation projects of simple reproduction were excluded from the capital

construction plan under a separate investment arrangement. Local governments

and governmental departments were, however, frequently in need of innovation projects and had to ask the finance department to set aside a fund for this

purpose. Since these innovation projects contributed a lot to the increase of fiscal revenue, the finance department was willing to help. In this way, the investment

scale of fixed assets was expanded through two channels of capital construction and technical innovation, and thus the special situation of double expansion of investment came into being in this period.

In 1975, Deng Xiaoping took to the political stage again and emphasized

overall economic improvements. In the middle of the same year, I returned to

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Beijing from the May Seventh Cadre Schools of the Ministry of Finance, and the

CCB, and I was transferred to the financial department for capital construction under the Ministry of Finance where I worked closely with the Capital Investment

Bureau of the State Planning Commission. When I came back, the authorities of the CCB had designated me to research the investment scale of fixed assets, and I

found that there was a large amount of innovation and renovation investment from the financial budget, government departments’ funds, bank loans, and enterprises’

production costs beyond the planned capital investment, which created a massive

expansion of fixed-asset investment. I joined the “ghost hunting” activities led by

Xu Yi in 1959 and studied the impact of runaway investment on the economy and finance during the Great Leap Forward. Later in 1962, I experienced the period

when the CCB was asked by the finance department to fill the capital holes created by the local government and government departments which were attempting to double investment, and thus deeply understood the severe damage of excessive investment expansion on financial works. We had prepared a report about the

double expansion of investment but it was not made public due to the political criticism of Deng Xiaoping.

Since the toppling of the Gang of Four in 1976, the national economy

experienced a period of contraction and rectification. Vice Premier Hua Guofeng

was anxious for success, so he demanded that we “aim high and go all out” and

intended to construct 10 oilfields as large as Daqing Oilfield, 20 iron and steel plants as powerful as Angang Steel, 10 sizeable coal bases, and 22 imported

projects. The construction scale was extremely huge. The root cause for the rush for quick results was the leftist thinking which pursued high speed and new

advances. In September 1978, Li Xiannian made a calculation in the TheoryDiscussing Meeting of the State Council. The planned investment in projects

under construction was RMB280 billion while now the total amount increased to RMB360 billion. There were 12,000 unplanned projects under construction with an investment of RMB12 billion. If all these projects were to be completed, RMB160

billion more investment was probably needed. The investment amount was inflated once again.

The Third Plenary Session of the 11th Party Central Committee was convened

in 1978. In early 1979, Deng Xiaoping and Chen Yun noticed the leftist thinking

in the economic works, and proposed to adjust the economy by “pressing down

accumulation and reducing capital construction.” Against such a backdrop, the Vice President of the CCB, Liu Lixin, asked us to recalculate the investment scale.

Based on the accounts of 1975, we continued to investigate the planned innovation

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and reformation projects beyond capital construction, and as a result, we got the five categories as stated in the previous section.

According to the calculation, the investment in capital construction within the

state plan was no larger than RMB39.6 billion while the unplanned investment in simple reproduction and renovation projects was RMB36.4 billion. The total

planned and unplanned investment amounted to RMB76 billion and was

collectively called the “six battlefields.” Of course, it was not parallel with the

current annual fixed-asset investment of several trillion, but under the then

national power, RMB 10 or 20 billion more investment would be enough to disrupt the whole economy.

What is the proper size of investment? The generally accepted standard was

the “two, three, and four principle” suggested by Bo Yibo when he concluded the

experience from the first five-year plan. The principle stipulated that accumulation

should account for 20% of national income, fiscal revenue should account for 30%

of national income, and capital construction expenditure should account for 40% of fiscal expenditure. Based on our previous calculation, the proportion of capital

construction expenditure to fiscal expenditure was around 38%, which was within the proper size of 40%; however, if the innovation investment was also included

(namely, all fixed-asset investment was counted in), the proportion would go up to 56%, much larger than the generally accepted ceiling and that of the first five-year plan but close to the percentage during the second five-year plan when the threeyear Leap Forward gave rise to a huge investment expansion.

A larger problem was that although a large amount of money was allocated

by the state to support those projects, there were no sufficient materials and even

no corresponding material supply channels. This material shortage caused the retention of funds. According to statistics, the annual surplus in the innovation and renovation funds in industrial enterprises nationwide was around RMB12–13 billion, among which half was for materials and remaining construction, and the

rest was bank deposits. The project duration was usually very long and among the 4,287 undergoing innovation and renovation projects above RMB1 million, 2,068

projects (48%) have been under construction for two years and are still not yet finished; 895 projects have been underway for three to five years, 307 projects for five to eight years, and 61 projects for over eight years.

Due to the double expansion of investment in capital construction and

renovation, all fixed-asset investment was equal to 56% of the total sum of capital in and out of the budget. Liu Lixin, Vice President of the CCB, asked us to draft a report about the current investment to the central government. The Report of the

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CCB said that the new situation of investment indicated that the term of capital investment could no longer truly reflect the construction investment scale and therefore “fixed-asset investment” comprising capital construction and technical

transformation was a better choice for measuring construction investment scale. It was a sensitive question, however. The CCB officials dared not directly report to the central government. Liu Lixin decided to turn the report to the Central Leading

Group on Financial and Economic Affairs of the Communist Party of China (CPC) and Chen Yun, and this created a great stir. The State Planning Commission

criticized the CCB for “placing a heavy bomb” for the group, and wrote an article

to rebut. The State Planning Commission said that the “depreciation fund is aimed

to compensate the wear and tear of fixed assets instead of expanded reproduction,” and “you cannot call the adding of a new motor in a manufacturing shop as a

capital construction. The commission also questioned the CCB’s definition of fixed-asset investment and thought that the definition “mixed up various funds

of a different nature, purpose and objective” and thus the new definition could neither accurately indicate the scale of capital construction nor show the difference between capital construction and innovation projects, and between expanded reproduction and simple reproduction. CCB was also blamed for “not being serious and conscientious” and “fabricating questionable figures and confusing the concept.

Chen Yun was cautious. He said the figures of just one year could hardly

disclose any problems and assigned the CCB to make a 30-year report by applying

the same criteria. Later on, the Ministry of Finance and the CCB collectively sent a new report of fixed-asset expenditure in and out of budge for 30 years to the

Central Leading Group on Financial and Economic Affairs and Chen Yun. Finally, Chen concluded that “economic adjustment is necessary.” He explained: “The

capital investment of the next year (namely, 1980) proposed by the State Planning Commission is RMB25 billion, and that by the finance department was RMB17

billion. Both figures are less than the investment in 1978 of RMB45.1 billion and that in 1979 of RMB36 billion. This actually proves that the investment in either

1978 or 1979 exceeded the state’s financial and material capabilities.” Chen Yun continued to emphasize that “the investment beyond national financial and material capabilities emerged after 1970, and that is why the duration of capital

construction was very long.” At that time, Chen Yun’s words carried weight and confirmed the excessively long duration of capital construction after 1970, and

therefore the State Planning Commission had to examine the planning work, especially the capital construction, of this period.

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Since the State Planning Commission stated that the depreciation fund could

only be used for simple reproduction rather than accumulation and expanded

reproduction, Tian Chunsheng and other people from the CCB including me drafted a report and prepared some special quotations from Marx on expanded reproduction and simple reproduction as an appendix to the report. One of the

quotations said that “The sinking fund, i.e., the fund for wear and tear of the fixed

capital, is, in my opinion, at the same time a fund for accumulation.” Li Xiannian

attached great importance to this sentence and regarded it as an important discovery.

The State Planning Commission and our CCB team split on the definition of

fixed-asset investment since the former insisted that innovation and renovation should not be counted in the expanded reproduction. At that time, Gu Mu was

the Director of the State Planning Commission and he appointed Xue Baoding to

take charge of the newly built Research Institution of Capital Construction. The institution was responsible for studying the concept of fixed-asset investment, and thereby a great debate on the concept of capital construction and fixed-

asset investment was started in the theoretical circle. The report from the CCB

for the first time formally adopted the term of “fixed-asset investment” and put forward that the investment sizes of its two components, namely capital

construction and technical reform, should be limited to a total amount with the increase of one at the expense of the decrease of the other. On the contrary, the State Planning Commission held that only capital construction would realize the

expanded production of the national economy and accused the CCB of confusing different concepts. The debate on the definition was just an appearance, the real

issue was whether and how to control investment scale. In spite of the argument

from the State Planning Commission, it was undeniable that the duration of capital construction was too long and the investment size was too large. Later,

the Research Institution of Capital Construction specially wrote an article on

this debate and admitted that capital construction was merely a concept of management rather than theory.

One of the important achievements of this debate was the confirmation of the

concept of “fixed-asset investment.” During The 4th Plenary Session of the 5th

National People’s Congress in August 1980, Zhao Ziyang substituted Hu Guofeng

as Premier of the State Council. When Zhao Ziyang talked about the plan of 1981 on the Central Work Conference on December 16, 1980, he said: “How to reduce investment? We should first cut down the investment in capital construction.

The capital construction investment within the state budget should be decreased

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from RMB24.1 billion of this year to RMB17 billion, a drop of RMB7.1 billion. The total scale, including the self-raised funds by the local government, government department and enterprises, bank loans, and investment in the installation of

imported equipment, should be reduced from RMB50 billion this year to RMB30 billion.” The total scale of investment in and out of the budget mentioned by his was in fact that of fixed-asset investment covering both capital construction and technical reform. The Report on the Work of the Government of 1981 decided that since 1982, the plan of fixed-asset investment prepared by the State Planning

Commission should collectively arrange the distribution of the capital construction fund and the technical reform fund. From then on, the investments in fixed-

asset renewal and that in innovation and reformation projects were collectively

called “technological upgrading investment,” which was listed in the fixed-asset

investment plan together with capital construction investment. The technological upgrading investment got its rightful place in capital formation mechanism

and the reproduction of fixed assets finally returned to its proper position in the reproduction theory of Marx.

Five Kinds of Moral Depreciation There is another problem in the fixed-asset upgrading, that is, concerning the wear

and tear of fixed assets, Chinese people for a long period of time focused only on

material depreciation rather than moral depreciation and its proper compensation. China’s financial system always practices a low depreciation rate and takes no account of moral wear and tear, and thus China is reluctant to adopt the

accelerated depreciation. Marx once talked about two kinds of moral depreciation of fixed assets, and in fact many more kinds of new moral depreciation are added

in real economic life since the upgrading of technology and technical equipment was really fast thanks to the rapid scientific and technological advances. In 1986, I made an analysis of five kinds of moral depreciation.

1. The drop of selling price of machines and equipment due to the improvement in labor productivity and the reduction in cost, or in other words, the loss

caused by the devaluation of old equipment is called “moral depreciation 1.” For instance, a factory buys two sets of C-type grinding machines when the

machine first comes out at a price of RMB50,000 per set. One year later, the price of the grinder is decreased to RMB20,000 per set due to the increase in

labor productivity, and thereby the C-type grinders bought at first depreciated RMB30,000.

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2. The emergence of new machines with better quality, lower consumption, and higher efficiency would bring down the economic benefits of the original machines, and thus give rise to the advanced replacement of the old machines. The loss in efficiency of old equipment is called “moral depreciation 2.” There are two examples: 1) The Model DG250/160 industrial pump with energysaving effect could substitute for the Model DG270/140 pump. If such a substitution is made at an early date, the money saved on electricity bills in one year will be enough to buy a new pump. On the contrary, if the old pump continues to be used, more than 720,000 kilowatt-hours of electricity will be consumed each year, and the moral depreciation of RMB57,000 production cost will thus be created; 2) The medium and low-voltage power generation units will consume 500 grams of coal per kilowatt-hour of electricity they generate, while the high-voltage units only need 350 grams. Therefore, the power plant can choose to either bear the moral wear and tear and replace the medium and low-voltage power generation units with high-voltage ones in order to save 150 grams of coal per kilowatt-hour of electricity and reduce costs, or continue to use the old units and pay the production cost of consuming 150 grams more of coal per kilowatt-hour of electricity. Moral depreciation 1 and 2 are the two types of wear and tear mentioned in Marx’s works. 3. The loss caused by the advanced retirement of fixed assets due to the upgrade of products is called “moral depreciation 3.” Different from the above two kinds, moral depreciation 3 is not a result of the change in the means of labor but that of the rapid development of science and technology. The significant breakthrough in science and technology brings about the upgrade of products and also calls for the adoption of new materials, new equipment, and new processes to produce multi-function and high-quality products. As a result, the subject of labor is changed and there is a need to transform factories, workshops, and production lines, which in turn causes the advanced retirement and upgrading of fixed assets even when their value and use value are in good condition and thus generating moral depreciation by redistributing productive forces. The following are the examples of moral depreciation 3 which appeared during the upgrading of products. Phosphate fertilizer products were produced in place of the products with normal superphosphate in order to lead to the production of the high-efficient

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ammonium phosphate fertilizers and heavy calcium carbonate fertilizers. Urea fertilizers and compound fertilizers were developed since ammonium bicarbonate is eliminated by nitrogen in fertilizer products. Consequently, a batch of equipment, production lines, workshops, and factories will be scrapped ahead of schedule and a number of qualified factories will be transformed and switched to the production of other things. Since the low-efficiency and highly toxic pesticides with chlorine as the main ingredient are weeded out, the whole fixed assets of some pesticide plants need to be abandoned. Moreover, the caustic soda industry lost a big consumer of chlorine and demanded rearrangement. Children’s toys used to be made of iron and wood, but now they are made of plastic and electronic parts. Therefore, a loss is incurred by the advanced retirement of the original production lines of wood and iron; on the contrary, the production lines of plastics and integrated circuits as well as new assembly lines will be needed. The product cycle of the electronic industry has accelerated the most significantly. China’s first tube television was available in 1957 and before the tube TV was popularized, transistor black-and-white TV was developed in the 1970s, followed by the emergence of integrated circuit color TV in the 1980s. The development of the computer took the same path: The first generation computer used vacuum tubes, the second generation used transistor computers, the third were computers with integrated circuits, and the fourth were large scale integrated circuit computers. The products’ development followed a trend of more miniaturized products, which apparently accelerated the advanced retirement and replacement of the original fixed assets. The above upgrading of products created a new kind of moral wear and tear, totally different from the already existing two kinds of moral depreciation. The reproduction of fixed assets is now not predetermined by the physical properties of fixed assets but whether the fixed assets could adapt to the needs of new products. The advanced retirement of equipment or production lines is a result of the loss of works instead of the loss of the productive capacity or efficiency.

4. The loss created by the rearrangement of enterprises’ fixed assets due to the socioeconomic adjustment is called “moral depreciation 4.” The first three kinds of moral depreciation are viewed within the scope of an enterprise, while moral depreciation 4 is related to the rearrangement of fixed assets among different enterprises and the early retirement of fixed assets during the merger and acquisition of enterprises and urban renewal, namely, socio-economic

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adjustment. This new moral depreciation is considered from the perspective of

the whole society instead of one enterprise, and roughly includes the following situations:

a. The development of socialized mass production and specialization and collaboration pushes enterprises to undertake scale management and reduce

costs, and thereby big and all-embracing plants built in the early period of

industrial construction have to be reformed into specialized ones with specialized division of labor and collaboration between each other. To be more specific, the

workshops of casting and forging, heat treatment, and plating process and the

parts production line will be separated into specialized production factories which collaborate in various forms (such as separated contractual joint venture, integrated contractual joint venture, joint venture company) to serve for a larger product and, therefore, advanced renewal and retirement of fixed assets will

be incurred due to the fact that some factories have to eliminate the workshops of casting and forging, heat treatment, and plating process and the parts production line in order to become specialized ones.

b. The Industrial restructuring causes the reorganization of productive forces

among different enterprises and industries. The reorganization sometimes resulted from the emergence of new products, new technology, or new industry; and at other times it may have been an industrial reorganization

since comprehensive utilization of raw materials facilitates the production of

new products. For example, oil refineries, chemical plants, and chemical fiber plants, which all depend on oil as raw materials, originally belonged to three

different industries of petroleum, chemicals, and textiles, but their production processes overlap with each other and some intermediate products discarded

by one factory may be absolutely necessary for the production of others. The

oil refineries cast away the highly processed products which are needed by the

chemical and chemical fiber plants, while C4 abandoned by the chemical fiber plants is indispensable for the chemical plants. This causes a waste of materials.

Later, learning from the overseas experience, China establishes the China

Petrochemical Corporation which undertakes the extensive processing of crude oil under the integrated planning of oil refining, chemical processing, and

chemical fiber production in order to develop more processed oil, chemicals, and chemical fiber products by making the most of crude oil, and, therefore, there is a need for the reorganization of fixed assets.

c. The pursuit of economies of scale in industrial development gives rise to the

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adjustment and early reformation of fixed assets among different enterprises. The most typical example is the small nitrogenous fertilizer plants. In the early 1960s, China built a group of small ammonia plants with an annual output of

3,000 tons. Due to the small size, these plants recorded a loss every year, so they were gradually transformed into plants with an annual output of 5,000

tons. However, the deficits were not eliminated until the plants expanded

their annual output into 10,000 tons, and if the plants intend to be profitable, they have to produce at least 40,000 tons of ammonia per year and at the same time be engaged in the co-production of other products. This transformation

towards economies of scale demands, of course, the adjustment of productivity among different enterprises and the early retirement of fixed assets.

d. Urban renewal will bring about industrial restructuring. For example, urban

renewal planning will decide which industry should be developed, retained, or restricted according to the development direction of a city. A city may regulate

the enterprises which generate liquid waste, waste residue, or waste gas in a centralized way and lead the high heat-consuming enterprises to replace dispersed heating with centralized heating, which will cause the reallocation of corporate fixed assets.

e. In the market-oriented reforms, enterprises undertake vertical or horizontal mergers and acquisitions as well as restructuring and practice technical

transformation in order to adapt to the socialized mass production. For instance, petrochemical enterprises have to take into account the mergers and acquisitions of upstream and downstream product processing firms; machinery

enterprises consider the common needs in manufacturing technique through

mergers and acquisitions to prop up the development of casting center, heat treatment center, and electroplating center. The facilities equipped by each

factory in the initial stage of industrialization, such as power, water, oxygen,

gas, machine maintenance, warehouses, and transportation will develop towards a trend of socialization during the market-oriented reform, which will cause the early retirement and losses of a number of workshops and facilities.

f. The moral wear and tear of intangible property is categorized as “moral

depreciation 5.” Enterprises of Western countries take account of intangible properties, while China only records tangible properties without consideration of intangible properties. In fact, however, Socialist enterprises own intangible

properties, such as imported technology, patents and know-how, and enterprises’ inventions and creations, production techniques, specialized

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technology, product design, drawings, etc. Moreover, corporate trademarks and goodwill also belong to intangible properties. All of these are properties created by the enterprise staff through hard work. Similarly, intangible properties will also generate moral depreciation which results from the shortening of economic life and the early obsolescence of these properties with the rapid development of science and technology. The problem is that the establishment of intangible property is just a one-time activity. Once a company buys and masters a technical patent or achieves knowhow, the company can repeatedly use the patent within the patent’s economic life. Before a more advanced patent or bit of know-how replaces the old one, the company will not bother to make another purchase. Therefore, the moral depreciation of intangible properties will be incurred when a more advanced technique or bit of know-how is created ahead of the termination of the expected economic life of the old ones. For example, in 1980, a computer factory introduced the S-model computer production line by investing RMB56 million, among which RMB10 million was used to purchase the S-model product design drawings and the production know-how. The factory originally conceived that after the construction of the factory, 400 sets of S-model computers would be produced every year with six years of the product lifecycle. However, when the factory was finally built in 1983, the technology was on the brink of elimination, so that among the 200 sets of S-model computers produced by the factory between 1983 and 1985, only 50 sets were sold. The factory, thus, had to update its production line and purchase new technical patents and know-how, and in this way, the factory simultaneously incurred moral depreciation 3 and 5. I believe that when calculating the production costs of industrial products, people should admit and take into account this kind of moral depreciation of fixed assets and study the development trend and rule, and the key to this is to carry out accelerated depreciation. China practiced a low depreciation rate during the planned economy and the early market-oriented reforms, and gave more attention to material depreciation

than moral depreciation and compensation of fixed assets. Over the years, voices for increasing the depreciation rate and practicing accelerated depreciation were frequently heard, but none of these generated any results. One high-sounding reason was that the increase of the depreciation rate will impact fiscal revenue and 1% growth of the depreciation rate will deprive the government of several billions in revenue. In fact, it reflects a lack of knowledge towards the positive impact of moral depreciation on scientific and technological advances. In China’s experience

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of financial works, people have long held a comparatively negative impression about moral wear and tear by regarding moral depreciation merely as a loss.

This view is one-sided. In reality, no matter which kind of moral depreciation

of fixed assets, it is the small price to be paid during the tremendous progress

in science and technology. Despite the fact that the advanced adoption of new

technology and equipment and the early obsolescence of old ones will incur a part of economic loss, the enterprise and the whole society will thereby receive larger economic benefits as a reward than when keeping the old equipment and

technology. Specifically, these economic benefits are reflected in four aspects: First, advanced means of labor reduces the consumption of raw materials and increases labor productivity, namely, reduces production costs; second, through replacing old products with new products in the market, enterprises will see a growth

in both production and profits; third, the reallocation of productive forces and

specialization and collaboration resulting from industrial restructuring, corporate mergers and acquisitions, and urban renewal, will create huge economic benefits; fourth, early upgrading of fixed assets and technical reform will create massive

economic benefits for both individual enterprises and the society. In conclusion, the moral wear and tear of fixed assets is an inevitable outcome of the scientific and technological progress.

For example, according to our investigation in 1980s, there were 260,000 sets

of outmoded draft fans in China’s industrial and mining enterprises, which could consume 3 billion kilowatt-hours of electricity every year. Then, we suggested the

fan factories accept the moral depreciation caused by the early upgrading of fan products and turn to the manufacturing of energy-saving fans while the industrial

and mining enterprises substituted the old-fashioned fans ahead of schedule in an

organized way. Although bearing the loss caused by advanced replacement, fan factories could make a profit by manufacturing energy-saving fans and industrial and mining enterprises could cut the cost of RMB240 million by consuming 3

billion kilowatt-hours less of electricity. More importantly, the society would save

an investment of RMB780 million in power station construction, coal mining,

and road building since the adoption of new fans was equal to increasing 600,000 kilowatts of power generating capacity, an annual output of 1.8 million tons of raw coal for generating electricity and the corresponding railway transportation power.

Unfortunately, the government cannot make up its mind to update the policy and

was reluctant to take out money to reform fan factories and replace over 200,000 sets of outmoded draft fans.

This makes two things explicit: First, moral depreciation of fixed assets is a

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natural outcome of scientific and technological advances. Only when we take a right attitude towards moral wear, and accept the achievements from scientific and technological development by eliminating early old products and equipment, can we transfer scientific and technological results into social productivity to push the advancement of society. Otherwise, we will hardly benefit from the scientific and technological achievements and be burdened with high-energy-consuming and low-efficiency outdated equipment. Second, people only see moral depreciation in financial works but are blind to the huge economic benefits accompanying the moral depreciation. When replacing equipment and production lines, people usually judge the economic benefits of this replacement from the perspective of an individual company instead of considering the huge social economic benefits from the perspective of national economy. People often say because of the shortage of money that they do not upgrade their equipment; however, the opposite is true — people have no money, because they do not update the equipment. Therefore, whether we or not we hold a proper attitude towards moral depreciation has a direct bearing on the transfer of scientific and technological achievements into social productivity.

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Financial Leasing

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Prologue: Financial Leasing during the Bus Upgrade Scheme in Hangzhou When an enterprise intends to scale up its production, it can rely on financial leasing instead of capital increases and bank credit. The greatest merit of this method is that it performs the functions of both financing assets and raising funds, which will leave the company with ample own capital and a credit line for other development opportunities. The enterprises under a market economy enrich capital culture with a leasing culture. Qu Yankai, Managing Vice President of the Leasing Business Committee of the China Association of Enterprises with Foreign Investment, told a story: In 1999, Hangzhou City planned to upgrade its buses. The local source of finance, however, could not afford the upgrading of the buses and considered pursuing financial leasing after discussions with leasing companies. The advantage of this method was that industrial users could choose the equipment and supplier they wanted while leasing companies raised the funds to purchase the specified equipment before renting it to the users. Rather than increasing capital or arranging loans, the lessees would pay monthly rentals which were counted as costs. The leasing company set out a condition: The public transit system had to be reformed and different bus routes must be contracted to different companies which would be charged operating expenses. Then, the leasing company placed a bus purchase contract with the automobile factory according to the bus company’s requirements, and at the same time signed a lease contract with the bus company. The local financial department offered 1/3 of the total transformation costs, and the leasing company who possessed the ownership of the new buses bore the rest of the expenses. The contracts were mortgaged to a bank by the leasing company for bank loans and the bank opened a special account for the leasing company to collect rentals which were directly deducted from the daily income saved in the same bank by each contracted company of different bus routes. Since the reform of the public transit system would both enlarge cash flow and expand deposits, the bank was willing to grant loans to the leasing company. This is a successful example of taking advantage of financial leasing to reform the urban public transit system.

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Financial Leasing: Industrial Users Select an Asset While Leasing Companies Rent It to the Users Financial leasing, also known as equipment leasing or modern leasing, is different from traditional operating leasing. Traditional leasing is a situation in which a finance company purchases an asset (such as a camera or an automobile), then leases that asset to a client for a specified amount of time. It is a trade and involves one lease contract and two contracting parties — the lessor and lessee. The operating leasing can only raise funds but not finance assets. In contrast, financial leasing can both finance assets and funds. In a financial leasing activity, industrial users can select which equipment and supplier they want, before leasing companies raise funds to buy the equipment for renting it to the industrial users. This activity involves one trade, two contracts, and three participants. The two contracts are: 1. A purchase contract in which the lessee chooses an asset that will be purchased by the lessor and the lessee bears the rights while the lessor shoulders the obligations; 2. A lease contract which specifies the rights of the lessor and the obligations of the lessee. These two contracts are inseparable from each other. Only when the lessee decides to use the equipment will the lessor buy the equipment; and as long as the lessor purchases the equipment, the lessee must rent the equipment. The three participants are lessor, supplier, and lessee. The leasing company is the buyer or lessor who will pay for the equipment specified by the lessee. Although it is the leasing company who makes the purchase, the supplier will deliver the equipment to and answer for the lessee instead of the lessor. Then, the leasing company charges a series of rentals from the lessee. The rights and obligations of the three participants are cross-performed in those two contracts. To put it simply, financial leasing collects lease fees based on the principle of accelerated depreciation and flexibly uses equipment as loan capital. This method is an innovation in the capital formation mechanism since it bypasses banks as intermediaries by regarding equipment as loan capital. Financial leasing, as an emerging industry, breaks the restrictions of traditional credit and financial institution systems, and injects new vigor into the reform of financial system. Now, financial leasing has become a major financing means for updating corporate equipment around the world and has thus been praised as a “sunrise industry.” The rise of financial leasing adds a non-banking financial sector to the financial system and introduces a competition mechanism in China’s financial industry. In addition, this method renders a new choice for the technological reform of enterprises in terms of the mode of both credit and trade.

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The innovations of financial leasing in capital formation mechanism lie in: 1. The leasing company invests in certain leased equipment rather than the whole industry and seizes the ownership of the equipment. The company sporadically sells the use value of the equipment by way of leasing and gains compensation and added value through rental fees which are equal to accelerated depreciation plus average profit. 2. The industrial user does not need to make additional investment, but can acquire the usufruct of the latest technological equipment by way of leasing in order to produce competitive products and repay rentals from profits. 3. Equipment leasing is different from applying for loans. What the leasing company lends is not money capital but physical capital, and to be more precise, the usufruct of physical capital. It is because of this that the industrial user can wholly devote themselves to operation instead of worrying about repaying the principal of loans. Meanwhile, equipment leasing, as a new investment industry independent from the banking industry, possesses a certain progressive significance. 1. It stimulates new investment demands and opens a vast new field for investment in the monetary market. 2. It is helpful for promoting the sales of equipment manufacturing firms by creating a new sales market. 3. It will speed up the transfer of scientific and technological achievements into social productivity by leasing the latest products. For the latest products which employ new technological achievements, equipment leasing will connect together scientific research, production, sales and application, and create an effective way for promoting the sales of new technology and new equipment. 4. It will enable industrial users to acquire new technical equipment by means of leasing and thus obtain larger marginal benefits. In fact, equipment manufacturing firms will directly participate in the creation and distribution of marginal benefit of the production enterprises (the users) by financial leasing. The government can also encourage such a method by tax cuts. 5. It renovates assets management mode. Financial leasing separates ownership from management right, which provides a space for the innovation of assets management. Now, some assets management companies take over from banks the troubled assets, among which the idle equipment, or even the whole

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production line, factory, and shop is rent out. Some multinational corporations only have current assets in their accounts and all the fixed assets are leased

from leasing firms, or gotten through the sale and leaseback. In the latter case, a company sells a property and then leases it back from the buyer, namely,

the leasing firm who will record the depreciation expenses in the account and

issue the rental invoice. On the account of the lessee, however, there are only working capital, rents, wages, expenses and income.

The History of Financial Leasing Modern leasing is derived from the United States. After the Second World War,

American producers adopted an installment plan in order to promote their

products. Concerning the great risk in capital recovery, the ownership of equipment was left to the producers while the purchasers only enjoyed the usufruct and would

not acquire the ownership until all the costs of the equipment were recouped by

the producer. This mode of transaction is called “financial leasing.” In 1952, the

world’s first financial leasing company was established in the United States. In the late 1950s, financial leasing was introduced to the rest of North America, in the 1960s to Western Europe and Asia, and in the 1970s to South America. As of now,

there are more than 80 countries engaged in financial leasing business. Since Japan

learned financial leasing from the United States, the leasing turnover annually grew by 91.4% before the rate slowed down to 20% after the 1980s, and thus financial leasing became the most vigorous emerging industry in Japan.

The rapid advances of science and technology accelerate the upgrading of

equipment. Enterprises place more and more attention on the liquidity of assets

in order to avoid the risk from obsolete equipment and improve their financial situations. In addition, the imbalance of regional development and the diversified demands of clients create a large space for the development of the leasing market.

Under such a background, the modern leasing industry represented by financial

leasing has developed rapidly in the international arena. In 2000, the turnover of global leasing transactions exceeded USD470 billion (excluding personal

automobile leasing). The United States is the country where the leasing business has flourished the most, and the industry occupies over 40% of the world’s

transaction volume of leasing. The leasing transaction volume of European

countries is USD140 billion, accounting for 30% of the world’s leasing business.

Asian countries record a leasing transaction volume of USD67.7 billion, 15.7% of the world’s total. In the developed countries, such as the United States and Europe,

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the leasing of equipment, such as aircraft, information equipment, construction

machinery, commercial vehicles, marine and medical equipment, takes up 50%– 80% of the global leasing transactions, and the proportion of the cross-border leasing business expands year by year.

The business models are constantly innovated during the development of

financial leasing and basically comprise the following three methods:

1. The most common and typical approach is the direct financial lease which

allows users to select the supplier and equipment that will be purchased and rented to the users by a leasing company. China’s mobile telecommunications is developed under such a kind of leasing model. In the past, the

telecommunication projects in China were funded by the state appropriation

or planned loans from China Construction Banks (CCB) allocated by the Planning Commission. In 1991, under the suggestion of leasing companies,

the financial department promulgated a document which allowed several categories of telecommunication projects, such as computerized telephone, mobile phones, and satellite ground stations to try financial leasing, which

paved the way for the business expansion of financial leasing joint ventures in the telecommunication leases.

Equipment leasing further develops from the direct leasing of single equipment

to that of a whole project. This method demands less time but offers more benefits than build operate transfer (BOT).1 The new approach is a great progress based on the BOT and also an advanced form of direct financial leasing.

2. Trust lease. Industrial enterprises can trust leasing companies with equipment, and investors or enterprises with ample capital can trust leasing companies with capital. Basically, the lessor will negotiate with the lessee about the

equipment and its model, and then the leasing company will purchase the

equipment according to the instruction of the lessor and at the same time bear the risks herein incurred. Trust lease creates a new investment channel for investors.

In a trust lease agreement, the leasing firm may take the initiative to make

a leasing arrangement, and now the leasing firm acts as a lease arranger. For instance, in a financial lease of large equipment or a big airplane, the leasing

firm has to apply for a bank loan since the money needed for this transaction is substantial. The bank demands 20% of the total purchase price as a guarantee

from the leasing firm, and if the leasing firm does not own or want to offer such an

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amount of money, it can find an investor to join this trust lease. The investor will trust the leasing firm with capital to purchase the airplane whose ownership is held by the investor. Then, the leasing firm will use the 20% of the total cost from

the investor as collateral to ask for a bank loan of 80% of total purchasing expense.

Meanwhile, the leasing firm has to assure the investor of his investment by hiring

an investment guarantee corporation. In addition, the ownership of the airplane,

the rights to earnings in the lease contract, and the insurance beneficial right are all mortgaged to the bank. The leasing firm shares the income with the lessor. Of course, all of these can be negotiated in advance and specified in the lease contract.

For some Western countries, such as the United States, the biggest benefit of

trust lease is tax avoidance, because the U.S. tax code stipulates that corporate investment can enjoy preferential income tax credit. In this kind of trust lease, the investor is the owner of the airplane and this investment is reflected on his balance

sheet, thus he can enjoy the exemption of income tax according to the price of the

airplane. So what the lessor is concerned about is not return on investment but tax benefits. The benefit is far larger than the return from investing 20% of the total

purchasing expense of the aircraft. This is one of the reasons why aircraft and large equipment leasing businesses have leapt forward in Western countries. Statistics

disclose that 60%–70% of the world’s airplanes are purchased through leasing. A great number of aircraft in China’s civil aviation industry were introduced into

service through leasing contracts. It can be said that China’s civil aviation took off

on the wing of leasing. Without leasing, the scale of China’s civil aviation would not be as large as it is today.

3. Sale-and-leaseback. Industrial enterprises may sometimes be in urgent need of money. When it is too late to ask for approval of state appropriation and

the enterprises are reluctant to lend money, they can resort to going to leasing

companies. An industrial enterprise can sell certain equipment (such as a rolling mill) which it owns to a leasing company in exchange for millions of dollars which are used to lease the equipment back by the industrial enterprise.

In this way, the turnover of capital is quickened without hindering the industrial production, and the equipment can be repurchased at any time if the enterprise has sufficient money.

In addition, there is leveraged leasing, joint leasing, and sub-leasing, among

other forms.

The organizational forms of enterprises in the financial leasing industry are of

a great variety. Some leasing firms are funded solely or controlled by commercial

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banks. Since industrial users prefer leasing rather than bank loans, the leasing firms set up by commercial banks which have advantages in capital and cost create a new investment channel of surplus capital to satisfy the needs of clients. Some

leasing firms are established by industrial enterprises or the circulation sector

through relying on manufacturers, which aim to promote the sales of industrial products or provide specialized services. Some are independent leasing companies which can offer a large range of comprehensive services. There are also strategic

financial leasing firms whose shareholders are mainly government, insurance

companies, brokerage firms, investment banks, and other investment institutions. Their targets are infrastructure projects relating to civil aviation, shipping, energy,

etc. They pursue a new kind of investment portfolio and investment method to secure safe and reliable long-term investment returns.

I was commissioned by the CCB to join the talks with Japan’s Nomura

Securities about the establishment of a joint venture called International Union Leasing Corporation in 1988. The meeting was hosted by the first general manager

of the Japanese party, and I was invited as a consultant. The Japanese partner was

told that when doing leasing business in China, the only choice is the middleand small-sized enterprises which can withstand market competition while large enterprises which are under the state planning sector will absorb investment

without repaying the debts. Later, I led the Japanese manager to visit Shougang Group, China Second Auto Works (now Dongfeng Motor Corporation), Wuhan

Iron and Steel Group, and other large state-owned enterprises which were listed

in the top 500 domestic large enterprises, which made him change his attitude towards China’s large companies. This manager was very enterprising and immediately decided to conduct financial leasing business with large enterprises.

During the two years when he assumed General Manager of the International

Union Leasing Corporation, the business developed quickly without rent arrears. In fact, the reason why Nomura Securities participated in the financial leasing

joint venture is not to undertake leasing business but to build a good relationship with large enterprises, which paves the way for its future listing recommendation business of large enterprises.

Since the 1990s, electronic commerce has been booming. It has enabled lessors

to break the traditional concepts of management and service and create brand-

new operation modes, such as network leasing providers, self-leasing business,

cell phone rental business, and information service centers, in order to achieve a client-oriented, all-embracing, personalized, and international service mode.

The operation model of leasing enterprises develops towards virtualization and

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intelligentization, the transaction cost is significantly reduced, and the market

competition rules are restructured. Currently, the trends of the global leasing industry are displayed in the following aspects:

Specialization (the leasing proportion of specific products is substantially

increased), business convergence (the boundaries between various kinds of leases are increasingly blurred), chain operation (rental chains will emerge),

regionalization (leasing business shows certain regional characteristics) and popularization (small-scale community leasing networks grow in number, and personal leasing networks, online leasing agents and internet intermediaries will be developed). Network Information has eliminated the information asymmetry

in the leasing business to the largest extent and greatly increased the proportion of matching or automatic pairing businesses with a significant reduction of transaction costs.

Policy Support Europe and the United States put the leasing industry at a significant place in the national economy, and have attached great importance to the industry in

legislation, taxation, insurance, and other areas by giving preferential policies of investment tax credit and accelerated depreciation, among others.

There are two lessons that are worth learning from the U.S. leasing industry:

1. The government formulates a sound regulatory system which provides a legal guarantee for the development of the rental market and effectively regulates trading

activities; 2. There is a complete security system which guarantees the simplification of leasing procedure and the expansion of leasing scale and varieties. In America,

leasing firms can check the credibility of enterprises or individuals at any time

through banks, tax departments, and other relevant government authorities. Credit card payment reduces the risk of rent arrears that may be entailed on the leasing

firms, and multiple types of services offered by insurance companies also lowers the risks to the leasing firms during the use of the leased items.

Japan is the most typical country concerning the policy support. The measures

that the Japanese government takes to encourage the leasing industry include: Policy-based loans will be given to certain industries or undertakings which the

government encourages or protects when they are doing leasing projects, that is 50% of total investment will be funded by the Development Bank of Japan; rental subsidies will be granted to the enterprises of government-supported industries

by relevant administrative departments; compulsory credit insurance in leasing is

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applied to all leasing businesses and once a lessee company goes bankrupt, policyoriented insurance companies will pay 50% of the rental loss; investment tax credit

will be given to the small and medium-sized enterprises according to a certain percentage of the rental fee when they import special mechanical equipment by way of leasing.

The Development of China’s Financial Leasing China introduced financial leasing at the initial stage of the reform and opening

up. At first, financial leasing was developed as a way to utilize foreign capital by the Ministry of Foreign Trade (now the Department of Foreign Trade under the

Ministry of Commerce), which was solely responsible for approving and managing

leasing projects. The Ministry of Foreign Trade only focused on leasing transactions

and evaded financing issues. But the leasing business could hardly develop without financing activities. Later, owing to the fact that many departments got involved

in the management of financial leasing and there was no special financial support or favorable policies, the leasing industry developed at a slow speed. The progress of domestic-funded leasing firms was not very smooth as well. In the latter half of 2004, the Ministry of Commerce and State Administration of Taxation collectively

launched a pilot project of operating financial leasing businesses in domesticfunded enterprises. Some 24 firms from 14 provinces or cities, such as Beijing,

Shanghai, and Zhejiang, jointed the pilot and enjoyed relevant preferential policies in taxation. In the following two years, the pilot enterprises made use of their

advantages and actively searched for new profit growth points and risk reduction

approaches. In 2006, the value of newly signed financial leasing contracts reached RMB6.57 billion with a profit of RMB135 million and a tax payment of RMB62.05

million. In the new contracts, there were not only currently mature operation

models such as direct leasing, leaseback, trust lease, but also some more flexible

and market-oriented models. For example, Shanghai Ronglian Finance Leasing Share Corporation signed a medical equipment leasing contract which distributed

profits according to the participants’ investment and connected among the lending

bank, the lessee, and the lessor of three different places. This contract provided a successful experience for supporting the off-site leasing projects by banks. Beijing Zoomlion Xinxing Construction Machinery Leasing Corporation drew in insurance companies in the leasing business in order to reduce the operation risk. Changjiang

Leasing Company purchased 10 aircraft via bank loans for leasing and broke the large-term monopoly of foreign enterprises in China’s aviation leasing market.

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Can banks get involved in leasing? Before the 1990s, banks were allowed to

carry out financial leasing business, but most operations were illicit and usually engaged in the investment in the stock and real estate markets, thus accumulating high risks. Under the shock of the Asian financial crisis in 1997, the non-performing

loan ratio shot up. With the hope of evading the financial tsunami, the Chinese government ordered banks to exit the financial leasing field. By then, China’s

financial leasing business fell to the bottom. Afterwards, regulatory authority once allowed private capital to participate in the leasing transactions in order to revive the financial leasing. In 2001, private capital dominated the financial leasing companies, but within less than two years, serious illegal operations

emerged in those companies owing to mixed motives. Many leasing companies

misappropriated money under the guise of financial leasing. As a result of this, the financial leasing industry which had been expecting a revival was hit with another

crisis. Up until the end of 2006, there were just 12 financial leasing firms under the China Banking Regulatory Commission (CBRC). Among these enterprises, six continued operation and recorded a total net after-tax profit of RMB130 million

in that year, two declared bankruptcy, two were closed for internal rectification,

and two suspended business operations. From 2000 when financial leasing firms started reorganization and rectification to 2006, the CBRC has not approved any new financial leasing company.

In 2008, the CBRC promulgated the Measures for the Administration of Finance

Leasing Companies, which was a milestone in the development of China’s financial

leasing industry. Prior to this, banking financial leasing was banned. In fact, there

was a huge demand for financial leasing service in economic life. China’s Minsheng Banking Corporation cooperated with a financial leasing company to launch a

banking-leasing win-win plan through bypassing the existing regulations, which spurred an increase in the assets of leasing business to RMB10 billion. This plan was a great innovation in rejuvenating the financial leasing industry in an indirect

way. After the Measures for the Administration of Finance Leasing Companies was announced, the bank-affiliated financial leasing business switched into the fast lane.

In 2007, the first group of banking firms, including the Industrial and

Commercial Bank of China, China Construction Bank, Bank of Communications,

China Minsheng Banking Corporation, China Merchants Bank, and China

Development Bank, were successively approved to set up financial leasing firms. After the absence from the financial leasing market for 10 years, the banking sector resumed the responsibility of reviving the financial leasing industry. But undertakings usually develop intermittently in China. After the icebreaking action,

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the approval for the financial leasing firms stalled due to prudential supervision.

In May 2009, the State Council gave permission to expand the pilot scope of bankbased financial leasing companies. A dozen joint-stock banks, such as Huaxia Bank,

Shanghai Pudong Development Bank, Industrial Bank, and China Everbright Bank, applied to join the pilot project and the list of approved banks was not

released until early 2010. According to the China Financial Leasing Industry Report 2006–2010 from the ResearchInChina website, during the 11th Five-Year Guideline

period, China’s financial leasing industry witnessed exponential growth, and the total leasing fund increased by 86-fold from RMB8 billion in 2006 to RMB700

billion in 2010. In 2010, the investment in financial leasing in China exceeded RMB20 billion, the operating income registered RMB15 billion, total profit RMB4.7

billion, and net income RMB3.6 billion. Financial leasing will no doubt develop into an important service provided by banks.

At present, China’s financial leasing firms face two kinds of difficulties:

First, the business staff of bank-affiliated financial leasing companies mostly

come from banks, therefore the financial leasing does not develop in a specialized

way since the staff can hardly get rid of their mindset of bank credit. As a matter

of fact, the real professional financial leasing should focus on the leased items, understand the production process, and know the industrial value. Financial

leasing separates the ownership from the use of the equipment by first letting the

lessee obtain the use of the product at the expense of regular rental payments or installments and then allowing the lessee to acquire the ownership at a low price

(typically the residual value) at the end of the lease term. It enables enterprises to produce with leased equipment without suffering from the pressure from the one-

off capital payment. The rental business, however, is essentially a kind of financial service, and its profitability comes from the knowledge towards the industry and

the leased items. If there is no professional staff, or specialized knowledge of the industry and equipment, the profitability will be limited once the clients own the upmost decision power in selecting the leased products.

Second, the leasing business is harassed by high taxes. For instance, if a

domestic leasing company plans to buy an aircraft from overseas for renting to a

domestic airline, the leasing company has to make a one-time payment of import

tax of around 24%. For a similar business, foreign leasing companies may enjoy a

very low or even zero tariff. This kind of tax makes domestic leasing companies less competitive in rental quotes.

According to the report of “Expansion of Financial Leasing” in Caijing

Magazine (Issue No. 10, 2010), the CBRC has to approve the establishment

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of project companies by the financial leasing firms under the Industrial and Commercial Bank of China, China Construction Bank, and China Minsheng Banking Corporation in bonded areas as the finance and taxation departments were reluctant to lower tariffs. This is a flexible method which indirectly solves the high taxes by amortizing the originally one-off taxes and dues over the whole lease term when the leasing firms import large pieces of equipment like aircraft. In foreign countries, investment banks avail themselves of loopholes in the laws and regulations to create marginal benefit. In China, however, it is the government departments which handicap the development of the leasing industry, so the CBRC has to take the lead to exploit the legal loopholes in taxation. It is really a creative step taken by the Chinese people in expanding the financial leasing business.

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Reorganization and Debt-For-Equity Swaps of Distressed Enterprises

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

Prologue: A Pair of Ice Skates In 1996, Professor Wang Weiguo from China University of Political Science and Law told us a story:

On the lake of a small town in Pennsylvania, a little boy called Hans was

skating in a pair of beautiful new skates. Suddenly, the boy skated on thin ice

and fell into the water. Another little boy who was there with Hans immediately jumped into the water to rescue Hans. The local town mayor praised the boy for his bravery and sacrifice. The boy bluntly answered back: “I do not understand why you are talking about courage; the truth is that I had to save Hans simply because he was wearing my new designer ice skates!”

Professor Wang recounted this story in a meeting about corporate bankruptcy

and reorganization in Tianjin. Then, he introduced the idea that Western countries had bankruptcy laws, but corporate bankruptcies and instances of insolvency

would generate social repercussions and this was not good for creditors. As a result, corporate bankruptcy law underwent a revolution in the United States in the 1970s, and one of the core concepts was the balancing of the interests of creditors and debtors.

It was during the United States congressional hearings on the reform of

bankruptcy law that Peter Coogan advocated the participation of creditors in the restructuring of distressed companies, and then he told the above story. Coogan

explained that he and all the other creditors were like the brave boy who had to

save debtors in order to save his loans, because the debtors were “wearing the ice skates” of the creditors!

In 1996, I represented China Construction Bank (CCB) in formulating a

bankruptcy reconciliation and reorganization plan for Xinghuo Pulp Mill in

Shanghai. When Hua Jianming, then Vice Mayor of Shanghai, asked me why the CCB undertook the bankruptcy reconciliation and reorganization of Xinhuo, I told him the same story and concluded my answer by saying “Because Xinhuo Pulp Mill was wearing my ice skates!”

In fact, the bankruptcy and reorganization of distressed enterprises should be a

part of capital culture.

The Revolution in Bankruptcy Law in Western Countries: Finding A Way Out from Reorganization In the market economy, it is right that when capitalists do business, they make use

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of own capital to make profits and repay debts after borrowing others’ money. If the enterprise cannot pay off its debts and is trapped in insolvency, it has to go bankrupt and be put into liquidation. Therefore, Western countries have long established bankruptcy laws to regulate the bankruptcy liquidation of distressed enterprises. Bankruptcy liquidation, however, is a backward concept in Western countries. Although it can compensate creditors for a portion of interests, the aftereffects of bankruptcy such as unemployment of staff will entail high social costs and social unrests. Besides, these aftereffects which usually last for a long time will also create huge losses to creditors. Consequently, since the 1970s, Western countries launched a revolution in bankruptcy law and intended to search for a solution from reorganization. The United States set about studying the bankruptcy law after 1970 and released the famous Brookings Report1 in 1971. The government enacted the new Bankruptcy Code in 1978, and the newly added Chapter 11 of corporate reorganization

stipulated that after an insolvent enterprise files its petition in the bankruptcy court, the enterprises can develop a plan of reorganization to be approved by the court under the permission of creditors. Thereafter, the trend of corporate reorganization swept Europe and America. In 1986, the United Kingdom formulated the Insolvency Act which provided that the Company Directors Disqualification Act and The Insolvency Rules were no longer applicable to enterprises on the verge of bankruptcy, and these enterprises had to adopt reorganization schemes. This act impacted the Commonwealth countries of Australia, Canada, and Ireland who had successively amended and enacted their bankruptcy laws or corporate laws in the 1990s. France is a country which has undergone a thorough reform of bankruptcy law. In 1985, France enacted Relative Au Redressement Et À La Liquidation Judiciaires Des Entreprises

(Judicial Reorganization and Liquidation of Enterprises) and also set up alert procedures and reconciliation and liquidation procedures. Some people argued that France stood in front of all other countries in the bankruptcy law reform by representing a comparatively progressive legal concept. There are theoretical bases for implementing corporate reorganization rather than bankruptcy liquidation for distressed enterprises: 1. Going-concern value theory. The theory admits that the value of an on-going business is higher than that of a liquidated company. If the enterprise operates well through reorganization, it will be sold at a better price than through bankruptcy liquidation. That is to say, it is wiser to make money by raising a horse to draw wagons than killing it and selling the horsemeat.

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2. Theory of common interests between creditors and debtors. Only when creditors assist debtors in corporate restructuring, the enterprises of the debtors can be sold at a good price, and thus the debt repayment rate will be raised. Just as the aforementioned story has shown, the other little boy had to save the life of Hans because Hans was wearing the other boy’s ice stakes! 3. Social interest theory. Corporate reorganization will reduce the asset loss, the number of laid-off workers and the chain bankruptcy of related companies, thus causing less social repercussions. Judging rationally from the perspective of overall social benefit, reorganization is beneficial to the conservation and effective use of resources of the whole society. The advocacy of reorganization by Western countries in their bankruptcy laws is in essence full recognition of creditors’ interests. One of the important measures in corporate reorganization is to allow bank creditors to carry out debt-for-equity swaps in struggling companies. A debt-for-equity swap is different from corporate bankruptcy in that creditors prefer to recoup losses by acting as shareholders than passively bear the risk of bad debt losses. This is a flexible exchange between debt and equity. The debt-for-equity swap has reshaped the capital formation mechanism and is unique in the following aspects: First, creditors are transferred into being the owners of enterprises; second, unpayable debts are changed into the capital of enterprises; third, once depressed enterprises own this converted capital, they are transformed from insolvent debtors into active operators with corresponding debt-bearing capacity and new financial power, and are thus able to borrow new loans from banks.

Credit Loans as Equity Shares Similarly, banks in Western European countries such as France, promote “share loans,” which redeem credit loans as equity shares. The operation mode of this kind of loan resembles that of preferred stocks, that is, the injection of capital into distressed companies and then the cultivation of marginal benefits from the revival of the enterprises. In 1981 when doing research in France, I learned that when some small-sized enterprises got trapped in financial difficulties, they welcomed the loans as shares and were unwilling to be taken over and reorganized. The characteristics of share loans were as follows: 1. The share loans are regarded as shares and once the borrowing enterprises file for bankruptcy, the loans will be settled before the shareholders’ equity but after all the outstanding debts.

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2. It is in nature a loan rather than a real share, because it has to be repaid at the end. 3. With share loans, the borrowing enterprises will increase their debt-bearing capacity and thus regain loan eligibility. 4. The interest rate of share loans is different from that of other loans. At first, the rate is very low or even zero and when the operation of the borrowing enterprise picks up, higher marginal benefits will be given to the bank as a special reward for bearing the risk. Thanks to these merits, share loans may well be a way to rescue the heavily indebted non-public or listed companies.

Bankruptcy Boom: The Frustration in Helping Out Distressed State-Owned Enterprises China has implemented a planned economy for a long time, and the stateowned enterprises are funded by the state. Therefore, once these enterprises are established, they should never be afraid of going bankrupt. Due to the long-term avoidance of talking about capital, and the lack of a capital culture, China is also absent from the culture of corporate bankruptcy and restructuring. During China’s economic transition to a market-oriented economy in the 1990s, local governments allowed their local state-enterprises to repudiate the debts in a creative way in consideration of local interests. There was a prevailing trend of bankruptcy and debt repudiation in China roughly between 1993 and 1995, which was a shock to the economy then, especially to the relationship between banks and enterprises. At first, a large general knitting factory in southwest China got into a predicament of excessive debts in 1993 and thus the factory had to announce bankruptcy by advocating “public tendering, conditional auction” in order to repudiate its debts to banks and leasing companies. Some people learned a lesson from this practice and realized that bankruptcy was the best way to disown debts. Consequently, a large number of bankrupt companies emerged in many cities. Since then, bankruptcy became the prevailing practice, for instance, there was the partial transformation of Liaoyuan Woolen Mill in Liaoning Province, the fraudulent bankruptcy of Yuncheng Detergent Factory in Shanxi Province, and the avoidance of debts by leasing of Qianxi County Fertilizer Plant in Guizhou Province. For a time, bankruptcy was widespread and was, in reality, a strategy for troubled state-owned enterprises to dodge debts. The most typical practice was

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partial transformation, that is, to detach the departments of profitable products

from the rest of the enterprises to form one or several individual new legal entities which will be transferred, rented, contracted to others or even independent

in order to fend off the debts of the original enterprise. On the other hand, the original enterprise continued operation with the rest of the departments and

assumed the outstanding bank debts. It seems that the indebted enterprises try to survive without evading their debts while banks permit the enterprises’ partial transformation without writing off the debts, but in reality the debts will never

be repaid. This partial transformation is also called an “escape-by-crafty-scheme” strategy or an “unshelling operation.”

“Partial transformation” or an “unshelling operation” are pleasant terms for

this process but the sad truth is that this practice allows distressed enterprises

to repudiate their debts or loans at the expense of banks. The climax of the bankruptcies was the case reported by Financial News in the headline on December 14, 1995 — “The bankruptcy of Wuhan Native Produce Company caused a loan loss of RMB80 million to Bank of China.” Afterwards, foreign trade enterprises

poured into Wuhan from other areas in the hopes of emulating that success, and

thus bankruptcy and debt defaults reached a peak. At that time, several stateowned large banks discussed the countermeasures and decided to implement

financial sanctions on Wuhan by declaring it a “high risk” city. The relationship between banks and enterprises became very tense. Financial News published a

signed article named “The bankruptcy of foreign trade enterprises should slow

down,” but in fact, the foreign trade industry was not the only industry that should decelerate the speed of bankruptcy. At last, this unhealthy trend of bankruptcy

was curbed as higher government authorities intervened by encouraging mergers,

standardizing bankruptcy procedures, and clarifying the guidelines of “more mergers and less bankruptcies.”

The root cause for the bankruptcies in China’s state-owned enterprises was

due to capital, rather than property rights. More importantly, after the replacement of state appropriation by bank loans in the 1980s, the policies of acquiring all

circulating funds through credit loans and financing through fiscal credit were also implemented, and in this way, several budgetary allocations were changed

into repayable loans. Accordingly, when local governments ran new projects or

established new companies, the state took out no or little money. Since the debtto-equity ratio can be as high as 98%, enterprises would hardly withstand risks. The negative result is: When setting up a new enterprise, local governments will

risk the money of banks; when the enterprise runs into difficulties in operation, the

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local governments will allow the troubled enterprise to default on debts through bankruptcy. The emergence of the bankruptcy boom is a serious outcome of a series of systematic defects. The significant restrictive function of the corporate capital fund system here can be seen. If the state does not explicitly demand stateowned enterprises to refill their capital within a fixed period but allows the absurd practice of operating without equity and the resulting bankruptcies to continue, the ultimate result will be bank failures. Meanwhile, this bankruptcy boom burdened the state-owned banks with the policy-based historical debts left over from the planned economic system, including foreign trade policy-related longstanding debts, old debts from decision-making mistakes of capital construction and technical reform, and the old accounts of loans for national stability and unity, which ought to be borne by local finance or shared among central and local governments. It is actually to let the commercial banks under the socialist market economy pay the bills of the past planned economy. The bankruptcy boom reflects a failure in China’s corporate reform and will have a serious impact on the relationship between banks and companies. This trend occurs when local enterprises try to repudiate their debts owed to the state banks, and it is essentially a twisted reflection of local finance directing financial pressure to central finance under the old economic system. The rise of this bankruptcy boom occurred for the following four reasons:

1. Severely inadequate capital of state-owned enterprises. In Western countries, the proportion of own capital in industrial enterprises usually accounts for around 30% of total operating capital and the own capital will be increased along with the development of business to maintain the average debt ratio at 50%–60%. After the founding of new China, state-owned enterprises, despite avoiding talking about capital, had plenty of capital from the 1950s until the mid-1980s. In 1980, the average debt ratio of enterprises was just 18% and own capital occupied 82% of the total working capital, namely the ratio of equity to debt was roughly 8:2. In 1988, the Chinese government carried out its trial Bankruptcy Law which was formulated based on the fact that enterprises owned sufficient capital. However, when the policy of the replacement of state appropriation by repayable loans was fully implemented in 1985, newly-built state-owned enterprises suffered a severe shortage of capital with a high debtto-equity ratio. Things were worse for local enterprises. Especially after the replacement of appropriations by loan, local governments contributed no or little capital to project construction or enterprise operation, and thus these local enterprises lost their risk resistance capacity. Local governments risked the

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banks’ money to fund new projects of enterprises and allowed these distressed enterprises to default on debts by filing for bankruptcy. These were the serious

consequences of the systematic deficits in the policies of the replacement of state appropriation by loans in capital construction, the acquisition of all

circulating funds through credits, and the implementation of fiscal credit. From here, we can see the important restrictive role of the corporate capital fund. (The

reasons why China’s state-owned enterprises got into financial troubles will be detailed in the next section.)

2. The Bankruptcy Law (refers to the trial Bankruptcy Law enacted in 1988) left some loopholes to be exploited later on. The socialist market economy, same as all the other market economies of socialized mass production, should expose enterprises to market competitions. It is impossible to only start new businesses

without shutting down uncompetitive ones. To allow the bankruptcy of some insolvent company is evitable in a market economy, so it does not need to be worried about. But the question is who will bear the loss? Bankruptcy,

by definition, is the state in which the shareholders’ capital cannot pay off the enterprise’s debts and the purpose of going bankrupt is to repay debts. However, the reality is that the policies of replacing appropriation with loans

in capital construction and acquiring all circulating funds through credits and the trend of substituting credit loans for local financial allocation enables some state-owned enterprises to operate on borrowings under the circumstances of

insufficient capital or even zero own capital. As a result, bankruptcy at that time means to redirect the loss to creditors (i.e. banks), which is unfair. The Bankruptcy Law stipulates that the bearers of decision-making mistakes and

the competent authorities of shareholders are included in the bankruptcy liquidation group while banks as creditors are excluded from the group. The

fact that the Bankruptcy Law lacks both effective protection for creditors and terms allowing creditors to perform receivership or trusteeship of the insolvent enterprises leaves loopholes for some local authorities and enterprises to take

advantage of. Besides, if the investment of a new project exceeds RMB200 million, the project in general should seek for approval from the State Council;

so how could the bankruptcy of a large enterprise with a liability of RMB800 million be permitted by the local Industrial Development Bureau of a big city instead of the state? Is this not unreasonable?

The causes for enterprises going bankrupt are various: The bankruptcy of some

enterprises is owed to wrong decisions and investment failures, that is to say, as

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soon as the wrongly-decided project is put into production, losses will be created; some bankruptcies are the results of the rash decisions of bureaucrats, such as to demand that the entire textile industry be equipped with more than 10 million spindles; some bankruptcies are subject to market changes which may cause a short-term investment to become a long-term one; some enterprises suffer from belated technical reforms and since backward technology and products give rise to long-term loss, these enterprises become insolvent; others declare bankruptcy also because of poor management. Above all, the high debt-to-equity ratio after the replacement of state appropriation by bank loans makes enterprises become more vulnerable to bankruptcy. If this situation continues and the state-owned enterprises still do not replenish their own capital, the ultimate result will be the bankruptcy of banks. 3. There is, however, an absence of due respect to bank creditors in the Bankruptcy Law. The members of the bankruptcy liquidation group could include, according to the Bankruptcy Law, competent authorities of the bankrupt enterprise, representatives from financial departments and other supervisors of the planned economy with bank creditors being left out. It indicates that

the formulation of laws and regulations is still strongly influenced by the old ideas of the planned economic system. Since all these members are either shareholders of the insolvent enterprises or bearers of decision-making mistakes, how would we ensure that the insolvency process was objective, reasonable, and fair if these people take charge of liquidation, appraisal, and the disposition and distribution of bankruptcy property? How could we expect them to not harm the interests of banks, the largest creditors? Why does not the Bankruptcy Law protect creditors in its terms? A compiler of the Bankruptcy Law said: “We think bankruptcy is, naturally, to force debtors to repay

the money of creditors, and how could we know that debtors should divert their losses to banks by taking advantage of the Bankruptcy Law? Foreign enterprises find loopholes in laws to evade taxes while China’s local governments use legal loopholes to repudiate the debts to state banks. Who says Chinese people are not creative?” 4. Bankruptcy which should be a market behavior now becomes an administrative act of local governments. Some cities point out that the whole process of bankruptcy from the drawing up of the list of distressed enterprises, formulation of bankruptcy plans, property liquidations, to auction and assets restructuring is solely decided by local government departments (Economic Commission, or Restructuring Commission). The process is, thus, by no means

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transparent, and there is no involvement of intermediary organizations, which will give rise to a lot of unjust losses. Some local governments monopolize the development of bankruptcy plans by excluding banks and creditors. Certain local governments even request banks in advance to neither question the decisions of bankruptcy courts nor affix legal liabilities on guarantors. Some courts yield to the power of local governments by declaring that “this decision is final,” which means the decision cannot be overturned. It is actually a conspiracy between courts and local governments against banks. In 1993, a large knitting factory in southwest China declared bankruptcy and was sold at a low price to an overseas company through the so-called “public tendering, conditional auction.” Later, a scandal was reported that the Deputy Mayor who was in charge of this bankruptcy had accepted bribes. Is that a coincidence? Certainly not in this case. Since corporate bankruptcy is regarded as a mere government behavior and there is no transparency in the bankruptcy process, it is hard to prevent some people from reaping some profits through illegal deals. Thus, if the bankruptcy process remains opaque and banks as the largest creditors still have no right to file a petition with the bankruptcy court for

the reorganization, trusteeship, and takeover of the insolvent enterprises, how could the interests of creditors be protected? And how would the socialist market economy be developed?

The Over-Indebtedness of State-Owned Enterprises Rooted in the Misallocation between Equity and Debt Why did Chinese enterprises get into deep debt during the seventh and eighth five-year plans? The over-indebtedness of state-owned enterprises is mainly reflected in the insufficient capital and the over-reliance on banking lending of enterprises. In essence, it is the result of a new systematic capital misallocation and deficiency created after the replacement of state appropriation by repayable loans. It reverses the places of borrowed capital and own capital in the capital formation mechanism. To understand this problem, I have made special investigations in the 1990s and found that this systematic capital misallocation and deficiency resulting from the excessive debts of enterprises has two major features.

1. The misallocation between capital and loans, namely, the money which should be allocated for capital funds is lent out as bank loans. There are roughly four

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kinds of enterprises which suffer from capital shortage: First, enterprises whose state funding for capital construction is replaced by repayable loans; second,

enterprises which are established based on bank loans; third, enterprises which are involved in foreign-financed projects, namely, utilizing foreign government loans or export credits; fourth, enterprises which are set up on the basis of financial credit. These four kinds of companies, due to a lack of capital

funds, operate on borrowings and are short of stable operating funds that can

be occupied for a long time without being repaid. Consequently, as soon as projects are completed and put into production, the enterprises are trapped in

long-term debt. The debt tension will never be gotten rid of, if the capital fund

is not refilled. This systematic capital misallocation and deficiency actually

reflects the reversed relationships between equity and debts in the capital formation mechanism, which is an inborn defect in the mechanism.

2. There are a series of funding gaps which have occupied the capital borrowed or diverted from other sources in state-owned enterprises, and these gaps are

also known as “capital deficiencies.” According to my investigations, there are

mainly 10 causes of capital deficiencies: 1. Local governments use their selffinanced funds to attract projects but these funds are hardly put into place;

2. Investment omissions in the project plan will lead to capital gaps; 3. The costs of construction exceed the budget; 4. The planned investment takes no account of the interest incurred during construction; 5. The fluctuations of

exchange rates, especially the strong appreciation of the Yen, cause the Yendenominated debts and other foreign currency-denominated debts to create

a severe deficiency in capital; 6. More money is needed to repay loans when the repayment of loans before tax is changed into after-tax loan repayment; 7.

The cost of trial production is omitted or underestimated in the budget; 8. The credit quota is not allocated for working capital; 9. Construction rework will

also increase the demand for capital; 10. Poor management brings about cost overruns.

Additionally, capital deficiencies may also result from the increase of

production costs due to the rising price of raw materials and a lack of credit quota

for working capital loans, among other things. In addition to the above factors, decision failures and market changes also drag many enterprises into financial plight in terms of capital turnover.

Overall, the capital tension of enterprises at that time is an outcome of

systematic capital misallocation and deficiency. The capital which should be

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appropriated by the government can only be obtained through bank loans, while

other capital which ought to be received from loans has to be raised through other financing channels. Although the money is spent, it is not used for its original

purposes, so it is necessary to correct the capital misallocation and deficiency in capital reserves.

The systematic capital shortage will bring about four serious consequences.

1. Enterprises lack stable operating capital and thus are vulnerable to risks. 2. There are a great many funding gaps which will be compensated by diverting

the money earmarked for other purposes, and therefore chain debts will be generated. In a considerable number of enterprises, the financial deficit accounts for 15%–20% of the total operating fund. This phenomenon exists,

more or less, in almost all the enterprises which rely on the state to grant loans for project construction, so it reflects a flaw in the system. The root problem

does not lie in the financial gaps, but the fact that no one promises to expand financing channels. Enterprises dare not ask for more money from higher authorities although the money is necessary for production and construction.

Consequently, these enterprises have to resort to makeshift solutions: To use the money for trial production to compensate for construction overruns; apply for working capital loans to eliminate exchange-rate spreads; and delay the

repayment of loans for raw materials and semi-manufactured goods to pay

back bank interest. In this way, those enterprises are trapped in endless chain debts. People often criticize the slack rules of debt settlement. In reality, since

there are some unfilled substantial financing gaps, the lax rules of settlement

ferment and amplify these gaps into chain debts after many arrears. And the above-mentioned unpromised funding gaps are the real cause for the financial

strain of enterprises. Imagine if a normal enterprise from the very beginning of corporate system design lacked stable operating funds, which accounted for 20%–30% of total working capital and can be occupied for a long time without being repaid, and an unpromised funding gap of 15%–20% of total capital once

the enterprise was put into production. It has to repay its debts and divert

money earmarked for other purposes to fill this financing gap. So how could the enterprise avoid chain debts?

3. Enterprises operate with insufficient own capital and possess no debt paying ability owing to an extremely high debt-to-equity ratio.

4. Once enterprises suffer from financial losses or fail to repay debts in a timely

way, banks will stop lending money to the enterprises, which will in turn

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generate a credit crisis. It should also be mentioned that the relationship between enterprises and banks is twisted in the case of over-indebtedness. Knowing that an enterprise fails to make debt repayments, the bank intentionally avoids the enterprise in case it will borrow new loans. The enterprise also feels embarrassed about being unable to repay the loans of the bank, so it has to turn away from the bank and resort to other banks to raise loans. Since similar situations will repeatedly happen, enterprises and banks are increasingly alienated from each other. We call it systematic capital misallocation and deficiency because the government agreed to allow enterprises to use pre-tax profits to repay loans at the initial stage of the replacement of state appropriation by repayable loans. Later, when banks issued loans and financial credit on the basis of savings, they followed the regulations of the policy to require pre-tax repayment. The financial department, however, changed the regulations by replacing pre-tax repayment with after-tax repayment in 1992 in view of the heavy losses of fiscal revenue caused by the pre-tax repayment. This change aggregated the financial burden of state-owned enterprises which fell into an inextricable systematic pitfall. In 2004, Zhou Xiaochuan, President of the People’s Bank of China, made an analysis about the reasons for huge non-performing assets of China’s banks. He believed that nearly 30% of the non-performing assets were created by poor decisions of local governments who left over massive toxic assets when pushing forward economic development; another 30% was owing to poor management of state-owned enterprises; 20% was attributed to banks’ own factors; the remaining 20% was caused by defects in laws and regulations and economic restructuring.

Debt-For-Equity Swap: An Innovation in China’s Capital Formation Mechanism The systematic defect of the misplacement between debt and equity in the capital formation mechanism after the replacement of appropriation by loans makes stateowned enterprises fall into over-indebtedness, and the fundamental solution is to swap debt for equity. The debt-for-equity swap in China is a good example of the innovation in capital formation mechanism. In 1995, 18 industrial cities participated in the pilot project of the optimization of capital structure. At that time, due to the long-term implementation of replacing state appropriation with bank loans, the ratio of equity to debt in state-owned enterprises was 16.7:83.3 (lower than 2:8), which signified a full-blown crisis of

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over-indebtedness. It was estimated that to lower the debt ratio by 20%, another RMB950 billion state capital would be needed.

Soon afterwards, the pilot of optimizing capital structure was expanded to

over 100 industrial cities. The Chinese government issued some official documents to help the distressed enterprises to overcome difficulties by encouraging mergers and acquisitions, standardizing bankruptcy procedures, suspending repayment

of loans and interest or reducing overdue interest, but a debt-for-equity swap was

not mentioned. Besides, various misunderstandings caused senior government officials to adopt a bitterly critical and prohibitive attitude towards several pilot cases of debt-for-equity swaps in banks.

In September 1995, China International Capital Corporation Limited (CICC)

was established. At that time, Wang Qishan was both President of CCB and

Chairman of CICC, and Edwin Lin and Harrison Young were the first and the

second presidents of the company. As the company’s Senior Consultant, I was invited to work with the two vice-presidents, Fang Fenglei and Bi Mingjian,

on the investigation of the over-indebted Xinhuo Pulp Mill in Shanghai. We prepared a plan of bankruptcy, reconciliation, and restructuring, and tried to

help the company through a substitution of bankruptcy liquidation with debtfor-equity swaps. This was proposed namely by asking the creditor bank to

entrust the CICC to temporarily hold shares of the distressed company. This was

an innovation which won the attention and support from the State Economic

and Trade Commission, the Central Bank, the Shanghai Municipal Government, and other authorities. We had placed high expectations on the popularization of

“Xinhuo restructuring mode,” but since high-level government officials were keen on encouraging mergers and standardizing bankruptcy, this pilot program (which could serve as a supplement to the mergers and bankruptcies in the state-owned

enterprises reform) came under heavy criticism and exclusion, and was prohibited from being imitated and promoted.

However, the government documents of encouraging mergers and

standardizing bankruptcies, as well as other relief measures, were not that

effective. The over-indebtedness was not fundamentally changed due to the fact that a large number of enterprises with high debt-to-equity ratios failed to

replenish their own capital. Until 1998, under the pressures from the impact of the

Asian financial crisis and the severe over-indebtedness of domestic state-owned enterprises, the state government set a time limit of three years to overcome the

difficulties of large- and medium-sized state-owned enterprises and made an

important decision to fundamentally solve the excessive debts. The government

220

Reorganization and Debt-For-Equity Swaps of Distressed Enterprises

decided to establish four asset management companies in the second half of 1999 and applied debt-for-equity swaps to a certain portion of large- and medium-sized

state-owned enterprises which defaulted on loans of state-owned commercial banks. It was encouraging that the government policy of a debt-for-equity swap basically accepted the experience and the major principles of the “Xinhuo restructuring scheme.”

The greatest merit of a debt-for-equity swap was to end the 15-year long over-

indebtedness of state-owned enterprises and correct the reversed roles of debt and

equity since the implementation of replacing state allocation with bank loans. It

was, in fact, the complete denial and final settlement of China’s 40-year avoidance of capital.

Through this debt-for-equity swap, the overdue bank loans (i.e., non-

performing loans) of RMB460 billion by state-owned enterprises were converted

into these enterprises’ shares held by the assets management companies. The

greatest innovation of the debt-for-equity swap was to transfer the bad loans into the equity of the indebted enterprises. After the swap, the rights of creditors

were transferred into stock rights and the enterprises reduced their debts while

increasing their capital. The more magic function of the debt-for-equity swap was to not only solve the excessive debts of enterprises but also optimize the capital structure of the enterprises. As a consequence, those financially distressed enterprises gained a debt-paying ability of RMB460 billion, and this method became an effective means to boost bank loans and ease inflation at that time.

The case of a debt-for-equity swap vividly illustrates that if you put the same

amount of money into equity instead of debt, its contributions to economy and finance will be totally different. This is an impressive lesson of capital culture for a large number of government officials, business men, as well as economic and financial professionals.

If the practice of debt-for-equity swap has any deficiency it is that this practice

ought to be a vigorous measure for investment banks to dilute non-performing

loans instead of a stiff administrative act promoted by issuing official documents by the government departments. People know more about the subservient

bureaucratic style of work rather than the customer-tailored intelligence service and financial innovation provided by investment bankers. It was rumored that on each flight to Beijing, there would be at least one passenger asking for approval from the central government ministries for a debt-for-equity swap, and this might not be just hyperbole.

Besides, the policy of debt-for-equity swap came out four years after the

221

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 1

policy of mergers and bankruptcy in state-owned enterprises reform. As a result, the financial power of some competitive enterprises without affluent capital was reduced once they increased their debt-to-equity ratios by annexing disadvantaged enterprises. If the pilot scheme of Shanghai Xinhuo Pulp Mill had been promoted in 1996 (which would have brought forward the implementation of a debt-for-equity swap by four or five years) the achievements of state-owned enterprises reform would now be more significant with mergers as the supporting measure. Still, the implementation of the debt-for-equity swap policy was a great achievement overall and, in 2001, Prime Minister Zhu Rongji rightly declared a victory in the three-year relief plan for state-owned enterprises in the Report on the Work of the Government.

222

Notes Preface 1.

2. 3. 4. 5.

6. 7. 8. 9.

10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

Marx, “Inquiry into How It Is Possible for the Annual Profit and Wages to Buy the Annual Commodities, Which Besides Profit and Wages Also Contain Constant Capital,” Chap. 3 in Theories of Surplus Value, Vol.4 of Das Kapital. Engels, Anti-Dühring, Vol. 3 of Marx and Engels Collected Works. Jiang Zemin, 16th Party Congress Report. Hu Jintao, 17th Party Congress Report. Marx, “The Expansion of the Market Does Not Keep in Step with the Expansion of Production. The Ricardian Conception That an Unlimited Expansion of Consumption and of the Internal Market Is Possible,” Section 13 in “Ricardo’s Theory of Accumulation and a Critique of it,” Chap. 17 in Theories of Surplus Value, Vol.4 of Das Kapital. Marx, “Credit and Fictitious Capital,” Chap. 25 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. Marx, “Letter from Marx to Nikolai Danielson in St. Petersburg (April 10, 1879),” Marx and Engels Correspondence 1879. Marx, “The Role of Credit in Capitalist Production,” Chap 27 in The Process of Capitalist Production as a Whole, Vol. 3 in Das Kapital. In preparation of next year’s expenditure budget, the previous year’s actual expenditure is regarded as a premise or base, and by taking into account the possible growth factors of the next year, the government would calculate the budget of the next year. Chen Yun, “Construction Scale Should Comply With National Power.” Zhao Xiao, “What Kind of Macroeconomic Control Does China Need.” Qian Yingyi, Bai Chongen, and Xie Changtai, “The Return to Capital in China,” 61–102. Sheng Songcheng, “The Implication and Practical Significance of Aggregate Social Financing.” Property income refers to the capital gains from bank deposits, securities, real estate, automobiles and collection. Jones, “Obama Talks about Financial Regulations.” Associated Press, “Wall Street Will Play Less Dominant Role.” Dow Jones Newswires, “Greenspan Repeats His Opposition to More Regulation of Derivatives.” Ibid. Greenspan, “We Need a Better Cushion against Risk.” Zuckerman, “Greenspan Shocked at Failure of Free Markets.” Greenspan, “We Need a Better Cushion against Risk.” China Securities News, “Liu Mingkang Talked about Financial Innovation and Warned Banks with Three ‘Resolute Oppositions’. ” Three-anti refers to: To combat corruption, waste, and bureaucratism; Five-anti refers to: To fight bribery, tax evasion, cheating in labor or materials, theft of government property, and stealing of state economic intelligence.

223

Notes

24. Socialist industrialization and socialist transformation of agriculture, handicrafts and capitalist industry. 25. To achieve socialism, the government adopted a policy of redemption by steps in nationalizing means of production privately owned by the bourgeoisie. After the conversion of private enterprises into joint stateprivate management by whole trades, redemption has taken the form of payment of a fixed rate of interest, i.e., for a certain period the state pays through the special companies for whole trades, a fixed rate of interest on their investment to the capitalists. (Liu Shaoqi, The Political Report of the Central Committee of the CPC to the Eighth National Congress of the CPC, September 15, 1956, http://www.marxists.org/ subject/china/documents/cpc/8th_congress.htm ) 26. Deng Xiaoping, “We Shall Draw on Historical Experience.” 27. Deng Xiaoping, “We Shall Concentrate on Economic Development.” 28. Deng Xiaoping, “We Shall Draw on Historical Experience.” 29. Deng Xiaoping, “We Are Taking an Entirely New Endeavor.” 30. Marx, “Position of the Communists in Relation to the Various Existing Opposition Parties,” Chap. 4 in Manifesto of the Communist Party.

Chapter 1 1.

2. 3.

Marx, “The Expansion of the Market Does Not Keep in Step with the Expansion of Production. The Ricardian Conception That an Unlimited Expansion of Consumption and of the Internal Market Is Possible,” Section 13 in “Ricardo’s Theory of Accumulation and a Critique of it,” Chap. 17 in Theories of Surplus Value, Vol.4 of Das Kapital. Marx, “Pre-Capitalist Relationships,” Chap. 36 in The Process of Capitalist Production as a Whole, Vol.3 of Das Kapital. Marx mentioned that the sinking fund is also a fund for accumulation in Part 3, Chapter 19, Section 12 in Theories of Surplus Value. He also discussed the issue in letters to Engels dated August 20, 1862, and August 24, 1867.

Chapter 2 Marx, “Contradictions in the General Formula of Capital,” Chap.5 in The Process of Circulation of Capital, Vol. 1 of Das Kapital. 2. Marx, “Interest-Bearing Capital,” Chap. 21 in The Process of Capitalist Production as a Whole, Vol.3 of Das Kapital. 3. Marx and Engels, “Bourgeois and Proletarians,” Chap. 1 in The Communist Manifesto. 4. Engels, preface to The Process of Circulation of Capital, Vol. 2 of Das Kapital. 5. Marx, “Inquiry into How It Is Possible for the Annual Profit and Wages to Buy the Annual Commodities, Which Besides Profit and Wages Also Contain Constant Capital,” Chap. 3 in Theories of Surplus Value, Vol.4 of Das Kapital. 6. Marx, “Genesis of the Industrial Capitalist,” Chap. 31 in The Process of Production of Capital, Vol. 1 of Das Kapital. 7. Marx and Engels, “Bourgeois and Proletarians,” Chap. 1 in The Communist Manifesto. 8. Zhou Youguang, “Looking Back on the Capitalist Age,” 23–31. 9. Marx, Critique of the Gotha Program, 9. 10. Engels, Anti-Dühring, 350, 340, 341. 11. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol.3 of Das Kapital, 497–498. 1.

224

Notes

Chapter 3 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24.

Marx, “The General Law of Capitalist Accumulation,” Chap. 25 in The Process of Production of Capital, Vol. 1 of Das Kapital. Marx, “Letter from Marx to Nikolai Danielson in St. Petersburg (April 10, 1879),” Marx and Engels Correspondence 1879. Marx, “Credit and Fictitious Capital,” Chap. 25 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. Deng Xiaoping, Selected Works of Deng Xiaoping, Vol.3, 373. Mao Zedong, “Refute Right Deviationist Views That Depart from the General Line,” Selected Works of Mao Tse-tung, Vol. 5. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol.3 of Das Kapital. Marx, “Circulation Costs,” in “Section Two: The Circulation Process of Capital, The Chapter On Capital,” The Grundrisse; Vitaly Vygodsky, “How ‘Capital’ took shape,” Chap. 8 in The Story of a Great Discovery; Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol.3 of Das Kapital. Editor’s notes: “Society” and “Social,” in the original German are “Gesellschaft” and “Gesellschaftlich,” which also mean “Company” and “Company’s.” Marx, “The General Law of Capitalist Accumulation,” Chap. 25 in The Process of Production of Capital, Vol. 1 of Das Kapital. Marx, “Circulation Costs,” in “Section Two: The Circulation Process of Capital, The Chapter on Capital,” The Grundrisse. Marx, “The General Law of Capitalist Accumulation,” Chap. 25 in The Process of Production of Capital, Vol. 1 of Das Kapital. Marx, “Letter from Marx to Nikolai Danielson in St. Petersburg (April 10, 1879),” Marx and Engels Correspondence 1879. Marx, “Circulation Costs,” in “Section Two: The Circulation Process of Capital, The Chapter on Capital,” The Grundrisse. Marx, “The Time of Production,” Chap. 13 in The Process of Circulation of Capital, Vol. 2 of Das Kapital. Marx, “Co-operation,” Chap. 13 in The Process of Production of Capital, Vol. 1 of Das Kapital. Marx, “Competition (continued),” in “Section Two: The Circulation Process of Capital, The Chapter on Capital,” The Grundrisse. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. Ibid. Engels, “Introduction,” Supplement by Frederick Engels, Vol. 3 of Das Kapital. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. Ibid. Ibid. Marx, “Competition (continued),” in “Section Two: The Circulation Process of Capital, The Chapter on Capital,” The Grundrisse. Marx, “Interest and Profit of Enterprise,” Chap. 23 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital.

225

Notes

25. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. 26. Ibid. 27. Marx, “Historical Tendency of Capitalist Accumulation,” Chap. 32 in The Process of Capitalist Production as a Whole, Vol. 1 of Das Kapital. 28. Marx, “Commodities,” Chap. 1 in The Process of Capitalist Production as a Whole, Vol. 1 of Das Kapital. 29. Marx, “Letter from Marx to Engels on April 2, 1858,” Marx-Engels Correspondence 1858. 30. Marx, “The Role of Credit in Capitalist Production,” Chap. 27 in The Process of Capitalist Production as a Whole, Vol. 3 of Das Kapital. 31. Ibid. 32. Shares in companies based in mainland China that trade on either the Shanghai or Shenzhen stock exchanges. B Shares are eligible for foreign investment provided the investment account is in the proper currency (Shanghai B shares trade in U.S. dollars, while Shenzhen B-shares trade in Hong Kong dollars).

Chapter 4 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

13.

226

Lenin, “The Immediate Tasks of the Soviet Government,” Lenin’s Collected Works, Vol. 27. Lenin, “The Economic Basis of the Withering Away of the State,” Chap. 5 in The State and Revolution, Lenin’s Collected Works, Vol. 25; Lenin, “Supplementary Explanations by Engels,” Chap. 4 in The State and Revolution, Lenin’s Collected Works, Vol. 25. Stalin, “Industrialization of the country and the Right Deviation in the CPSU (B.),” Works, Vol. 11, 255– 302. Stalin, “2. Commodity Production under Socialism,” Economic Problems of the USSR. Ibid. Mao Zedong, “Critique of Stalin’s Economic Problems of Socialism in the USSR,” Selected Works of Mao Tse-tung, Vol. 8. Stalin, “2. Commodity Production under Socialism,” Economic Problems of the USSR. Mao Zedong, “Critique of Stalin’s Economic Problems of Socialism in the USSR,” Selected Works of Mao Tse-tung, Vol. 8. Hoover, Inaugural Addresses. Mao Zedong, “On the Draft Constitution of the People’s Republic of China,” Selected Works of Mao Tsetung, Vol. 5. Xiang Huaicheng, Fifty Years of China’s Finance. At that time, the planning department left out the following 10 projects from the fixed-asset investment: 1. equipment rebuilding; 2. housing renovation and relocation; 3. water conservancy projects and the refurbishment of embankments and reservoirs; 4. oilfield maintenance; 5. expansion projects of the extractive and logging industry; 6. municipal engineering maintenance; 7. railway overhaul and water damage repair; 8. fairway, road, and bridge maintenance; 9. the construction of simple warehouse sheds by commercial, food, and supply and marketing departments with simple construction funds; 10. the construction or purchase of a single piece of equipment or an individual project of fixed assets below RMB50,000. The 5 exclusions include: 1. The construction of elementary and secondary schools by the stand-by financial resources of local governments and enterprises or extra-budgetary funds; 2. the construction of hospitals, health centers, cultural centers, sports centers, libraries, and museums of or below the county level by the stand-by financial resources of county governments or extra-budgetary funds; 3. Highway expansion with the toll for highway maintenance; 4. the construction or expansion of urban highways and

Notes

the purchase of new public transportation vehicles with the city maintenance and construction funds; 5. the arrangement of the employee dormitory by long-established enterprises by their own funds. 14. Namely, a secure job, stable pay, and a guaranteed leading post. 15. Jiang Zemin, 15th Party Congress Report. 16. “Three attributes”: Safety, principle, and efficiency. “Four-self ”: Self-management, self-financing, risk selfretention, and self-balancing.

Chapter 5 1. 2. 3. 4. 5. 6. 7. 8.

9. 10. 11.

12.

13. 14.

Marx, “Introduction,” Chap. 18 in The Process of Circulation of Capital, Vol. 2 of Das Kapital. Marx, “The Turnover of Variable Capital,” Chap. 16 in The Process of Circulation of Capital, Vol. 2 of Das Kapital. Marx, “Letter from Marx to Engels on August 20, 1862,” Marx-Engels Correspondence 1862. Engels, “Letter from Engels to Marx on September 9, 1862,” Marx-Engels Correspondence 1862. Marx, “Letter from Marx to Engels on August 24, 1867,” Marx-Engels Correspondence 1867. Engels, “Letter from Engels to Marx on August 26, 1867,” Marx-Engels Correspondence 1867. Engels, “Letter from Engels to Marx on August 27, 1867,” Marx-Engels Correspondence 1867. Marx, “12. The Social Essence of Malthus’s Polemic against Ricardo. Malthus’s Distortion of Sismondi’s Views on the Contradictions in Bourgeois Production,” in “Thomas Robert Malthus,” Chap. 19 in Theories of Surplus Value, Vol. 4 of Das Kapital. Marx, “15. Malthus’s Principles Expounded in the Anonymous ‘Outlines of Political Economy’,” in “Thomas Robert Malthus,” Chap. 19 in Theories of Surplus Value, Vol. 4 of Das Kapital. Ibid. Marx, “3. Necessary Conditions for the Accumulation of Capital. Amortization of Fixed Capital and Its Role in the Process of Accumulation,” in “Ricardo’s Theory of Accumulation and a Critique of it,” Chap. 17 in Theories of Surplus Value, Vol. 4 of Das Kapital. Marx, “4. The Connection between Different Branches of Production in the Process of Accumulation. The Direct Transformation of a Part of Surplus-Value into Constant Capital — a Characteristic Peculiar to Accumulation in Agriculture and the Machine-building Industry,” in “Ricardo’s Theory of Accumulation and a Critique of it,” Chap. 17 in Theories of Surplus Value, Vol. 4 of Das Kapital. Economics Institute of the Academy of Sciences of the U.S.S.R.,“Socialist Accumulation. Accumulation and Consumption in Socialist Society,” in “Socialist Reproduction,” Chap. 39 in Political Economy. Marx, “Simple Reproduction,” Chap. 20 in The Process of Circulation of Capital, Vol. 2 of Das Kapital.

Chapter 6 1.

Build–operate–transfer (BOT) is a form of project financing, wherein government and contractors cooperate to undertake infrastructure projects. The operation mode is specifically as follows: A government grants the concession of an infrastructure project, such as the construction of roads, bridges, and quays, to a contractor (usually an international consortium). The contractor is responsible for the project design, financing, construction, and operation during the concession period. At the same time, the contractor also has to recover the costs, repay loans, and earn a profit. The infrastructure project will be transferred to the government at the end of the concession period.

Chapter 7 1.

Stanley and Girth, Bankruptcy: Problem, Process, Reform.

227

References Preface English materials: Associated Press. “Wall Street will play less dominant role.” The Economic Times, May 3, 2009. http://articles.economictimes.indiatimes.com/2009-05-03/ news/27638276_1_financial-sector-risk-taking-president-barack-obama. Dow Jones Newswires. “Greenspan Repeats His Opposition to More Regulation of Derivatives.” Berkman Center for Internet and Society of Harvard University, March 19, 1999. http://cyber.law.harvard.edu/rfi/press/ opposition.htm. Engels, Friedrich. Anti-Dühring. Vol. 3 of Marx and Engels Collected Works. Beijing: People’s Publishing House, 1972. Jones, Athena. “Obama talks about financial regulations.” NBC News, February 25, 2009. http://firstread.nbcnews.com/_news/2009/02/25/4432813-obamatalks-about-financial-regulations?lite. Marx, Karl. Manifesto of the Communist Party. Moscow: Progress Publishers, 1848. http://www.marxists.org/archive/marx/works/1848/communistmanifesto/ (accessed April 15, 2013). ———. Marx and Engels Correspondence 1879. New York: International Publishers, 1968. http://www.marxists.org/archive/marx/works/1879/letters/. ———. The Process of Capitalist Production as a Whole. Vol. 3 of Das Kapital. New York: International Publishers, 1894. http://www.marxists.org/archive/ marx/works/1894-c3/. ———. Theories of Surplus Value. Vol.4 of Das Kapital. Moscow: Progress Publishers, 1863. http://www.marxists.org/archive/marx/works/1863/theoriessurplus-value/. Qian Yingyi, Bai Chongen, and Xie Changtai. “The Return to Capital in China.” Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 37, 2 (2006). Zuckerman, Sam. “Greenspan Shocked at Failure of Free Markets.” San Francisco Chronicle, October 24, 2008. http://www.sfgate.com/business/ article/Greenspan-shocked-at-failure-of-free-markets-3188694. php#ixzz2Q2plvoiO (accessed April 10, 2013).

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Chinese materials: Chen Yun 陳雲. “Jianshe guimo yao he guoli xiang shiying” 建設規模要和國力相適 應 (Construction Scale Should Comply With National Power). Xinhua Net, January 18, 1957. http://news.xinhuanet.com/ziliao/2005-01/05/content_2418623.htm (accessed April 22, 2013. China Securities News. “Liu Mingkang tan jinrong chuangxin, gaojie yinhang tichu sange ‘jianjue fandui’ ” 劉明康談金融創新 告誡銀行提出三個“堅決反 對” (Liu Mingkang Talked about Financial Innovation and Warned Banks with Three “Resolute Oppositions”). Xinhua Net, April 24, 2009. http://news.xinhuanet.com/fortune/2009-04/24/content_11246764.htm (accessed April 10, 2013). Sheng Songcheng 盛松成. “Shehui rongzi zongliang de neihan ji shijian yiyi” 社 會融資總量的內涵及實踐意義 (The Implication and Practical Significance of Aggregate Social Financing). Website of the People’s Bank of China, February 17, 2011. http://www.pbc.gov.cn/publish/diaochatongjisi/866/2011/ 20110217180043605992604/20110217180043605992604_.html. Zhao Xiao 趙曉. “Dangqian Zhongguo xuyao shenmeyang de hongguan tiaokong” 當前中國需要什麼樣的巨集觀調控 (What Kind of Macroeconomic Control Does China Need). Zhao Xiao Sohu Blog. http://zhaoxiao.i.sohu.com/ blog/view/37415865.htm.

Translated materials: Deng Xiaoping 鄧小平. “Women gan de shiye shi quanxin de shiye” 我們干的 事業是全新的事業 (We Are Taking an Entirely New Endeavor), October 13, 1987. Deng Xiaoping wenxuan 鄧小平文選 (Selected Works of Deng Xiaoping), Vol.3. Website of People’s Daily. http://english.peopledaily.com.cn/dengxp/vol3/text/c1810.html (accessed April 15, 2013). ———. “Yixinyiyi gao jianshe” 一心一意搞建設 (We Shall Concentrate on Economic Development), September 18, 1982. Deng Xiaoping wenxuan 鄧 小平文選 (Selected Works of Deng Xiaoping), Vol.3. Website of People’s Daily. http://english.peopledaily.com.cn/dengxp/vol3/text/c1030.html (accessed April 15, 2013). ———. “Xiqu lishi jingyan, fangzhi cuowu qingxiang” 吸取歷史經驗 防止錯誤傾 向 (We Shall Draw on Historical Experience), April 30, 1987. Deng Xiaoping wenxuan 鄧小平文選 (Selected Works of Deng Xiaoping), Vol.3. Website of People’s Daily. http://english.peopledaily.com.cn/dengxp/vol3/text/ c1730.html (accessed April 15, 2013).

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Greenspan, Alan. “We Need a Better Cushion against Risk.” Financial Times, March 26, 2009. h t t p : / / w w w. f t . c o m / i n t l / c m s / s / 0 / 9 c 1 5 8 a 9 2 - 1 a 3 c - 11 d e - 9 f 9 1 0000779fd2ac.html#axzz2Q28EBxP9 (accessed April 10, 2013). Hu Jintao 胡錦濤. “Zhongguo gongchandang Shiqi ci quanguo daibiao dahui baogao” 中 國共產黨十七次全國代表大會報告 (17th Party Congress Report). Report presented at the 17th National Congress of the Communist Party of China, October 24, 2007. http://news.xinhuanet.com/english/2007-10/24/content_6938749_7.htm. Jiang Zemin 江澤民. “Zhongguo gongchandang Shiliu ci quanguo daibiao dahui baogao” 中國共產黨十六次全國代表大會報告 (16th Party Congress Report). Report presented at the 16th National Congress of the Communist Party of China, July 10, 2007. http://www.chinadaily.com.cn/china/2007-07/10/content_6142007.htm.

Introduction English materials: Greenspan, Alan. “Equities Show Us the Way to Recovery.” Financial Times. March 29, 2009. ———. “We Need a Better Cushion Against Risk.” Financial Times. March 26, 2009. Marx, Karl. Shengyu jiazhi lilun 剩餘價值理論 (Theories of Surplus Value). Trans. and eds. Central Compilation and Translation Bureau for Works of Marx, Engels, Lenin, and Stalin. Beijing: People’s Publishing House, 1975. ———. Ziben lun 資本論 (Das Kapital). Trans. and eds. Central Compilation and Translation Bureau for Works of Marx, Engels, Lenin and Stalin. Beijing: People’s Publishing House, 2004.

Chinese materials: Ba Shusong 巴曙松. “Cidai weiji de genyuan” 次貸危機的根源 (The Root Causes of the Subprime Crisis). China Macroeconomic Information Network, April 10, 2009. Bai Chongen 白重恩, Xiechang Tai 謝長泰, and Qian Yingyi 錢穎一. Zhongguo de ziben huibaolü 中國的資本回報率 (Return on Capital in China). Beijing: CITIC Publishing House, 2007. Cao Erjie 曹爾階. “Rang laodongzhe chengwei youchanzhe” 讓勞動者成為有產 者 (Turn Workers into Men of Property). Guoji hangkong bao 國際航空報 (International Aviation News), April 17, 2000.

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Chen Huai 陳淮. “Fangdi chanye fazhan yu zhongguo guoqing” 房地產業發展 與中國國情 (Real Estate Development and China’s National Conditions). Zhongguo Jingji shibao 中國經濟時報 (China Economic Times), February 23, 2009. Deng Xiaoping 鄧小平. Deng Xiaoping wenxuan 鄧小平文選 (Selected Works of Deng Xiaoping). Beijing: People’s Publishing House, 1993. Fan Gang 樊綱. “Weiji jiuzai nail, ni zenme keneng bu shou yingxiang?” 危機就 在那裡 你怎麼可能不受影響 (Crisis Is Right There, How Could You Not Be Affected?). Speeches made in the International Convention Center of National Accounting Institute, April 11, 2009. ———. “Zhongguo yao dali fazhan zhonghua gongye” 中國要大力發展重化工業 (China Should Vigorously Develop the Heavy and Chemical Industries). 21 shiji jingji baodao 21世紀經濟報導 (21st Century Business Herald), August 27, 2005. Research Group of the Subprime Mortgage Crisis. Cidai fengbo qishilu 次貸風波啟 示錄 (Revelation of Subprime Mortgage Crisis). Beijing: China Financial Publishing House, 2008. Sheng Songcheng 盛松成. “Shehui rongzi zongliang de neihan ji shijian yiyi” 社會 融資總量的內涵及實踐意義 (The Implication and Practical Significance of Aggregate Social Financing). Website of People’s Bank of China, February 17, 2011. Song Guoqing 宋國青. “Zhongguo touzilü taidi” 中國投資率太低 (China’s Investment Rate Is Too Low). 21 shiji jingji baodao 21世紀經濟報導 (21st Century Business Herald), August 29, 2006. Song Hongbing 宋鴻兵. Huobi zhanzheng 貨幣戰爭 (Currency War). Beijing: CITIC Publishing House, 2007. Tang Shisheng 湯世生. “Cong Meiguo ciji zhai wenti kan Zhongguo jinrong chuangxin zhi lu” 從美國次級債問題看中國金融創新之路 (To Find a Road for China’s Financial Innovation by Learning from the U.S. Subprime Debt Crisis). Dangdai jinrongjia 當代金融家 (Modern Bankers), (3) (2008). The Chinese Academy of Social Sciences. Chengshi lanpishu: Zhongguo chengshi fazhan baogao 城市藍皮書 : 中國城市發展報告 (Blue Book of Cities in China: Annual Report on Urban Development of China). Beijing: Social Sciences Academic Press, 2009. Wang Jian 王建. “Lun zouchu digu de weiyi daolu shi chengshihua” 論走出低谷的 唯一道路是城市化 (The Only Way Out of China’s Economic Downturn Is Urbanization). China Macroeconomic Information Network, April 16, 2009.

232

References

“Woguo gengdi zongshu jiejin 18 yi mu hongxian, kongzhi mianji chaoguo 1 yi mu” 我國耕地總數接近18億畝紅線 空置面積超1億畝 (The Total Arable Land in China Is Close to the Warning Line of 1.8 Billion Mu, and Idle Rural Land Has Surpassed 100 Million Mu). Banyuetan 半月談 (China Comment), February 17, 2011. Xin Qiaoli 辛喬利, and Sun Zhaodong 孫兆東. Cidai weiji 次貸危機 (Subprime Crisis). Beijing: China Economic Publishing House, 2008. Xu Xiaonian 許小年. “Jinrong gaige he touzi yinhang de fazhan” 金融改革和投資 銀行的發展 (Financial Reform and the Development of Investment Banks). Website of Renmin University of China News, April 9, 2003. Zhang Weiying 張維迎. “Lijie he hanwei shichang jingji” 理解和捍衛市場經 濟 (Understand and Defend the Market Economy). China Economic Net, December 23, 2007. Zhaobing Xian 趙炳賢. Ziben yunying lun 資本運營論 (Theory of Capital Operation). Beijing: Enterprise Management Publishing House, 1997. Zheng Xinli 鄭新立. “Wu da xiaofei redian jiang tuidong weilai Zhongguo jingji” 五大消費熱點將推動未來中國經濟 (Five Growth Points in Consumption Will Drive Forward China’s Economy). Sina News, August 26, 2003. http:// news.sina.com.cn/c/2003-08-26/0349636034s.shtml (accessed March 26, 2013). Zhong Wei 鐘偉. “Cong cidai weiji kan jinrong lilun he shijian de kunhuo” 從次貸 危機看金融理論和實踐的困惑 (The Confusions in Financial Theories and Practice Judging from the Subprime Mortgage Crisis). Nanfang zhoumo 南方週末 (Southern Weekly), April 27, 2009. Zhu Xiaohuang 朱小黃. “Cidai weiji: Huoqi ganggan shikong” 次貸危機 : 禍起杠 杆失控 (Subprime Mortgage Crisis: Result from Out-of-Control Leverage). Fengxian guanli cankao 風險管理參考 (Risk Management Reference), (10) (2008).

Translated materials: Roach, Stephen. “Meiguo shiheng yu zhongguo wuguan” 美國失衡與中國無關 (America’s Inflated Asset Prices Must Fall). FT Chinese Website, January 15, 2008.

Chapter 1 English materials: Marx, Karl and Engels, Frederick. Letters of Karl Marx and Frederick Engels for the 1860s. http://www.marxists.org/archive/marx/letters/date/1860s.htm.

233

References

Marx, Karl. The Process of Capitalist Production as a Whole. Vol. 3 of Das Kapital. New York: International Publishers, 1894. http://www.marxists.org/archive/ marx/works/1894-c3/. ———. Theories of Surplus Value. Vol.4 of Das Kapital. Moscow: Progress Publishers, 1863. http://www.marxists.org/archive/marx/works/1863/theoriessurplus-value/.

Chinese materials: Cao Erjie 曹爾階. “Tuokuan ziben xingcheng jizhi chuangxin de huodong kongjian” 拓寬資本形成創新的活動空間 (Enlarging the Space for Capital Formation and Innovation). Financial Times, May 2006.

Translated materials: Adda, Jacques. Jingji quan quanqiuhu 經濟全球化 (The Globalization of Economy). Trans. He Jing and Zhou Xiaoxing. Beijing: Central Compilation & Translation Press, 2001. Chesnais, François. Jinrong quanqiuhua 金融全球化 (The Globalization of Finance). Trans. Qi Jianhua and Hu Zhenliang. Beijing: Central Compilation and Translation Press, 2006. ———. Ziben quanqiuhua 資本全球化 (The Globalization of Capital). Trans. Qi Jianhua. Beijing: Central Compilation & Translation Press, 2001. Martin, Peter N. and Hollnagel, Bruno. Zhiben zhanzheng 資本戰爭 (Capital War / Die großen Spekulationen der Weltgeschichte). Trans. Wang Yinhao. Tianjin: Tianjin Education Press, 2008. Marx, Karl. Ziben lun資本論 (Das Kapital). Beijing: People’s Publishing House, 2004. Mishkin, Frederick. Xia yi lun weida de quanqiuhu下一輪偉大的全球化 (The Next Great Globalization). Trans. Jian Shiming. Beijing: CITIC Publishing House, 2007. Sachs, Jeffery. Pinqiong de zhongjie 貧窮的終結 (The End of Poverty). Shanghai: Shanghai People’s Publishing House, 2007.

Chapter 2 English materials: Engels, Friedrich. Anti-Dühring. Vol. 3 of Marx and Engels Collected Works. Beijing: People’s Publishing House, 1972.

234

References

———. Preface to The Process of Circulation of Capital. Vol. 2 of Das Kapital. Moscow: Progress Publishers, 1885. http://www.marxists.org/archive/marx/works/1885-c2/index.htm. Marx, Karl and Engels, Frederick. “Bourgeois and Proletarians.” Chap 1 in The Communist Manifesto. Moscow: Progress Publishers, 1848. http://www.marxists.org/archive/marx/letters/date/1860s.htm. Marx, Karl. Critique of the Gotha Program. Vol. 3 of Marx and Engels Collected Works. Beijing: People’s Publishing House, 1972. ———. The Process of Capitalist Production as a Whole. Vol. 3 of Das Kapital. New York: International Publishers, 1894. http://www.marxists.org/archive/ marx/works/1894-c3/. ———. The Process of Circulation of Capital. Vol. 1 of Das Kapital. Moscow: Progress Publishers, 1887. http://www.marxists.org/archive/marx/ works/1867-c1/index.htm. ———. Theories of Surplus Value. Vol.4 of Das Kapital. Moscow: Progress Publishers, 1863. http://www.marxists.org/archive/marx/works/1863/theoriessurplus-value/.

Chinese materials: Cao Erjie 曹爾階. “Ziben wenti yiersan” 資本問題一二三 (One Two Three: Questions on Capital). Touzi yanjiu 投資研究 (Investment Studies), (2) (1998). Feng Zibiao 馮子標 et al. “Shehui zhuyi ziben” huigu yu yanjiu “社會主義資本”回 顧與研究 (Review and Research of Socialist Capital). Beijing: Economic Science Press, 2000. Mao Yushi 茅於軾. Guofu guoqiong: Zhidu he zhongguo de jingji gaige 國富國窮 : 制 度和中國的經濟改革 (The Wealth and Poverty of Nations: System and China’s Economic Reform). Website of TECN, January 7, 2008. Zeng Kanglin 曾康霖. Zijin lun 資金論 (On Capital). Beijing: China Financial Publishing House, 1990. Zhang Duan 張端. “Shehui ziben” chulun 社會資本初論 (Preliminary Discussion on Social Capital). Touzi yanjiu 投資研究 (Investment Research), (7) (1995). Zhou Youguang 周有光. “Huigu ziben zhuyi shiqi” 回顧資本主義時期 (Looking Back on the Capitalist Age). Zhou Youguang banshui xingao 周有光百歲新稿 (New Writings of a Hundred Year-Old Man).Beijing: People’s Publishing House, 2005.

235

References

Translated materials: Marx, Karl. Ziben lun 資本論 (Das Kapital). Trans. Central Compilation and Translation Bureau for Works of Marx, Engels, Lenin and Stalin. Beijing: People’s Publishing House, 2004.

Chapter 3 English materials: Engels, Frederick. Supplement by Frederick Engels. Vol. 3 of Das Kapital. New York: International Publishers, 1894. http://www.marxists.org/archive/marx/ works/1894-c3/supp.htm#intro. ———. The Process of Circulation of Capital. Vol. 2 of Das Kapital. Moscow: Progress Publishers, 1885. http://www.marxists.org/archive/marx/works/1885-c2/index.htm. Marx, Karl and Engels, Friedrich. Marx-Engels Correspondence 1858. http://www. marxists.org/archive/marx/works/1858/letters/. Marx, Karl. Letter from Marx to Nikolai Danielson in St. Petersburg (April 10, 1879). Marx and Engels Correspondence. New York: International Publishers, 1968. http://www.marxists.org/archive/marx/works/1879/letters/79_04_10. htm. ———. The Grundrisse. http://www.marxists.org/archive/marx/works/1857/grundrisse/ch10. htm; ———. The Process of Capitalist Production as a Whole. Vol. 3 of Das Kapital. New York: International Publishers, 1894. http://www.marxists.org/archive/ marx/works/1894-c3/. ———. The Process of Circulation of Capital. Vol. 1 of Das Kapital. Moscow: Progress Publishers, 1887. http://www.marxists.org/archive/marx/ works/1867-c1/index.htm. Vygodsky, Vitaly. The Story of a Great Discovery, 1965. http://www.marxists.org/ archive/vygodsky/1965/ch8.htm.

Chinese materials: Cao Erjie 曹爾階. Zhongguo zhengquan shichang yanjiu yu zhanwang 中國證券市場研 究與展望 (The Research and Outlook of China’s Securities Market). Beijing: China Financial and Economic Publishing House, 1993. Cao Fengqi 曹鳳岐. Zhongguo qiye gufenzhi de lilun yu shijian 中國企業股份制的理 論與實踐 (Theory and Practice of the Sharing System in China). Beijing: Enterprise Management Publishing House, 1989.

236

References

Liu Hongru 劉鴻儒. “Guanyu woguo shixing gufenzhi de jige wenti” 關於我國 試行股份制的幾個問題 (Several Questions on the Pilots of a Joint-Stock System). People’s Daily, June 23, 1992.

Translated materials: Deng Xiaoping 鄧小平. Deng Xiaoping wenxuan 鄧小平文選 (Selected Works of Deng Xiaoping), Vol. 3. Website of University of Mississippi, http://www. olemiss.edu/courses/pol324/dengxp92.htm (accessed April 26, 2013). Mao Zedong 毛澤東. “Pipan likai zong luxian de youqin guandian” 批判離開總 路線的右傾觀點 (Refute Right Deviationist Views That Depart from the General Line). Speech delivered on June 15, 1953. Mao Zedong xuanji 毛澤 東選集 (Selected Works of Mao Tse-tung), Vol. 5. http://www.marxists. org/reference/archive/mao/selected-works/volume-5/mswv5_28.htm. Marx, Karl. Ziben lun 資本論 (Das Kapital). Trans. and eds. Central Compilation and Translation Bureau for Works of Marx, Engels, Lenin and Stalin. Beijing: People’s Publishing House, 2004.

Chapter 4 English materials: Hoover, Herbert. Inaugural Addresses, delivered on March 4, 1929. http://www. bartleby.com/124/pres48.html. Lenin, V. I. Lenin’s Collected Works. http://www.marxists.org/archive/lenin/works/cw/index.htm Stalin, J. V. “Industrialization of the country and the Right Deviation in the CPSU (B.).” Speech delivered at the Plenum of the C.P.S.U.(B.) on November 19, 1928. Works, Vol. 11. Moscow: Foreign Languages Publishing House, 1954. http://www.marx2mao.com/Stalin/ICRD28.html. Stalin, J. V. Economic Problems of the USSR. Beijing: Foreign Language Press, 1972. http://www.marxists.org/reference/archive/stalin/works/1951/ economic-problems/ch03.htm.

Chinese materials: Bai Hejin, et al. 白和金 等. Jingji Zhongguo 經濟中國 (China’s Economy). Beijing: China Financial and Economic Publishing House, 1998. Bian Hongdeng 卞洪登. Ziben yunyin fanglue 資本運營方略 (Capital Operation Strategy). Beijing: China Reform Publishing House, 1997. Bo Yibo 薄一波. Ruogan zhongda juece yu shijian de huigui 若干重大決策與事件的回 顧 (Reviews on Several Major Decisions and Events). Beijing: CPC Central

237

References

Party School Publishing House, 1991. Cao Erjie, et al. 曹爾階 等. Xin Zhongguo touzi shigang 新中國投資史綱 (Investment History of New China). Beijing: China Financial and Economic Publishing House, 1992. Ding Bing 丁冰. “Xin Zhongguo gongye jianshe, liushi nian zhujiu huihuang” 新 中國工業建設 六十年鑄就輝煌 (Industrial Construction of New China Obtains Splendid Achievements in Sixty Years). Hongqi Wengao 紅旗文稿 (Red Flag Manuscripts), October 27, 2009. Fang Ning 房寧. Shehui zhuyi shi yizhong hexie 社會主義是一種和諧 (Socialism Is a Kind of Harmony). Beijing: China Social Science Press, 2007. Jia Kang 賈康. “Zhongguo caizheng gaige sanshi nian de lujing yu mailuo” 中國 財政改革30年的路徑與脈絡 (Thirty-Year Reform of China’s Finance). Jingji yanjiu cankao 經濟研究參考 (Review of Economic Research), February 6, 2009. Jiang Yiwei 蔣一葦. Wo de jingji gaige guan 我的經濟改革觀 (My Ideas on Economic Reform). Beijing: Economy and Management Publishing House, 1993. Li Rongrong 李榮融. “Guoyou qiye gaige zai xin de qidian shang wen bu tuijin” 國 有企業改革在新的起點上穩步推進 (To Steadily Promote the State-Owned Enterprises Reform on a New Start). Qiushi 求是 (Seeking Truth), August 2007. Li Rui 李銳. Mao Zedong de zaonian yu wannian 毛澤東的早年與晚年 (Mao Zedong in His Early and Later Years). Guiyang: Guizhou People’s Publishing House, 1992. Liu Xuyi 劉緒貽 and Yang Shengmao 楊生茂. Fu lan ke lin D. luo sifu shidai 佛蘭克 林·D·羅斯福時代 (The Age of Franklin D. Roosevelt [1929–1945]). Beijing: People’s Publishing House, 1994. Lü Zongsu 呂宗恕. “Chu Shijian shoushen” 褚時健受審 (The Trial of Chu Shijian). Xin Jingbao 新京報 (The Beijing News), January 3, 2009. Peng Jianguo 彭建國. “Zhongguo qiye gaige sanshi nian huishou” 中國企業改革 三十年回首 (Thirty-Year Review of China’s Corporate Reform). Zhongguo xiangzhen qiye 中國鄉鎮企業 (China Township Enterprises), (12) (2008). Qin Hui 秦暉. “Zhongguo qiji de xingcheng yu weilai, gaige sanshi nian zhi wo jian” 中國奇跡的形成與未來 改革三十年之我見 (The Formation and Future of the China Miracle, My Views on the 30-Year Reform). Nanfang zhoumo 南 方週末 (Southern Weekly), February 21, 2008. Sun Yefang 孫冶方. Shehui zhuyi jingji de ruogan lilun wenti 社會主義經濟的若干 理論問題 (Several Theoretical Problems on Socialist Economy). Beijing: People’s Publishing House, 1982.

238

References

Wu Jinglian 吳敬璉. Lun jingzheng xing shichang tizhi 論競爭性市場體制 (On Competitive Market System). Beijing: China Financial and Economic Publishing House, 1991. Xiang Huaicheng 項懷誠. Zhongguo caizheng wushi nian 中國財政50年 (Fifty Years of China’s Finance). Beijing: China Financial and Economic Publishing House, 1999. Xue Muqiao 薛暮橋. Lun jingji tizhi gaige 論經濟體制改革 (On Economic Reform). Beijing: People’s Publishing House, 1990. ———. Zhongguo shehui zhuyi jingji wenti yanjiu 中國社會主義經濟問題研 究 (Research on China’s Socialist Economic Issues). Beijing: People’s Publishing House, 1979. Yang Jishen 楊繼繩. Deng Xiaoping shidai 鄧小平時代 (The Era of Deng Xiaoping). Beijing: Central Compilation and Translation Press, 1998. Zhang Dicheng 章迪誠. “Guoqi gaige sanshi nian, shishi zhua da fang xiao zhanlue” 國企改革三十年 實施抓大放小戰略 (Thirty-Year Reform of StateOwned Enterprises, Implementation of the Policy of Invigorate Large Enterprises While Relaxing Control Over Small Ones). China Industry News Net, November 26, 2008. Zhang Weiying 張維迎. Zhongguo gaige sanshi nian 中國改革30年 (Thirty Years of China’s Reform). Shanghai: Shanghai People’s Publishing House, 2008. Zhang Zuoyuan 張卓元. “Cong Bainian ji ruo dao jingji daguo de kuayue” 從 百年積弱到經濟大國的跨越 (Development from a Weak Country to an Economic Superpower). Guangming ribao 光明日報 (Guangming Daily), August 27, 2009.

Translated materials: Jiang Zemin 江澤民. “Zhongguo gongchandang Shiwu ci quanguo daibiao dahui baogao” 中國共產黨十五次全國代表大會報告 (15th Party Congress Report). Report presented at the 15th National Congress of the Communist Party of China, September 12, 1997. http://www.fas.org/news/china/1997/970912-prc. htm. Keynes, John Maynard. Jiuye lixi he huobi tonglun 就業利息和貨幣通論 (The General Theory of Employment, Interest, and Money). Trans. Shang Hongye 商鴻業. Beijing: Commercial Press, 1963. Krugman, Paul R. Meiguo zenme le? 美國怎麼了 (The Conscience of a Liberal). Trans. Liu Bo. Beijing: CITIC Publishing House, 2008. Mao Zedong 毛澤東. “Du sidalin ‘sulian shehui zhuyi jingji wenti’ pizhu” 讀史達 林 蘇聯社會主義經濟問題 批註 (Critique of Stalin’s Economic Problems of

239

References

Socialism in the USSR). Mao Zedong xuanji 毛澤東選集 (Selected Works of Mao Tse-tung), Vol.8. http://www.marxists.org/reference/archive/mao/ selected-works/volume-8/mswv8_66.htm. Mao Zedong 毛澤東. “Guanyu Zhonghua renmin gongheguo xianfa caoan” 關 於中華人民共和國憲法草案 (On the Draft Constitution of the People’s Republic of China). Mao Zedong xuanji 毛澤東選集 (Selected Works of Mao Tse-tung), Vol. 5. http://www.marxists.org/reference/archive/mao/selected-works/ volume-5/mswv5_37.htm Ohmae Kenichi. M xin shehui M型社會 (M-Shape Society). Trans. Liu Jinxiu 劉錦秀 and Jiang Yuzhen 江裕真. Beijing: CITIC Publishing House, 2007.

Chapter 5 English materials: Economics Institute of the Academy of Sciences of the U.S.S.R. Political Economy. London: Lawrence and Wishart, 1957. Marx, Karl and Engels, Friedrich. Marx-Engels Correspondence 1862. http://www.marxists.org/archive/marx/works/1862/letters/. ———. Marx-Engels Correspondence 1867. http://www.marxists.org/archive/marx/works/1867/letters/ Marx, Karl. The Process of Circulation of Capital. Vol. 2 of Das Kapital. Moscow: Progress Publishers, 1956. http://www.marxists.org/archive/marx/ works/1885-c2/index.htm. ———. Theories of Surplus Value. Vol. 4 of Das Kapital. http://www.marxists.org/archive/marx/works/1863/theories-surplusvalue/

Chinese materials: Cao Erjie 曹爾階. “Chanpin gengxin huandai yu guding zichan zai shengchan” 產品更新換代與固定資產再生產 (Product Updates and Reproduction of Fixed-Assets). Jingji yanjiu 經濟研究 (Economic Research Journal), (10) (1984). ———. “Guding zichan zai shengchan he xin de wuxing sunhao” 固定資產再 生產和新的無形損耗 (Reproduction of Fixed-Assets and New Moral Depreciation). Caizheng yanjiu 財政研究 (Public Finance Research), (5) (1986). Liu Guoguang 劉國光. Shehui zhuyi zaishengchan wenti 社會主義再生產問題 (Socialist Reproduction). Beijing: Joint Publishing, 1980.

240

References

Tian Chunsheng 田椿生 and Liu Huiyong 劉慧勇. Lun zhejiu 論折舊 (On Depreciation). Beijing: China Financial and Economic Publishing House, 1986.

Translated materials: Davidson, Sidney. Xiandai kuaiji shouce 現代會計手冊 (Handbook of Modern Accounting). Trans. Yang jiwan et al. 楊紀婉 等. Beijing: China Financial and Economic Publishing House, 1982. Marx, Karl. Shengyu jiazhi lilun 剩餘價值理論 (Theories of Surplus Value). Trans. and eds. Central Compilation and Translation Bureau for Works of Marx, Engels, Lenin and Stalin. Beijing: People’s Publishing House, 1975.

Chapter 6 Chinese materials: Dong Yuxiao 董欲曉, and Zhang Man 張曼. Jinrong zulin zai kuorong 金融租賃再 擴容 (Re-expansion of Financial Leasing). Caijing 財經 (Finance), (10) (2010). Qu Yankai 屈延凱. “Rongzi zulin zai ziben shichang zhong de yingyong” 融資租賃 在資本市場中的應用 (The Application of Financial Leasing in the Capital Market). Xiang cai zhengquan gaoji luntan 湘財證券高級論壇 (Xiangcai Securities High-Level Forum), July 2000. R e s e a rc h I n C h i n a . “ 2 0 1 0 – 2 0 11 n i a n Z h o n g g u o ro n g z i z u l i n h a n g y e yanjiu” 2010–2011年中國融資租賃行業研究 (Research on China’s Financial Leasing Industry 2010–2011). http://wenku.baidu.com/ view/5d638246852458fb770b56ba.html (accessed July 31, 2013). “2006 nian Zhongguo rongzi zulin hangye fenxi” 2006年中國融資租賃行業分析 (Research on China’s Financial Leasing Industry 2006). Baogao zaixian 報告 在線 (Report on line), March 23, 2007.

Chapter 7 English materials: 1. Stanley, David T., and Girth, Marjorie. Bankruptcy: Problem, Process, Reform. Washington, D.C.: Brookings Institution Press, 1971.

Chinese materials: Cao Erjie 曹爾階. “ ‘Zhai zhuan gu’ de teshu gongxian” “債轉股”的特殊貢獻 (Special Contribution of Debt-For-Equity Swaps). Jingrong shibao 金融時報 (Financial News), November 13, 1999.

241

References

Cao Erjie 曹爾階. “ ‘Zhai zhuan gu’ gongbukemo” “債轉股”功不可沒 (The Important Role of Debt-For-Equity Swaps). Beijing jingji bao 北京經濟報 (Beijing Economic Daily), September 18, 2000. Cao Erjie 曹爾階. “ ‘Zhai zhuan gu’ yu jinrong zichan guanli gongsi de gongneng dingwei” “債轉股”與金融資產管理公司的功能定位 (Functions of Debt-ForEquity Swaps and Financial Assets Management Companies). Shanghai touzi 上海投資 (Shanghai Investment), (1) (2000). Cao Erjie 曹爾階. “ ‘Zhai zhuan gu’: Zhongguo chongxin renshi ziben” “債轉股”: 中國重新認識資本 (Debt-For-Equity Swaps: To Rethink Capital). Guoji hangkong bao 國際航空報 (International Aviation News), August 23, 1999. Cao Erjie 曹爾階. “Mo dao bu wu kan chai gong” 磨刀不誤砍柴工 (A beard well lathered is half shaved). Beijing jingji bao 北京經濟報 (Beijing Economic Daily), February 9, 2001. Cao Erjie 曹爾階. “Zai tan ‘zhai zhuan gu’ de teshu gongxian” 再談“債轉股”的特殊 貢獻 (Special Contribution of Debt-For-Equity Swaps Two). Jingrong shibao 金融時報 (Financial News), March 11, 2000. Cao Erjie 曹爾階. “Zhai zhuan gu: Fei gong jingji de jinru jiyu” 債轉股:非公經 濟的進入機遇 (Debt-For-Equity Swaps: Opportunities for Non-Public Economies). Beijing jingji bao 北京經濟報 (Beijing Economic Daily), December 12, 1999. Cao Erjie 曹爾階. “Zican chongzu de xin jiyu” 資產重組的新機遇 (New Opportunities for Asset Restructuring). Jingji ribao 經濟日報 (Economic Daily News), February 19, 2001. Wang Weiguo 王衛國. “Lun chongzheng zhidu” 論重整制度 (On Corporate Restructuring). Faxue yanjiu 法學研究 (Chinese Journal of Law), (1) (1996). Zhou Xiaochuan 周小川. Chongjian yu zaisheng 重建與再生 (Restructuring and Rebirth). Beijing: China Financial Publishing House, 1999. Zhou Xiaochuan 周小川. “Tan yinhang buliang zichan” 談銀行不良資產 (On Toxic Assets of Banks). Speeches presented at the Chinese Economists 50 Forum. Zhengquan zhixin 證券之星 (Securities Star), December 7, 2004.

242

Index accelerated depreciation 42-3, 47, 150, 1702, 184, 189, 195-6, 201 accumulation 2, 5, 9, 41-2, 50, 57-61, 63, 69, 110, 166-7, 169-70, 172-4, 178-81, 183 advanced capital 42, 74, 170, 172 asset-backed securities (ABS) 17-19, 22, 267, 29, 44, 46 assets management 47, 50, 196 bankruptcy boom 211, 213 bankruptcy law 43, 208-10, 214-15 bankruptcy liquidation 208-9, 215-16, 220 borrowed capital 6-7, 40-1, 54, 216 build operate transfer (BOT) 198 capital construction 6, 88, 100, 103-5, 10910, 112-14, 119, 141, 164-7, 174-5, 17784, 213-14, 217 capital construction investment 105, 11314, 120, 164-6, 174, 176-8, 183-4 capital construction plan 105, 112-13, 1747, 179 capital culture 5-9, 70, 95, 100, 167, 194, 208, 211, 221 capital expansion 5, 19, 37, 40-1, 43-4, 4850, 103, 107, 118-19, 122 capital formation mechanism 3, 18, 37-8, 41-50, 66-9, 75, 87, 89, 105, 108-11, 1723, 175-7, 195-6, 216-17, 219 capital formation mechanism innovation 41, 44, 46-8, 50, 54 capital investment 172, 178-9, 182 capital market 2, 4-8, 10, 12, 16, 18-24, 32-4, 42-51, 88-90, 102-4, 116-18, 134-6, 1424, 154, 158-60 capital socialization 65, 67, 69, 75

capitalist mode 59-60, 73-5, 77, 79 capitalist production 41, 55, 58, 74, 77-8, 92, 168, 170 capitalist redemption 30, 72 China Construction Bank (CCB) 48, 66, 71, 80-1, 103, 108, 113, 144-5, 164, 166, 171, 177-8, 180-3, 198, 208 collateralized debt obligation (CDO) 22, 44 commodity production 55, 92-3, 101, 110, 112, 115, 117-18, 122, 129 compensation fund 59, 166-7, 170-2 corporate bankruptcy 208, 210-11, 216 credit default swap (CDS) 22, 44 credit loans 112, 121, 124, 141, 210, 212 credit quota 121, 142-6, 217 debt-for-equity swaps 130, 155-6, 207, 20911, 213, 215, 217-22 depreciation funds 105-6, 163, 165-7, 16971, 173-7, 179, 181-3, 185, 187, 189, 191 depreciation rate 42, 150, 169-72, 184, 189 direct financing 17-18, 26, 43-4, 47-8 distressed enterprises 155, 207-9, 211-15, 217, 219-21 equipment leasing 195-6, 198 equity 6, 49, 116, 130, 160, 210, 219, 221 excess capital 45, 47, 50-1 excessive debts 6, 15, 129-30, 155, 211, 220 excessive investment 165-6 expanded reproduction 101, 163-7, 169-71, 173-9, 181-3, 185, 187, 189, 191 extra-budgetary funds 83-4, 118-19 fictitious economy 23, 25, 46-7, 51, 154 financial crisis 10, 12, 19-23, 25-6, 29, 38,

243

Index

44, 46, 48, 95, 147-8 financial innovation 22, 24-5, 27, 29, 47, 108, 221 financial leasing firms 199, 201-5 fixed-asset investment 105, 141, 176, 180-4 fixed assets 7, 15, 99, 102, 137, 167, 170-1, 175, 178, 184-90, 197 gross national product (GNP) 91, 104, 171 Great Leap Forward 30, 72, 101, 103-4, 164, 166, 174, 176, 179-80 intangible assets 43, 173-4 investment banks 6, 22, 28, 44, 47-8, 50-1, 103, 159, 200, 205, 221 investment expansions 118, 120-1, 151, 164-6 investment scale 9-10, 16, 68, 104, 118-19, 122, 149, 166, 178, 180 joint-stock system 3, 6, 64-7, 69-73, 75, 77, 79-83, 85, 135, 156 leasing companies 194-201, 203-4, 211 management buy-outs (MBO) 33, 137, 159 marginal benefits 8-9, 94, 196, 205, 210 market economy 8, 46, 49, 51, 84-5, 89, 945, 111, 115, 118, 122-3, 135-6, 140-3, 145-7, 214 mergers 5, 20, 43-4, 84, 128, 134, 136, 138, 155, 157, 186, 188, 212, 220, 222 moral depreciation 170, 184-6, 188-91 National Construction Committee (NCC) 113-14, 116 non-state economy 30-1, 140-3, 146

pilot enterprises 82, 129, 135, 202 planned economy 9, 16, 29, 42, 48-9, 62, 66, 84-5, 88, 93-4, 97-101, 128, 135, 140-2 private capital 16, 30-3, 42, 63, 71-2, 74-5, 77, 79, 98, 135, 157-9, 203 private investment 11, 42, 47, 96, 149-50, 154-5, 158 proactive fiscal policy 10, 147-9, 152-4 property income 3, 21, 35-6, 85 public ownership 2, 59-60, 62, 83, 89, 98, 101-2, 108, 117, 129, 132, 135, 166 simple reproduction 101, 166, 178-9, 181-3 social capital 4-5, 41-4, 47, 50, 69, 73-5, 77, 79, 148 socialist market economy 9, 30, 49, 63, 73, 111, 122-3, 126, 132, 135, 144, 148, 21314, 216 socialized mass production 41-2, 44, 60, 6770, 102, 187-8, 214 state capital 156-7, 159, 220 State Development Planning Commission (SDPC) 49, 80, 113-14, 128, 177 state intervention 87-9, 91, 93, 95, 97-9, 101, 103, 105, 107, 109, 113, 115, 117, 147-9 State Investment 87, 89, 91, 93, 95, 97, 99, 101, 103, 105, 107-9, 111, 113, 115, 117 state-owned banks 144-5, 213 state-owned economy 30, 33, 60-1, 71, 8990, 98, 100, 134-5, 142-3, 156, 159-60 state-owned enterprises 6, 33, 48, 62-3, 83, 98-9, 103, 111-12, 123-4, 126, 128-37, 155-60, 211-17, 219, 221-2 State Planning Commission 66, 80, 88, 100, 166, 176, 178, 180, 182-4 strategic adjustments 33, 135, 156-9 surplus labor-time 2, 57-8, 60-2 surplus value 2, 55-7, 59-62, 169

opportunity cost 8, 51, 115, 137 tax-sharing system 111, 122-3, 125-7

244

Published by Enrich Professional Publishing, Inc. Suite 208 Davies Pacific Center 841 Bishop Street Honolulu, HI, 96813 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 2/F, Rays Industrial Building, 71 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Hai Dian Zhong Jie, Haidian District, Beijing, China Singapore Office: 16L, Enterprise Road, Singapore 627660 English edition © 2014 by Enrich Professional Publishing (S) Private Limited Chinese original edition © 2012 China Renmin University Press Translated by Barbara Cao and Ben Ma Edited by Barbara Cao, Glenn Griffith, and Ben Ma 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 and retrieval system now known or to be invented, without prior written permission from the Publisher. ISBN (Hardback)

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This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. 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. Printed in Hong Kong with woodfree paper from Japan

Contents Chapter 8

The Non-Public Sector: Indefinite Vitality............................. 1

Chapter 9

The Use of Foreign Capital and Dual Transformation........ 29

Chapter 10

Knowledge Economy and Human Capital from the Perspective of Venture Capital.............................................. 65

Chapter 11

Capitalization and Corporate Equity and Debt Financing...................................................................... 105

Chapter 12

Creative Destruction: Mergers and Acquisitions.............. 167

Chapter 13

Mutual Funds: An Alternative to Bank Loans................... 201

Notes........................................................................................................................ 241. References................................................................................................................ 243 Index......................................................................................................................... 253

8

Chapter

The Non-Public Sector: Indefinite Vitality

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: Deng’s Three Defenses for Nian Guangjiu The story of Nian Guangjiu is a vital topic when we talk of the development of the

non-public sector in China. Throughout the history of the non-public sector, he is

the one figure who must be discussed. Nian Guangjiu, also known as the founder of the Fool’s Melon Seeds (Shazi guazi 傻子瓜子), was a symbolic figure who was hailed as the No. 1 vendor in China. Given the introduction of the policy of Reform

and Opening Up in 1978, Nian’s involvement in business aroused controversies and Deng Xiaoping, surprisingly, made three statements to shelter him from

attacks. In the end, Deng’s remarks not only reshaped Nian’s destiny, but also influenced the forthcoming progression of the first generation of individual and private businesses in China.

Back in 1963, Nian, in order to make a living, sneaked into Jiangxi and started

selling Chinese chestnuts. At that time, commercial activities were seen as “tails

of capitalism,” so peddlers were considered capitalist and their presence an illegal occupation. Charged with engaging in speculation and profiteering, Nian was then

put in jail for a year. From 1972 onwards, he began to sell small bags of self-fried

melon seeds at a price of five cents each outside the entrance of the theater or along the street. Surely, anti-speculation officers from the government always took “good

care” of him. Thanks to his tasty yet cheap melon seeds, Nian soon built up a little reputation in Wuhu of Anhui Province. But why was Nian called the Fool? It was

because whenever people had bought some melon seeds from him, he would ask

if the snack was weighed accurately, stuffing a handful of extra seeds into the bag. With people calling him the “Fool,” Nian simply decided to set up a brand — the

Fool’s Melon Seeds — and just sold melon seeds in the daytime. Thereafter, his business enjoyed tremendous growth. By 1978, Nian had become a 10,000-yuan household as his savings reached RMB10,000. In contrast, the average monthly

salary of a university graduate was just RMB56 while there were about 800 million

peasants earning an average of RMB76 a year, and 200 out of 800 million annually

earned RMB50 or less. Besides, peasants back then each received no more than

300 catties of raw grain as rations for the entire year. Considering the poor lives of others, there was no way that Nian’s action would not make noise in society.

Then, how did Deng get to know the Fool’s Melon Seeds and protect Nian

later?

Deng’s first attempt to protect Nian took place at the initial stage of Reform

and Opening Up. Back then, Nian opened a store and his business was thriving, as was proven by the fact that two 100-meter queues stretched outside his store.

2

The Non-Public Sector: Indefinite Vitality

Also, in the hopes of attracting more customers, certain people could be exempted

from lining up, and they included soldiers, expectant parents of a single child (if buying 2 catties of melon seeds or more), travelers in Wuhu (if buying 2 catties of

melon seeds with bus tickets), and the newly married (if buying 10 catties of melon seeds with their marriage certificate). His business was booming. Afterwards, the bold fool even dared to act against the prevailing “social norms” by hiring melon seed fryers. However, after all the years of class struggle education, could

a Socialist society be tolerant of a man living as an employer? Nian was obviously “exploitative” was he not? Consequently, the officials of the Anhui provincial

government carried out an investigation and Du Runsheng, the then Head of the

Central Rural Policy Research Office, found the report meaningful and sent a copy to Deng’s office.

After reading the report on the Fool’s Melon Seeds, Deng expressed recognition

towards the development of individual and private businesses, clarifying that the debate on who were being Socialist or capitalist should be put aside. This marked the first time of Deng’s protection of Nian.

The second time Deng spoke up was when Nian expanded his factory and

recruited more workers, which, again, triggered extensive controversy.

With the coming of the 1980s, the brand Fool’s Melon Seeds gained popularity

in major cities such as Beijing, Shanghai, and Nanjing. The sales pattern was also switched from a retail outlet to a sales agent, and then to sales promotion and

wholesale business. This explained why Nian needed to promptly enlarge the scale of his factories and workforce. Up to 1984, a total of 103 people were working for Nian, who consequently was on the list of the earliest millionaires in China.

Nevertheless, Nian violated the regulation issued by the State Administration for Industry and Commerce which limited the number of employees of a private business to eight. Once again, controversy over Nian was sparked off. Focuses

of discussion included “the upstart Nian Guangjiu,” “the new capitalist Nian Guangjiu,” “Nian Guangjiu advocating Capitalism,” and “if Socialism allows millionaires and capitalists to exist?” The debate became heated among Party

organs and eventually went outside of Anhui Province, all the way to Beijing. Some even proposed struggling against Nian.

In the third plenary session of the Central Advisory Commission held

on October 22, 1984, Deng raised the issue to the level of the development of

individual businesses, stating that “We don’t have to hastily settle certain issues. Remember a while ago, we were still concerned with the employment problem, weren’t we? What I mean is we can wait for another two years. Does a particular

3

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

case affect the general situation? If there is an extensive struggle, the masses will

say the policies change again, and people will become anxious. You can surely

do away with a fool selling melon seeds, but it is unworthy to influence people’s minds. What does it hurt to let him continue with his business? Socialism isn’t

undermined, is it?” This time, Deng not just simply protected Nian — who was in the teeth of the storm — but also dispelled the wait-and-see attitude among other private businessmen, and this markedly stimulated and facilitated the growth of the individual and private businesses.

Known as a fool, Nian Guanjiu was not foolish at all. Feeling insecure after

all, he decided to look for a “protective umbrella” and approached the Ministry

of Industry and Commerce for joint management. Eventually, a joint operation agreement was signed between Nian, the trademark owner and technology supplier, and two other companies — Xinwu Labor Services Company and

Qingshui Industrial Company in Wuhu County (which jointly invested RMB300,000). On July 1, 1984, Nian founded the Wuhu Fool’s Melon Seeds Company and became the General Manager. With the participation of state organs,

Nian thought he could have gotten rid of being labeled a capitalist. However, once an individual management approach was applied to a collectively-owned enterprise, internal conflicts were likely to arise. After repeated discussions, it

was agreed that the company would be solely run by Nian. Yet, the brief joint

management brought misfortune to Nian. By the end of 1987, an assistant manager of Nian’s company filed a report to the procuratorate in Xinwu Region, requesting

that an investigation be done in relation to the “economic issue” of Nian. As a result, Nian was accused of embezzling a total of RMB43,800 for he allegedly failed

to submit an account when borrowing money from the accounting department.

What’s more, he was blamed for lending raw materials such as melon seeds and gunny sacks to his son (who was also engaged in private business), and was hence charged with the misappropriation of public funds. On December 25, 1988,

the Wuhu Municipal Procuratorate officially sued him for the above charges and he was kept for “custodial interrogation” until September 25 of the next year,

when he was officially arrested. By May 3, 1991, a public trial was opened by the Wuhu City Intermediate People’s Court. Even though Nian, owing to insufficient

evidence, was found not guilty of the alleged economic crimes in the first instance,

the procuratorate still lodged a protest against the court judgment to the Anhui Provincial High People’s Court. Subsequently, the high people’s court specially sent an investigation team to Wuhu, and thus the procuratorate cancelled its counter-appeal.

4

The Non-Public Sector: Indefinite Vitality

The third occasion of Deng mentioning the Fool was when Nian was accused

of committing economic crimes. By early 1992, Deng went on a tour of southern

China and he arrived in Shenzhen, where he delivered his famous southern speech. Deng said, “At the primal stage of rural reformation, there was the issue of a ‘Fool’s Melon seeds’ in Anhui. At that time, many people felt uneasy, saying that Nian had earned a million, and so he should be done away with. However, I told them to hold back, otherwise people would say policies had changed. This game

isn’t worth the candle [the loss outweighs the gain]. There are still plenty of such

problems. Our principles would easily shrink if these issues are unduly dealt with, and this could affect the entire reformation process. The primary policy of urbanrural transformation should remain consistent in the long run.”

Yet, why was it the time to bring up the Fool? It was said that the branches

of the Fool’s Melon Seeds had been expanded to Shenzhen when Deng visited the place, and it was rumored that a branch office manager had made a banner reading “The Fool Welcomes Deng Xiaoping Visiting Shenzhen!” after learning

that Deng would come. When Deng learned of this, he responded with delight:

“The Fool even comes to Shenzhen! Well done!” So, this might have been the occasion when Deng had recalled the Fool’s Melon Seeds. All in all, the southern speech did become a turning point in Nian’s life. At last, after more than three

years of detention, he was released on March 15, 1992, after being found innocent. Apparently, Deng’s remarks had not only saved Nian but helped people explore a

new path in Reform and Opening Up which gave free rein to the non-public sector. With the wide coverage of the news of Nian being released and reporters flocking to Wuhu, Nian had become a celebrity in one short year.

In 1997, the Fool’s Group was officially established. Having overcome internal

splits and conflicts, Nian’s business, ultimately, could enjoy healthy growth.

In March 2008, Zhu Wenna, a reporter for Faren Magazine, published an article,

titled “Nian Guangjiu: An Explorer Towards a Wealthy and Prosperous Path,” which said:

The three statements made by Deng not only just altered Nian’s destiny

but most importantly decided the future of the first generation of private entrepreneurs in China. It was Nian, through his own story, who enabled

his countrymen to gradually understand that it was not essentially sinful to be a speculator or profit-maker, and that neither hiring laborers

nor pursuing wealth was a crime! Nonetheless, under that particular circumstance, Nian, who took courage to pioneer the development of the

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

non-public sector and engage in the still unshaped market economy, could not evade being captured. Yet, from his story, we could see how the very first cluster of private entrepreneurs in China strived to break through the rigid economic structure.

Deeply filled with grief and frustration, Zhu added: It was always those walking at the front who paid as well as bore the rather ruthless costs of the era.

Through Nian’s life, we could witness and experience the obstacles in the

development of the non-public sector in China. Deng’s three defenses for Nian did not merely safeguard the melon seeds vendor but the emerging non-public sector — which is the focus of this chapter.

Meandering Path of China’s Non-Public Economy In the 16th National Congress of the CPC held in 2002, the idea was put forward

that “any positive factors should be mobilized as extensively and adequately as possible to empower the Chinese race and to add in new forces” and to strive

for the goal of “building a moderately prosperous society in all aspects.” In the meantime, it was pointed out that “the development of the non-public economy should be firmly encouraged, supported, and guided,” and this was equally essential to “unshakably consolidate and advance the public economy.”

Indeed, from 1949 to 1978, these viewpoints could barely exist at least for

the first 24 years out of the 30-some years of reform and opening-up. In the 15th

National Congress of the CPC convened in September 1997, it was proclaimed that

“the non-public sector is an important component of the country’s Socialist market

economy.” Despite rectifying previous views like that the non-public element was a subordinate or complementary part, such a proclamation did not affirm that the

non-public economy be substantially supported and developed. Finally, in the 53rd year of the PRC (2002), the advancement of this economic component was deemed necessary, after countless objections were overcome. Undoubtedly, the consensus

on this view over the non-public sector was invaluable, for it was the outcome of 53 years of arguments.

For a rather long period of time after the founding of the Party, an inappropriate

approach had been adopted towards the non-public sector.

6

The Non-Public Sector: Indefinite Vitality

As Mao mentioned in the report On Coalition Government in 1945, China

should free up room for capitalism to attain “broad development” in the period

of New Democracy. Anyway, permission should be given to the development of the non-public sector, and the term “broad development” was rewritten as “necessary development” when compiled into the Selected Works of Mao Zedong

in 1953. In fact, this judgment fit into China’s conditions quite well and drew the attention of numerous liberal capitalists, who were then motivated to take part

in the revolution against the “three big mountains”: imperialism, feudalism, and bureaucratic capitalism.

Concerning the country’s transition from New Democracy to Socialism, the

CPC believed it could only take place as long as mature conditions were created under the certain development of a New Democratic form of society. Until 1950,

leaders of the CPC including Mao and Liu Shaoqi were still of the same viewpoint.

For instance, in the second meeting of the first Chinese People’s Political Consultative Conference (CPPCC) convened on June 23, 1950, Mao expressed the idea that the nationalization of private industries and the Socialization of the

agricultural industry were “still in the distant future.” But in 1952, Mao had a new

perception. Eager to proclaim the “General Line” for transitioning to Socialism, Mao promptly proposed criticizing the establishment of a New Democratic

order and announced that the country would start shifting to Socialism. It was

also announced that the three Socialist transformations — in terms of individual agriculture, manufacturing, and private business — were to be pushed forward. Instead of awaiting the “distant future,” the transition was to be accomplished within the period of three Five-Year plans.

However, what made Mao change his attitude and policies towards the non-

public sector? Socioeconomic changes were not factors he anticipated. First, the situation of the Korean War became less intense and the extensive land reform had basically been completed, while the task of national economic revival had been,

miraculously, completed earlier than expected. Second, the variation of the ratio

of state-owned industries to the private ones was unanticipated; the proportion of state-owned industries abruptly grew from 43.8% in 1949 to 67.3% in 1952, surpassing that of the private sector. Third, in terms of policy over the private

sector, Mao, after the implementation of the Five-Antis Campaign, added the idea of “transformation” to “constraining” and “making use” of it. As a result,

private enterprises were incorporated into the general development piloted by the public sector, and there appeared manifestations of state-capitalism — such as manufacturing and placing orders, selling as a consignee or a sales agent,

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

centralized procurement and marketing, public-private partnership, etc. Fourth,

Stalin published his essay “Economic Problems of Socialism in the USSR” in 1952, which offered a model of a “product economy” and categorized the abolition of

commodity economy as a feature of Socialism. At that time, this economic model lured almost the entire generation of leaders of international Socialism, who even

attempted to subvert the pattern of ownership in order to establish a “product

economy,” i.e. to give up experimenting in a commodity economy. All in all, the prompt proclamation of the realization of Socialism was very attractive, for it

was a heroic and astonishing act beyond any doubt. Just as Mao’s saying went: “Whether one is a truly great man of the time, depends on today.” It was under this circumstance that Mao changed his mind and put forward the idea of the

“General Line” for the transitional period, taking a “leftist” turn towards Socialism. What came closely after were the comprehensive establishment of joint public-

private enterprises in 1956 and the overall introduction of people’s communes in

1958. After that was the decade-long proletarian Cultural Revolution, in which the

bourgeoisie as well as revisionists were bitterly criticized. Throughout the period,

Socialism was the trend, with a general distaste of capitalism — even peasants who possessed personal farmland were characterized as “tails of capitalism,” let alone individual businesses and private enterprises in cities. It was the era when China’s non-public sector was on the verge of vanishing.

It was not until the Third Plenary Session of the 11th CPC Central Committee

held in 1978 that the idea of “righting wrongs” was proposed, and certain misconceptions about the non-public sector were slightly cleared up. Meanwhile,

teens who had received training in rural villages between 1978 and 1979 began to move back to their homes in cities. It was estimated that there were about 17 million rusticated youths which made up 10% of the urban population. As being

unemployed was too much a taboo to be mentioned, a new phrase “awaiting employment” was invented to refer to unemployment, and so youngsters would

not lose much face. Nevertheless, how could they get a job at once? The problem lied in the limited availability of job vacancies from the oppressed individual

businesses, which was the result of the prolonged emphasis on collective

ownership by the people and the transition to a state economy. Even if parents

working at state-operated industries resigned to let their children work, only a small portion of them would be employed, and the number of idle youth was on

the rise. As food was the paramount necessity of the people, they had to work to survive. As a result, the younger generation of individual businessmen and women

— automobile mechanics, shoe cobblers, tinkerers, photographers, seamstresses,

8

The Non-Public Sector: Indefinite Vitality

and food vendors — opened up shops across streets and alleyways in the cities, and this green economic force remarkably accelerated the growth of the private sector. Xue Muqiao, an economist, published an article in 1979 to promote the

idea that people should be allowed to start individual businesses so that there

would be more job opportunities. On September 29, 1979, Ye Jianying delivered a

speech in celebration of the 30th anniversary of the founding of the PRC, in which

he admitted that “at present, the individual businesses of workers, which now exist in a limited capacity in cities and rural areas, are merely subordinate and complementary to the Socialist public sector.” According to statistics of late-1978, there were about 140,000 individual businesses in the country, and the amount

was boosted to 310,000 in 1979, surpassing 800,000 a year later. In the Sixth Plenary Session of the 11th CPC, it was endorsed that individual businesses were to be “the necessary supplement to the public sector.”

Since the introduction of the policy of Reform and Opening Up in 1978, along

with the guidance of Deng Xiaoping and the innovations in theoretical study, people progressively built up a correct understanding of the non-public sector.

However, the general opinion did not follow the idea of going through the stage of New Democracy but people instead believed that “our Socialist system was still in a primary stage,” a concept that was mentioned in the Resolution on the Various Historical Issues since the Founding of the People’s Republic of China in the Sixth Plenary Session of the 11th CPC. It was the very first document from the Party where the

idea of a primary stage of Socialism appeared, and much room was created for “the many economic sectors developed under the prerequisite of public ownership

being the core.” Thereafter, this idea was also briefly touched upon in the report of the 12th National Congress in 1982 as well as the 12th Plenary Session of the Sixth CPC and the meetings of the Central Politburo. However, the phrase was not

elaborated on in detail until October 1987, when the 13th National Congress was

convened. As seen in the reports of the forthcoming national congresses, there was more explanation.

Admittedly, since China was long under the influence of Socialist ideology,

people were in general resistant to the non-public sector or a non-state economic system. Even though the State Council announced policies and regulations to

approve the running of non-agricultural individual businesses in 1981, people still paid little attention to them. Thus, individual private enterprises had to survive under the “collective” label despite their nature, and they were, very

often, exploited by state organs. In the Third Plenary Session of the 12th CPC held

in 1982, it was acknowledged that individual businesses were “an essential and

9

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

beneficial supplement in a Socialist economy, and it was subordinate to a Socialist economy.” In the Fifth National People’s Congress (NPC) the same year, it was decided that the Constitution would officially legitimatize individual businesses

of rural and urban workers, which would become a supplement to the Socialist economy. In the 13th National Congress convened in October 1987, it was agreed

that the country was still in the primary stage, and that “a certain development of the private sector could stimulate production, revitalize the market, enlarge the job market, and better satisfy people’s living needs; so it was a necessary and beneficial supplement.” Yet, from 1989 to 1990, as pro-revolutionary thoughts struck back,

doubts such as “who were the capitalists and Socialists” were resurrected, which severely frustrated the non-public sector. By the end of 1989, the number of private

enterprises slumped down by 50%, dipping from about 200,000 to around 96,000.

The number of individual businesses dropped to about 12 million and shop

employees numbered around 19 million, a 15% and 15.7% decrease, respectively, when compared to 1988.

What entirely reversed the circumstance was Deng’s speech in 1992,

which came after the affirmation of entering a Socialist market economy in the 14th National Congress together with the announcement of the policy of the “simultaneous development of various economic sectors.” Consequently, the number of private enterprises bounced from just more than 90,000 in 1990 to 238,000 later. At the same time, there was prosperous development among

individual businesses while reformation of the property rights of state-owned enterprises was in progress. Hence, the spearhead of reformation was diverted to the ownership system. Still, the “leftists” were unwilling to recede and

advocated distinguishing public economies from the private ones between 1995

and 1997. Believing that a new form of bourgeoisie would be born in China, the

apprehensive “leftists” asserted that an overweight private sector would definitely exert grievous impacts on the nature of China’s economy, which might also threaten national security.

In September 1997, during the 15th National Congress, the idea of “mixed

ownership” was put forward and it was proclaimed that “the non-public sector is an important component of the country’s Socialist market economy.” In the report released in the 16th National Congress in 2002, it was clarified that “any forms of the non-public sector, no matter individual or private, are key components of the Socialist market economy” — which subverted the conventional conception

over the non-public sector. Additionally, it was added that the non-public sector should be supported and guided, and it is as crucial to unremittingly fortify

10

The Non-Public Sector: Indefinite Vitality

and advance the public sector. Politically, this proposition marked the first instance of formulating policies for the non-public sector. Such an idea was then

restated in the 17th National Congress and was textualized in the Constitution,

where new social strata such as private entrepreneurs were deemed to be the constructers of Socialism in China. In 2005, the State Council announced the

Several Opinions on Encouraging, Supporting and Guiding the Development of the Individual and Private Economy and Other Non-Public Sectors of the Economy, which

was considered a symbol of the private economy heading towards perfection. However, simultaneously, a heated debate over the drainage of state assets in the course of reforming state-owned enterprises was sparked off by Larry Hsien Ping Lang, a professor at the Chinese University of Hong Kong, who challenged the direction of reformation. Soon, the discussion spread to other fields and even to the general goal of Reform and Opening Up in China. The entire debate was known

as the “Third Great Debate on the Course of China’s Reform.” Fundamentally, it represented a trend of denial and opposition against reformation with the excuse

of criticizing neoliberalism. Surely, it did not manage to gain popularity and their proposition exerted much less influence than they expected.

From this piece of history, we can see that any measures discriminating against

or restricting the development of the non-public economy are pro-revolutionary behaviors that surpassed the current stage of social development, and they are a mere manifestation of the “leftist infantile disorder.” Moreover, the attempt to push

forward the non-public economy is no temporal and expedient effort but a long-

term goal which will, at least for a century, be “adjusting to the economic system in the primary stage of Socialism.”

From the 16th National Congress onwards, the non-public economy advanced

tremendously. The first success was the boom in the number of enterprises. By

the end of 2006, there were a total of more than 4.9 million private enterprises,

accounting for 57.4% of the national total and representing a 104.6% growth of about 2.5 million, when compared to 2002. The size of registered individual businesses also grew by 9.2% to about 25.9 million, an increase of more than 2.1 million compared

to that of 2002. Another achievement was the rapid expansion of registered capital. In the year 2006, the aggregate amount of registered capital of private enterprises

totaled up to RMB7.6 trillion, a 206.5% growth of RMB5.12 trillion compared with 2002. As for that of individual businesses, the amount added up to about RMB646

billion, a 71% increase of RMB268 billion compared to 2002. Third, a new record was set in the size of the employed population. In 2006, a total of 658 million people were

hired by private enterprises, a 111.1% growth of 360 million people than that in 2002;

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

the number of investors rose to 127 million, a 104.2% growth of 6.4 million people; there were 531 million laborers, an increase of 90.7% growth of 258 million people

compared to 2002; and the number of employees of registered individual businesses

was 51.5 million, a growth of 416 million people, and an 8.8% rise from 2002. The fourth success was the continual growth of the amount of fixed investment.

According to data from the National Bureau of Statistics of China, the aggregate

amount of fixed investment in 2006 reached RMB10.9 trillion, in which private enterprise had gathered RMB6.7 trillion — a 220.9% rise of RMB4.6 trillion when compared to 2002, and it also accounted for 61.8% of the national fixed investment aggregate value, which was 13.1% more than that in 2002. Fifth, the value of total

imports and exports escalated quickly. As reported in the surveys released by the

General Administration of Customs, by the end of 2006, the aggregate value of imports and exports of private enterprise added up to USD307 billion, which was

17.5% of the national value and a 4.8 times, or an 8.9%, increase when compared to

2002. As for exports, the aggregate value attained a 5.5 times rise compared to 2002. The number of private enterprises engaging in the exporting business also broke 100,000, a 5.3 times growth compared to that in 2002.

As the China Quality Supervision News1 reported on December 8, 2008, Shen

Jianguo, the Vice President of the All-China Federation of Industry and Commerce

(ACFIC) expressed the idea during the China Enterprise Development Forum that

the private economy had become one of the backbones of China’s economy after 30-some years since China opened up. With reference to brief statistics, the private economy yielded 65% of the country’s GDP, and 70% to 80% of the economic

growth was contributed to by this sector. In the employment market, the private economy has become the widest channel, which absorbed 75% of the labor force.

On January 19, 2009, in the ACFIC Lunar New Year Reception, President

Huang Mengfu delivered a speech saying, “In the year 2008, though the globe

was under the shadow of a financial crisis, the private economy in China, when vertically compared with the national economic trend, showed a similar tendency — they were both severely impacted. But when horizontally compared, the

private economy still maintained a relatively stronger momentum.” In China, the expansion of the private economy was as follows:

•• There was continual growth of the number of private enterprises and growth

in the scale of capital. Up to September 2008, the number of registered private enterprises went up to 6.4 million, a 6.67% growth compared to 2007. The amount of registered capital also climbed to RMB 11.26 trillion, a 19.97%

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The Non-Public Sector: Indefinite Vitality

increase compared to that of late-2007.

•• A comparatively faster growth rate was seen in the investment in the private

economy. By November 2008, an accumulated RMB2.42 trillion-worth of fixed investment was made by private enterprises in the urban areas, which saw a 34.9% growth — 8.1% higher than the national rate.

•• As for private industries, there was relatively quicker progression as well. As

of November 2008, private industrial enterprises grew by 20.8% on a year-onyear basis, which was also higher than the national rate of 7.1%.

•• Likewise, there was sustained growth in the import and export business of

private enterprises. Up to October 2008, the national total import and export

value of private enterprises added up to USD3.7 trillion, which presented

a year-on-year increase of 33.5%, and it was 9.1% higher than the national growth rate.

Indeed, the rise of the private sector in the post-Reform and Opening

Up period consisted of multifarious development models which were closely related to the geographical and historical settings, culture and tradition, market

conditions, and the policies and system of a certain region. Therefore, we can often

hear phrases like “Wenzhou model,” “Sunan model,” and “Zhujiang model” of development. Briefly, the “Wenzhou model” refers to a pattern of development

that relies upon individual and private businesses. Before the policy of Reform and Opening Up was implemented, there were few commune- and brigaderun enterprises (shedui qiye 社隊企業) and the area of land per capita was small. That’s why established enterprises could gain an upper hand in development

when the government loosened its control. The most noticeable feature was the

non-agricultural industry which was built upon a household system and market specialization, which eventually brought about the appearance of a prosperous

small commodity market. As for the “Sunan model,” it basically involves a regional

development mode centered on the growth of township and village enterprises (TVEs), and it is sometimes termed “local state corporatism.” Unlike Wenzhou, the commune- and brigade-run enterprises in southern Jiangsu (as the word “Sunan”

implies) were of a certain scale prior to the opening up of the country, and it was convenient to travel in between cities like Shanghai and Nanjing. When the dual-

track price system was introduced in the 1980s, much room was created for these collective enterprises to thrive. As for the “Zhujiang model,” it is chiefly based

on the development of export-oriented economy and the utilization of foreign

capital. Conventionally, the economies of cities in the area of the Pearl River Delta

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

(PRD) were quite dependent on the export business. After the country opened up, the area experienced an economic restructuring — some enterprises, making

use of foreign investment, started engaging in materials and samples processing,

components assembling, and compensation trade of limited scale, and these were collectively called the “processing and assembly factory business (PAFB).” In fact,

the economic prosperity in Guangdong had much to do with its distance to Hong

Kong and Macau and its traditionally export-oriented economy. Additionally, the region benefited from the labor force too. It was also widely perceived that

the “Zhujiang model,” in a period when the planned economy was transforming into a market economy, was to merge its edges such as the advantageous location, materials, and labor force with foreign resources to establish a highly-

industrialized and export-oriented economic development pattern led by the local government.

Dissecting Private Investment through the “Wenzhou Model” of Development As soon as the country opened up, notable growth was observed in the non-public sector. Yet, people were, to a certain extent, resistant against certain forms of non-

government credit, just as in the case of their inadequate understanding towards the non-public sector. Evidence of this was the presence of the rotating credit associations in Wenzhou.

For a long time, when people discussed the “Wenzhou Model,” they merely

placed the focus on its market and the market economy but neglected how the seed capital was accumulated. As a researcher in investment and its history, I personally pay much attention to the study of the amassment of the seed capital. For instance,

the original capital of state-owned enterprises, very often, came from state funding or bank loans; while during the later stage of the Cultural Revolution, microcredits

were the main source of capital for small and medium-sized enterprises (SMEs) in cities like Shanghai, Changzhou, Shashi District, and Xiangyang. As for the seed

capital of the TVEs during the 1980s, it was discovered that the seed capital mainly

came from illegal loans. So, how did private enterprises under the “Wenzhou model” of development acquire their original capital? To me, the process was once mysterious but after reading the article “Discuss the Function of Private Finance

in the ‘Wenzhou Model’ of Development” written by Xia Xiaojun, the mystery

was unraveled. Under the “Wenzhou Model,” the original capital of private enterprises was amassed through private financing activities such as rotating

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The Non-Public Sector: Indefinite Vitality

credit associations — which, in reality, played a similar role to that of venture

capital funds in the West. In the article, Xia also estimated that the scale of private finance in Wenzhou accounted for one-third of the total financial assets in the

area, which exerted a big influence on the formation of the original capital. Within this one-third segment, another one-third to a half constituted the initial capital, functioning as the major economic driver in Wenzhou.

Dating back to the late-1970s, there was a huge population in Wenzhou but

relatively little land, the educational level of the people was low, and the economy

was backward. All in all, Wenzhou was below the average level of development in the country. According to Xia, it was two minor institutional changes in 1978 that laid the groundwork for the forthcoming achievement in Wenzhou. The

first change was the policy adjustment made by the municipalities — peasants

performing external trade were allowed to establish collective enterprises, which

dealt with the issue of their legal identity. Another change was the breakthrough in cash management of rural credit cooperatives in Wenzhou — peasants, instead of settling payments over a certain limit through checks, were permitted to withdraw cash from sales deposits. In such a way, small retailers could complete

purchases by cash in specialized markets, hence settling the problem of cash flow between state-owned commercial systems and the primitive small commodity market. Thanks to these two institutional adjustments, the flow of people and capital in a primitive commodity economy was regulated, which left enormous

room for peasants to circulate their goods outside of the planned economic system. Even though the changes were groundbreaking, the impact was confined to

the approach and scope of commodity circulation, and their intended influence could have been more fundamental. After all, the accumulation of private capital

functioned as the key to the abrupt appearance and continual development of the “Wenzhou model” of development.

In fact, the progression of Wenzhou originated from the advancement in

production and circulation of small commodities. To coordinate the production and circulation of petty commodities, a sum of initial capital stock, regardless of

its size, is always needed. One example is the well-known cufflinks market in

Wenzhou. Initially, there were no domestic manufacturers and multiple cufflinks were purchased from places around the globe for wholesale use, and this process required thousands of Yuan in capital. Moreover, in order to cater to button

salespersons in the country, a minimum of several thousand Yuan was a must to

do business promotion, or else their travelling expenses could not be covered by their profits. Then, where did their seed capital stock come from? As of the year

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

1978, the annual per capital income was just RMB113, and apparently, people with such an income level had difficulties in even satisfying their hunger. As peasants could barely accumulate wealth, nor were they able to provide loans, how was the capital to be garnered? As research suggested, there was a direct relationship

between the entrepreneurial activities of peasants in Wenzhou (self-employed businesspeople inclusive) and domestic financial activities.

In Wenzhou, one of the primary channels of private financing was associations,

while the other was a kind of loans mediated by mediators called moneybrokers (qianzhong 錢莊); some also directly borrowed from relatives and the neighborhood. The most basic way of financing (associations) had to a large extent contributed to the emergence of capital formation.

Domestically, these associations or unions are normally called rotating credit

associations, but the name also has several variations in which chenghui (呈會) had

the closest pronunciation to the dialect of Wenzhou. With reference to the folkcustom section of Records about Wenzhou published in 1998, the entry on rotating credit associations went as follows: “If one is in urgent need of money but has no

way to borrow, one could approach their neighbors, friends, and relatives. For the

amount of capital that the members would offer, it would depend on the need of the convener (or the head of the association). Normally, 10 members are invited.

The convener treats the congregants and the meal is called a ‘Union Feast.’ To

start the second round, there is a regular monthly rotation during which a dice

is thrown, and the one with the highest points would be the representative and take hold of the capital. Afterwards, the representative has to transfer the money

gathered to the convener. The monthly interest ranges between 1% and 1.5%, but

some do not collect interest at all. There are superstitious conveners who often wish for the blessings from the spirits and gods in the hopes of dismissing the association as soon as possible.” In financial terms, the entire process could be

depicted as assembling small sums of money from 10 people to alleviate one’s immediate financial need. To the former representatives, they can raise loans and

have them repaid with interest by stages, while the latter ones are like depositing money and retrieving the principal plus the interest.

Though a rotating credit association was a custom in Wenzhou and Taizhou,

it was also found in other parts of the country. In Peasant Life in China, the PhD.

thesis of Fei Xiaotong, a pioneering researcher and professor of sociology and anthropology, the details of picking representatives through a roll of the dice was described. In Wenzhou, these representatives were traditionally chosen either by

drawing lots or a roll of the dice, but nowadays, most of the details like the order

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The Non-Public Sector: Indefinite Vitality

of rotation and the amount of loans are settled through negotiation when the members first meet.

In the past, rotating credit associations were prevalent in rural villages and

cities in the coastal parts of Wenzhou where people’s communes coexisted. The major difference was that the purposes of these associations were for consumption

and mutual assistance within the neighborhood, thus the interest rates were exceptionally low, or even nonexistent. After the reformation of the rural economy

was implemented, these associations underwent functional changes and expanded rapidly, for an immense population of peasants started entering the commodity

economy. Yearning for start-up capital, peasants would first resort to these associations on most occasions. As the business scale continued to grow, peasants already engaging in the production and circulation of commodities would

continue relying upon these associations to increase liquidity. Among the Wenzhou people, rotating credit associations related to start-up capital rarely resulted in bad debts. Even though some did fail in their businesses, they still strived to work out

any possible solutions to repay their debts. In the worst scenario, debts would be paid off with the future income of the obligors.

Outside of the territory of Wenzhou, these associations were also common

among Wenzhong people living in France. There were as many as roughly

100,000 Chinese people from Wenzhou who had migrated to France over the

past two decades. Typically, a Chinese migrant to France would go from being an illegal worker to the owner of a shop or restaurant after first securing permanent residence and some business knowledge. This sort of process created a market

for rotating credit associations which were needed at the preparatory stage of a business. In Paris, opening a restaurant cost at least 500,000 francs, which was,

obviously, beyond the savings capability of a Chinese migrant who lived upon illicit work. Furthermore, it was hard to build up personal credit in a foreign banking system and so a rotating credit association transplanted from the

migrant’s hometown functioned as the source of seed capital. It was found that no

less than 90% of successful Chinese businesses in Paris had relied on these private associations to garner their start-up capital.

Admittedly, these credit associations did facilitate the formation of start-

up capital, but they were far from being a perfect form of credit mechanism.

In Wenzhou, domestic credit associations have moved in two directions. One direction is the emergence of “bidding associations (biaohui 標會)” that are formed through comparing and competing interest rates. Whoever offers the highest

interest rate can first take hold of the capital of the association. Some of them are

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

specifically established for certain individuals, so there will be no rotation and the keeper of the collective capital just needs to repay the principal plus the interest.

Another direction is direct loans among the people, which might have much to do with the prosperous foreign trade business of the Wenzhou people, as they frequently go on business trips and it would be inconvenient to meet routinely.

Money-brokers, another private financing channel, are a form of non-public

finance intermediary. Briefly, there are two kinds of mediators. The first sort functions as an observer when the capital supplying party meets the other and a certain amount of commission will be paid to these brokers. For the second kind,

the brokers will act in between the two parties — provided that the two have

chosen not to meet — by receiving money on one side and loaning out on the

other, hence capturing the interest margins. In reality, these money brokers are professional currency transactors whose scope of activities is generally confined

to one or several neighboring villages. Afterwards, they entered cities along with the urbanization of the rural areas. The institutionalization of these mediators was represented by the appearance of private banks in Wenzhou, yet these banks were later forbidden by monetary authorities.

The third form of private financing is free loans between individuals or parties;

normally there are no specific procedures. The longer the loan period and the larger the amount of loans, the more likely the lender requests that the debtor

write a debit note. Free loans are characterized by a less restrictive investment orientation, an interest rate adjustable to the market, a flexible loan period, and a

covert mode of transaction. In a word, regardless of the form of direct loans, the

major purpose is to compensate for the temporary lack of cash or capital, this is why these loans are functionally different from those made through rotating credit associations.

On the whole, the various approaches of how start-up capital is formed

in Wenzhou have determined the particularities as well as peculiarities of the socioeconomic development of the region.

First of all, there is a strong moral constraint in the process of raising capital, as

members of the association are neighbors, relatives, or friends if not sworn brothers and sisters, so they are familiar with the background of each other and the loans are different from those offered by banks or rural credit cooperatives. Additionally,

this sort of financing requires no collateral or financial guarantees and involves no sophisticated procedures, unlike the banking industry. Meanwhile, such forms of loans are of the nature of mutual assistance which, surely, places moral pressure

on the debtors. Yet, lenders also feel morally obliged to offer help, particularly in

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The Non-Public Sector: Indefinite Vitality

credit associations that are not profit-oriented. Besides, unlike those engaging in

venture capital funds, lenders merely get back the principal plus interest rather

than dividends. Therefore, the risks of starting a new business are solely borne by

the debtor. If a debtor’s business happens to flourish, he or she will have to do the lender a favor in return — for example to lend in the future. Furthermore, he or she has the obligation to assist the lender or even lender’s children.

Second, the rotating credit associations exhibit their procedural characteristics

in financing. Other than building up credit relationships, these associations also serve as a venue where the participants can evaluate the use of capital, and this

helps minimize the risks to be undertaken by both parties. As for the capital of rotating credit associations, it is usually invested in small-scale commercial

activities rather than the industrial sector. Note that the conveners are not advised to roughly describe his or her intended capital usage but should offer a detailed and thorough account on his or her business plan instead, so that

other members can have an in-depth discussion and review his or her proposal,

and most importantly, his or her capability. If a proposal is deemed too risky, recommendations will be provided and it is also possible that some members will refuse to offer financial support — this happens quite often within the rotating

credit associations of Wenzhou people in Paris. Nonetheless, the convener (who functions as an investor or a manager) is usually backed by his or her sworn

brothers or sisters, who essentially form a review committee in which the very aim is to sensibly select a manager as well as a business suitable for their private assets.

Third, given the intrinsic limitations in terms of circulation, the amount of

one-time transfers within the private financial system of Wenzhou is constrained.

Ordinarily, one-time transfers are several thousand yuan, although in exceptional cases the amount can exceed RMB50,000. In other words, the scale of transfer of

private loans is never too large. The first reason is that private financing activities are “non-institutionalized” (i.e. the absence of an established institution), thus

sources of capital are limited. Also, the amount of capital assembled by a rotating

credit association is highly influenced by the number of members and their financial conditions. Unavoidably, the least economically capable member would bring about boundaries to the credit association he or she is in. The other reason is

the risk-averse nature of investment diversification. As legal protection is absent in

private loan activities, personal credibility depends much upon one’s face, which,

very often, has a shadow price. As long as a one-time capital transfer is deemed higher than the “price of face,” it will become an insecure venture. As a result,

there is a self-controlling mechanism working on the scale of private finances, and

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

so their capacity never expanded uncontrollably.

Owing to the constraint in one-time transfer, enterprises in the real economy,

when they reach a certain scale, will approach formal financing institutions. On

the other hand, since the mid-1980s, individual businesses born from the capital of rotating credit associations started engaging in joint ventures by partnering with

family members and sworn brothers (or sisters), hence moving closer towards a

shareholding system. Since then, Wenzhou entered a new stage of development — institutional innovation in enterprises. Consequentially, the role of rotating credit associations is weakened in this new round of entrepreneurial capital formation.

Fourth, not only are private financing activities closely monitored and banned

from systematization and institutionalization by the monetary authorities, they

also have to satisfy a number of circumstances. An incompact system rooted in local culture (i.e. geographical connections and affinity), such kind of financing

activities operate efficiently and are effective in evading the manipulation from village gentry and officials. As seen in the selection of prospective borrowers

and mediators, these activities represent a cautiously designed mechanism in

which moguls and powerful figures are averted at the greatest extent. Currently a lecturer in social anthropology at Oxford University, Xiang Biao has written on this

phenomenon in his title Transcending Boundaries: Zhejiangcun: The Story of a Migrant Village in Beijing: “When making a touch, a well-known middleman is necessary.

This middleman should meet three requirements: first, the mediator should have a fair connection with creditors so he or she can speak up; second, the middleman

should possess a certain amount of money, so creditors can resort to him or her

to recover their loans when needed; and third, the middleman should be rather powerful in society, so he or she can settle disputes when needed. It is noteworthy that these requirements should be very well-balanced — if a mediator leads a gang,

creditors will certainly hesitate for they dare not to approach the middleman when the debtors fail to repay. Who creditors would approach should be a wealthy

yet honest middleman.” Similar to Xia’s observation, Xiang’s descriptions also elaborated how the intricate set of criteria in private financing activities affected

people’s behavior. Compared to a tangible mechanism, private financing activities are more resistant to the interference and manipulation from the administration

and undesirable powers of a society. In Wenzhou, private financing activities were

so common that nearly everyone was involved in the economic activities and

support from private capital was crucial. Besides, people’s inclination towards private financing activities exerted a deep induction effect on morality and

people’s behavior — big shots will certainly win the support of private businesses

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The Non-Public Sector: Indefinite Vitality

if they are mild-mannered, humble, good to the people, and commercially reliable, and vice versa. Loosely organized or even amorphous, private financing activities are different from actual financial institutions in the sense that they are not to be manipulated by regional heavyweights through personnel control or any other

means; they are also very unlikely to serve rent-setting or rent-seeking ends.

Probably because of this, the financial sector in Wenzhou has enjoyed a healthier development. The credit status of the entire society is also in good condition,

thanks to the less influential will of the officials as well as the limited amount of projects from leading officials and non-performing loans.

By the end of 1985 in Leqing and Pingyang of Wenzhou, there were several

taihui2 (抬會) incidents which involved more than RMB20 million and a dozen

neighboring prefectures were impacted as well. Similar cases were reported in Albania, Quanzhou of Fujian Province, and Pan Prefecture of Guizhou Province a couple of years ago. This resulted in serial cases of thrashings, kidnappings, or

even murders. These incidents adversely shook the social stability in Wenzhou. Unlike other forms of credit associations, taihui features a pyramid-shaped financing structure where smaller units are put at the bottom to form the base

while the larger ones are to make up the layers above. The higher the layer, the higher the interest rate is, and the capital moves upward, concentrating on the

upper levels. Initial members could capture a higher interest rate and lure others

to join, and the amount of money multiplies quickly. As the capital of taihui is

primarily independent from the real economy and yields no profits, the high

interest earned by initial members would “eat up” the principal of the latter

members. Ultimately, no new capital would be injected and the entire system would be dragged down. All in all, taihui is beneficial to neither the people nor the

country, so financial authorities should resist and smash them through policies and measures. Yet, do not throw out the baby with the bath water, or else other

forms of credit associations would also be obliterated. After the taihui incident in 1985, lessons were drawn and absorbed to prevent credit associations of this kind from being resurrected, which thus protected the financial order of society from

disturbance. In the eyes of Xia, bad debts must be incurred in any financial activity, and so was the RMB200 million-worth loss. Surprisingly, even if measured by

the ratio of bad debts and factoring in the loss, the proportion of good assets still

stood exceptionally high. Nonetheless, such a loss is incomparable to the impact of financial institutions shut down by the People’s Bank of China in recent years.

In a nutshell, a mechanism boosting the formation of entrepreneurial capital is

embedded in private financing activities in Wenzhou. Originating in an indigenous

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

folk culture, this mechanism also manifests a rich color of folk custom and is characterized by the function of facilitating the accumulation and circulation

of entrepreneurial capital. Additionally, the activities under such a mechanism are centered on the common people and resist manipulation from the powerful

personages. To the people of Wenzhou, private financing activities are a custom and a way of life that entitle people equal chances to start their own businesses.

Moreover, private financing activities allow them to become property owners

within a relatively shorter period of time. This also contributed to the birth of a property system based on individual property right. Ultimately, this mechanism

became the determinant factor in laying a sound foundation for healthy economic and social development in Wenzhou.

On the contrary, most rural villages are not as fortunate as Wenzhou. The

biggest challenge in starting new businesses lies in the process of capital formation. At present, the Central Government is in dire need of developing rural areas, so peasants can become wealthy soon and work in cities — which will help expand

the domestic demand and impel the economy to enter a new stage. Sadly, without an effective mechanism of autonomous capital formation, this aspiration could, after all, be a mere dream, as every single step taken by peasants must involve capital and costs. Thus, quite a number of people have suggested setting up private

banks and initiating venture capital funds to consolidate the financial support to the non-public sector. Still, even if it takes a little time to open private banks and

there are numerous branches, this approach could just deal with the loan issue of certain SMEs. As for the venture capital funds, they are not even a bit related to peasants, nor could they play the role of private capital as in Wenzhou and eastern Zhejiang. Thus, such a suggestion essentially fails to surmount the difficulty in capital accumulation. That is also why Xia believes that particular emphasis

should be put on the role of domestically born financing activities and should not universally curb various other systems such as the rotating credit associations.

Instead, recognition can be offered in terms of laws and policies (depending on

time and location), or to encourage them to develop under stipulated conditions. By doing so, the defects in China’s existing financial system can be remedied, and the development of start-up capital can be fostered.

Coming from Wenzhou and acquainted with immigrants from China in Paris,

Xia made a reliable analysis for he grasped firsthand information on private

financing activities in Wenzhou. His elaboration on the distinctions between rotating credit associations and taihui as well as the comparison between the

loss endured by taihui and the non-performing loans borne by banks was also

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The Non-Public Sector: Indefinite Vitality

convincing. All in all, a policy of persuasion should be adopted with regard to

non-governmental financing activities like credit associations and money-brokers.

Rashness in decision-making and a negative attitude are also inappropriate, not to mention that they knock things down in one stroke.

Eventually, Xia’s passage was published in Economic Highlights in February

2002. As far as I can recall, rotating credit associations and money brokers have existed in the Jiangsu area, which explains that private financing activities indeed

have a long history. Dating back to the 1940s in my hometown in northern Suzhou, we also treated our friends whenever some relatives happened to be in need of money, and money-brokers were occasionally invited as well. Upon the founding

of New China, explicit orders were made to ban illicit financing, but still, these activities continued secretly.

Nowadays, the construction of a Socialist economy is already in a new phase,

thus we should launch large-scale development programs in northwestern China

to speed up urbanization, particularly in the smaller cities. Hence, thousands of peasants — the excess labor force in rural areas — can be transferred to cities. In

the process, there might be some hints on how to make the best use of private financing activities to assist peasants in gathering their start-up capital.

Original Sin of Private Entrepreneurs? Around 2004, several people of great wealth including Zhou Zhengyi (the richest man in Shanghai) were publicly denounced, and a trend of tracing the “original sin” of private entrepreneurs was sparked off.

Yet, some applied this religious idea to the private enterprises and

entrepreneurs. It was interpreted that the upstart layer amongst private enterprises was endowed with original sin. A considerable portion of people believed that

these enterprises were illegal from the start, and so every single activity they

performed, regardless of time, was not plausibly legal; they were even considered

as being linked with smuggling and selling counterfeit products. Besides, there were those who said that these enterprises made their first fortune through dirty

or dubious means, hence their primitive accumulation was full of blood and sins.

In a traditional Chinese mindset, the wealthy are considered malevolent, which is similar to Karl Marx’s view: “Capital comes dripping from head to foot, from

every pore, with blood and dirt.”3 Together with the culpable rich men, the antirich sentiment in society was reinforced, which allowed some to make a fuss out

of the issue. For a time, the public naturally became preconceived about private

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

enterprises — just as a Chinese idiom goes, a repeated rumor is liable to be taken as truth.

In early 2004, the Hebei Provincial Government announced a No. 1 Document

in which the early crimes of private entrepreneurs were said not to be liable to

prosecution, arousing widespread concern in society. Accordingly, two kinds of

opinions appeared. First, the document was considered an “extralegal mercy” and it was believed that letting off private enterprises was a resemblance of rational

and constructive separation from the institutional contortion in the past. As China has been in a stage of economic take-off, it would do more good than harm to

give up chasing after the “suspicious tycoons” — as if granting the group of welloff people an amnesty — and transform them into “sunshine rich men.” Some

also cited precedents in Hong Kong or other countries, saying this policy would be beneficial to the growth of private enterprises. However, some people were

of another viewpoint — they believed that since the prescription of prosecution has been delineated in China’s laws, the treatment towards private entrepreneurs

could not have been an “extralegal mercy.” If there is equality before the law, any “extralegal mercy” will not exist. All in all, they believed that these enterprises

were built under policies of the Party, therefore views like the original sin of private enterprises and extralegal mercy were unjustified.

In fact, attacks against the original sin of private enterprises were nothing new.

Ever since the country was reformed and opened up, there had been prejudices and accusations against private enterprises. Yet, considering that these enterprises

were the products of the country’s transition and were guided by the progressive

instructions from the Party, their existence and growth would, inevitably, go against the conventional social system. Essentially, these businesses symbolized the

confrontations between the old and new systems and policies. In a word, remarks and comments about the sin of private enterprises or on extralegal mercy were

unfounded and irresponsible. Instead, we should view the development process and

existence of private enterprises from an objective, historical, and critical perspective. Most importantly, it is worthwhile to notice the frequent institutional changes. If

we have to impartially and realistically review the relationship between private

enterprises and the Party and government, the responsibility will be attributed to the Party and government — who have made a mistake in the first place.

In Mao’s work On Coalition Government published during the Second Chinese

Civil War, it was stated that the New Democratic Revolution ought to be defined as a bourgeois democratic revolution. Nevertheless, after the foundation of the

PRC, Mao changed his stance and so there were many new policies. In 1952, Mao

24

The Non-Public Sector: Indefinite Vitality

proposed disapproving of a New Democratic social order and hastily announced the “General Line” for the transitional period in order to take a proactive yet

adventurous step — to completely transition to Socialism within the time of the

three Five-Year Plans — instead of waiting for the distant future. Hence, in the

forthcoming decade, the bourgeoisie and revisionists were bitterly condemned in the Cultural Revolution, which at the same time nearly eradicated everything laid down by private enterprises and the non-public sector.

Subsequent to the opening up of the country, a lot of private entrepreneurs

explored their own path to wealth. When talking of the issue, people always

attributed the success to the Party and government who proposed that a portion

of people should get rich first. However, to be accurate, it was the initiative

of the authorities to rectify inappropriate policies that had led to success. Furthermore, the intelligence, courage, and diligence of private entrepreneurs

were indispensable, and their fruits were a proof of the bravery of challenging the

systems, laws, morality, and values under a planned economy, particularly the illadvised anti-Capitalist policy; some even risked being jailed. At this point, we have

to recall the story of Nian Guangjiu. Under that peculiar background and setting,

Nian, as a pioneer in the private sector, was much doomed to be trapped in prison

and bear the ruthless costs of the era. Doesn’t it seem more brutal and senseless to

judge the so-called sinfulness of private enterprises and entrepreneurs like Nian, or to denounce the so-called extralegal mercy?

Reviewing the 30-year long history of Reform and Opening Up, no one

can deny that private enterprises and entrepreneurs had grown along with the transformation of the country. Throughout the period, private entrepreneurs in China emerged in four conditions.

The first condition was the nation’s transformation into a Socialist market

economy, during which a considerable portion of the first generation of private entrepreneurs was born. Simultaneously, quite an amount of previously illicit

economic activities were legitimatized. For instance, people were formerly prohibited from engaging in long-distance transportation of goods but could now

publicly run their businesses as the government had amended its policies. People

can also openly practice the household-responsibility system. As for peasants, some had been criticized for selling the fruits of their harvests and were labeled as capitalist, but they can now legitimately open their stores and recruit employees

as retailing had become a legitimate business. Government bonds also went from

underground trades to listing. During this period, whenever an adjustment was

made, it would be accompanied by impacts and conflicts against the existing

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

policies and laws, and this had given birth to numerous overnight tycoons.

Meanwhile, there were some “warriors” who dared to risk taking advantage of the

loopholes in economic transition. As a consequence, these people were condemned for clashing with the current legal system when they started their businesses.

However, in a way, these ruthless prices were unavoidable but one thing is certain — private enterprises (or entrepreneurs) have no original sin. More importantly,

when the CPC managed to seize control of the state, it had promised that capitalism

would be “redeemed,” i.e. the ideology would still be practiced under limitations

and reformations. Yet, it turned out that the Party did not keep its word. By the time pro-revolutionary and rash errors were identified, revision of policy was deemed needed, but no options were left except for reverting to old policies. That is why,

in my opinion, if we look into the issue rationally and reasonably, there is no way

for the CPC and People’s Government to escape from the burden of the original mistake, and the blame shall never be put on private enterprises.

Another case was that entrepreneurs were originally workers, peasants,

intellectuals, or even cadres. These entrepreneurs became the economic casualties

of the transition to a Socialist market economy. Laid off and downgraded in society, they still refused to accept jobs or subsidies offered by the government. They instead figured out ways to start their own businesses and accumulate wealth to

solve their employment problems and to pay taxes. It should also be noted that there was an intrinsic difference between the primitive accumulation of capital

and the wealth of these entrepreneurs — the fruits of their legitimate businesses. Therefore, these entrepreneurs were innocent and there is but the guilt of the Party and government towards these entrepreneurs!

The third condition was in the 1990s, when a group of entrepreneurs called

the “New Generation” were raised. This richer population mostly consisted of businesspeople and technical staff from private technological enterprises. In the past, their fathers or preceding generations enjoyed no opportunity to establish

their own business. For example, the founder and CEO of NetEase, Ding Lei, was

born in 1971 and he made his first fortune in between 1995 and 1996 by writing computer programs. Another example was the CEO of Broad Group, Zhang Yue,

who invented an atmospheric pressure water heater and earned his first profits;

they were both the representatives of the new generation of entrepreneurs. What people learned is that the intellectuals not only are capable of creating wealth but also contributing to the construction of Chinese Socialism; they were also praised

as constructors of Chinese Socialism in the Report on the Work of the 16th National Congress, which showed that the Party and government had given respect to them.

26

The Non-Public Sector: Indefinite Vitality

The fourth condition was that some in the non-public sector were making

profits through illegitimate means. There were a very limited number of tycoons who had committed serious crimes, such as Lai Changxing, Zhou Zhengyi, and

Zhang Rongkun. Regardless of the quantity, these particular cases represented

neither private enterprise nor entrepreneurs; even though some did break the law, they were merely acting illegally rather than born with sin, therefore what they should face should only be legal sanction.

As stated in the 16th National Congress and reassured in the 17th National

Congress, the development of the non-public sector should be backed by sturdy support and guidance, and such spirit has been written into the Constitution.

According to the new version of the Constitution, the new strata in society

(including private entrepreneurs) are classified as the constructors of Socialism. On the whole, private entrepreneurs have made immense contributions to the economic and social development of the state. Now, our sole mission is to actualize

the spirit of the two congresses while abandoning a pro-revolutionary attitude towards the non-public sector, so as to lead and support the non-public sector for the healthy growth of the private economy.

Only One Article Needed: Limit State Enterprises In February 2005, the State Council published the Several Opinions on Supporting and Leading Individual Private Businesses and the Non-Public Sector (commonly termed the 36 Articles) in a bid to foster the development of China’s private

economy. Due to policy adjustment, there was a marked increase in the number of private enterprises and the share of non-public businesses exceeded that of state

enterprises in a number of provinces. According to statistics, there were altogether 6.9 million private enterprises as of June 2009, which made up 70% of the national

total. Specifically, SMEs accounted for 95%, of which 95% was privately-owned.

For the five years after the 36 Articles were announced, dominant industries and existing interest groups still intended to separate private capital from the market,

thus there existed “metal doors,” “glass doors,” and “swing doors” — in the first place, “metal doors (dominant industries)” had already monopolized the market, blocking the entrance; next, even though official documents are announced to

create space, private enterprises still fail to squeeze into the market as if there

were “glass doors”; at last, some manage to get in but are attacked as if facing the

rebound of a “swing door.” For those who happen to survive in the market, they are even liable to the suppression from state-owned enterprises. Anyhow, there

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

seems no way to execute the 36 Articles.

On May 7, 2010, the State Council published Several Opinions on Stimulating and

Leading the Sound Development of Private Capital (also known as the New 36 Articles) in a bid to crush monopoly in the market and create room for private investment.

In accordance with the New 36 Articles, attention was put on the four key areas (finance, railways, energy, and municipal administration) for the following year or so, though the progress was relatively stagnant.

The key lies in the many management ministries and commissions responsible

for the execution of the New 36 Articles. Yet, the reformation was indeed impractical and unrealistic, as the ministries and commissions were concurrently the targets of reformation.

In fact, the restriction of private capital in China is quite worrying. When

China’s membership in the WTO was acknowledged in 2001, foreign banks rather than domestic private financial institutions were permitted to enter the domestic

capital market. Around the convention of the NPC and CPPCC in 2002, one of the

NPC members Qin Chijiang expressed his regret at the absence of private banks in the Central Financial Work Conference. Besides, he said banks ought not set up forbidden areas but allow financial institutions of different organizations, forms,

and ownerships to compete. Now eight years have passed, the New 36 Articles has brought about the utilization of private capital in starting, running, or investing in

financial institutions such as village banks as well as loan companies. Nonetheless,

by June 2010, or the second month following the announcement of the New 36 Articles, the People’s Bank of China, China Banking Regulatory Commission, and

China Insurance Regulatory Commission jointly published Several Opinions on Further Doing a Good Job in the Financial Services for SMEs which stated that, as the

China Insurance Regulatory Commission suggested earlier, only commercial banks could serve as the initiator of village banks, and that a minimum of 20% of shares

would have to be controlled by the initiator. From these regulations, we can tell the fear of private capital is beyond a doubt. Therefore, the majority of enterprises and

experts believe history will repeat itself unless there is a forceful mechanism that ensures the effective implementation of the New 36 Articles.

On May 23, 2011, exactly a year after the promulgation of the New 36 Articles,

an editorial titled “Only One Article Needed: Limit State Enterprises” was published in the 12th issue of Caijing Magazine. The title simply hit the nail on the head!

28

9

Chapter

The Use of Foreign Capital and Dual Transformation

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: My Relationship with Foreign Capital The use of foreign capital in post-war development was a problem encountered by

many developing countries; it was also a key issue in the construction of Socialism in China.

As soon as the country opened up, the idea of using foreign capital was

proposed. Consequently, the China Investment Bank (where I used to work) was established by the China Construction Bank (CCB) to serve as a window for worldwide bank loans. Yet, it was after 1986 when I dabbled in foreign capitalrelated business.

By the fall of 1986, Premier Zhao Ziyang had met with Seisoku Itō, the Deputy

Director of Nomura Securities as well as a consultant of the State Economic and Trade Commission. Itō brought out a proposal on the feasibility of working with

one Chinese bank in order to combine Middle Eastern capital with Japanese

technology and run some investment projects in China. At that time, the CCB was a bank that specialized in supervising loans for investment in infrastructure and

so was delegated by Premier Zhao to initiate a partnership with Japan. As a result,

Zhou Daojiong, the President of the CCB, asked me to liaise with Itō. At the time, Japanese enterprises were very picky about investments; for more than a year, we

talked over 100-some projects which ranged from cooking oil extraction in Dalian to shrimp farming in Weihai. Itō at last rejected my offer by saying that the global shrimp market was weak; still, something had to be achieved after these meetings. How about just shrimp farming in Weihei? Apparently, Itō was reluctant to agree. So, I told him, now that we had decided to work together, we should do better than being paltry with our projects. More importantly, catching shrimps did not

seem to be an auspicious beginning (for zhuaxia 抓蝦 [catching shrimp] can be

interpreted as a metaphor for losing one’s head in Chinese). Itō did not understand the pun, therefore his translator Chen Junming, a capable Chinese man, vividly explained it. Eventually, the International Union Leasing (now known as China

Jiantou Leasing), a Sino-Japanese joint venture, was founded in 1989, which symbolized the first partnership with Nomura Securities, was reached in 1989.

The first General Manager was served by Yoshimasa Nakamura, who was a friend of mine and the founder of Guangyao International Investment, after he resigned

from the International Union Leasing. Taking advantage of his personal network

and reputation earned through his years in listing securities, Nakamura started a co-investment fund in Hong Kong, absorbing around USD1 billion that was dedicated to quite a number of real estate investments in Beijing.

30

The Use of Foreign Capital and Dual Transformation

My other brush with foreign investment was in 1986, when Shanghai

Petrochemical intended to use foreign capital to launch a series of projects that

would produce 300,000-ton ethylene. Thus, the corporate entity resorted to the CCB for global syndicated loans. Though the Shanghai branch was eager to assist, international business was unavailable even in the CCB head office, so the branch

could do nothing but to contact me. As the matter was to do with the business

expansion of the banking industry in utilizing foreign capital, I approached Zhou Daojiong to arrange a meeting among me, him, and Chen Jinhua (the then Deputy Mayor of Shanghai). In the end, the head office and the Shanghai Municipal

Government jointly drafted a report to the State Council to suggest that the CCB

amass a sum of USD272 million outside of China. Subsequently, the State Council

approved the plan and four consortium loan agreements were signed among the CCB and 42 foreign banks. Finally, the very first step in the international business of banks was taken by the CCB, which was also the first specialized bank that succeeded in financing such a large sum of consortium loans since China was opened up.

Nevertheless, there was one thing about foreign investment in China which I

intended to do but failed to do.

Back in 1987, when working with Nomura Securities, I heard that an airport

in Xiamen was constructed with Kuwaiti capital. In my view, this matter went

beyond the question of where the capital came from — rather, it was a question about cementing the relationship with Middle Eastern countries. Efforts should

be made to foster the economic and commercial cooperation between Islamic countries and China, the home to thousands of Hui people. We also went to visit

Isma’il Ehmed, the Chairperson of the State Ethnic Affairs Commission, and Zhao

Yannian, the Executive Deputy Director of the commission. In the first place, my aim was to start an Islamic bank, but they told me that the commission had filed a report to the State Council explaining their plan to establish an Islamic

investment trust company. Moreover, Premier Zhao had approved of their plan

and preparation was already in progress, and they also expressed that they were willing to coordinate with the CCB.

Afterwards, I rented an office at the Cultural Palace of Nationalities and

recruited several graduates of Arabic from the Central Institute for Nationalities

(renamed Minzu University of China in 1993). Going through nearly a year of

preparation, the Central Bank declared that supporting specialized banks was not its business. Coincidentally, there was internal restructuring and rectification within the CCB, which left me no choice but to quit. Until now, I still feel sorry

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

for those Arab comrades, as they could not enjoy chances to apply what they had learned.

In a word, an idea, no matter how ambitious or innovative, can be realized as

long as institutional obstacles exist. Let’s begin.

The Post-War Path of Developing Countries and the Use of Foreign Capital After the end of the Second World War, the many colonies in Asia, Africa, and

Latin America successively declared independence. To these newly independent

states that were considered underdeveloped or developing, the primary solutions to getting away from poverty and, most importantly, the reliance on super powers were to develop their economies and forms of commence industrialization. But,

in what ways could the economy advance? How to industrialize the construction

industry and by what means could a national industry be developed to enlarge the

job market and pursue economic independence? The fundamental question was, how to acquire the capital necessary for economic development and industrial

construction? Could we make use of the capital from developed countries without being controlled by them? To the economists, this urgent need to move forward

was definitely a challenge. In the past, capitalist countries discovered their way to prosperity via the market mechanism and a laissez-faire policy. However, the

international circumstances and domestic situation in developing countries did not create conditions for them to follow the same path. At this point, we can

refer to several examples: the first example was the success of the Soviet planned economy; the second was the achievement of government intervention in reviving the economy and combating unemployment under the New Deal during the Great Depression; the third was the American Marshall Plan implemented in the

post-war period. Thus, economists drew the conclusion that developing countries should devise economic plans and utilize foreign capital in relation to economic

development and industrialization. It was under these circumstances that countermeasures were taken to help developing countries break out of national

poverty. Ultimately, these measures evolved into a practical branch of economics — Development Economics.

In view of post-war economic development, Japan and certain Asian countries

were celebrated for their abrupt rise. When the Second World War ended in

1945, the Japanese economy was but “a heap of rubble.” Thanks to the Economic

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The Use of Foreign Capital and Dual Transformation

Recovery Plan introduced in 1949, import substitution was carried out and remarkable success was attained in revitalizing the economy. Concurrently, during the Korean War (1950–1953), the U.S. army had to rely upon Japanese assistance owing to its over-extended supply lines, which in turn provided Japan with

foreign capital. By the late-1950s, the Japanese government decided to further the country’s trade business. In 1960, the Income Doubling Plan was announced and the economy thrived as a result. Throughout 1960 to 1985, the average annual

rate of increase of people’s income reached 10%. By 1985, Japan had become one

of the major producers of home appliances, cars, and semiconductors, and its total export value ranked third in the world. Because of the signing of the Plaza

Accord in September 1985, the yen was forced to appreciate against the dollar,

which also markedly motivated local enterprises, banks, and securities firms as well as their overseas investments. As a result, the overseas export of Japanese

capital was quicker and more massive than the American acquisition of European enterprises. By 1986, Japan superseded the U.S. to be the largest capital supplying

state. With USD1.46 trillion-worth of external assets, Japan became the world’s

biggest creditor nation in 1988. Thereafter, Japanese capital was spread across

the American territory and injected into industries such as manufacturing, the property market, financial companies, movie studios, and even Rockefeller

Center. No wonder the Americans once thought that the Japanese were out to buy America.

In the mid-1960s, the economies of Korea, Singapore, Hong Kong, and Taiwan

took off one after another. From then onwards, the GNP (or GDP) growth rates in

the regions were approaching or exceeding 10% — this was why the cities were named the Four Asian Tigers and their economic achievement was known as the Asian economic miracle.

Since 1953, the South Korean government managed to invigorate the stagnant

economy brought by warfare under immense American assistance. In 1962, the

first Five-Year Plan was implemented and as a result, the economy flourished. Given Koreans’ strong national character, the country’s development was much

contributed to by external loans than by foreign direct investment. Among developing countries, the economic performance of South Korea was the most

noticeable: the per capita GNP of South Korea grew from USD87 in 1962 to

USD243 in 1970. As of 1980, South Korea’s total export value was 534 times that of 1960. In the meantime, the agricultural sector accounted for a smaller proportion in

the domestic economy, dropping from 47.4% in 1961 to 15% in 1985, while that of

the industrial sector grew from 16.5% to 33.4%. By 1995, South Korea had become

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

the 11th largest economy in the world with a per capital GNP of USD9,700. By the

end of 1996, South Korea had joined the Organization for Economic Cooperation and Development (OECD) and become a member of the Group of Eight (G8).

Similarly, Taiwan achieved her economic success with American help. Unlike

South Korea, Taiwan’s economy chiefly relied upon internal accumulation as well as direct investment from overseas Chinese people and foreign merchants. In South Korea, the role of government was emphasized not just in economic

development but also in adjusting the industrial structure and the development of enterprises. On the contrary, in Taiwan, the emphasis was put on the market mechanism, and the government interfered only when needed. During the 1960s and 1970s, both capital and human resources were accumulated through the export

of labor-intensive products; the total export value in 1970 was 9 times that of 1960, and the value in 1980 was 13 times that of 1970. In terms of economic structure, the agricultural sector became less weighty and shared a decreasing proportion,

dipping from 35.7% in 1952 to 12.1% in 1978. Concurrently, the proportion of the

industrial sector doubled, jumping from 17.9% to 40.3%. In the 1980s, Taiwan’s economy began to incline towards electronics, computers, and information

industries, and gradually, the economy was successfully transformed by the mid-

1990s. Between 1980 and 1992, the average growth rate per annum was as much as 10.6%. In 1995, Taiwan entered the list of higher-income regions, as for the first time, the GDP per capita had surpassed USD10,000.

For the free port of Hong Kong, the colonial government continued with its

laisser-faire economic and trade policies during the post-war period, therefore

no specific plans were devised, nor were solid measures designed. Given this background, foreign direct investment became the primary momentum behind Hong Kong’s development. The groundwork of Hong Kong’s industrial

development was laid by the flooding in of a large group of Shanghai weavers

who wanted to escape from the Party’s influence when the PRC was founded

in 1949. What followed was the injection of American capital into the Asian

market in the 1960s. Correspondingly, garment, plastic manufacturing, toy, and electronics industries were met by the huge demand in the American market as well as American investment activities. Since then, there was sustained growth

in external trade. At first, exports made up less than 40% of the GDP in the 1960s and the percentage surged to about 50% by the1970s. As soon as China opened

up in the 1980s, Hong Kong entrepreneurs decided to shift their labor-intensive

businesses to the Pearl River Delta (PRD) region where factories would be built. Consequently, entrepôt trade thrived and Hong Kong was, gradually, transformed

34

The Use of Foreign Capital and Dual Transformation

into an international trade hub and a global financial center in the Far East Area. For a time, exports contributed nearly 100% to the GDP of Hong Kong. Along with

the deepening of the policy of Reform and Opening Up, Hong Kong’s economy continued to prosper, rendering the city a window for the country to open to the

outside world. In the 1990s, the total export value exceeded the total value of

GDP. Looking back to the mid-1960s, the GDP per capita in Hong Kong was not

even one-third of the American figure; yet by 1995, the percentage rose to 98.4%, catching up with the U.S. A year before the Handover, Hong Kong was among the largest economies in the world with a GDP per capita close to USD25,000; note

that Hong Kong also outdid its colonial ruler for the GDP per capita of Britain back then was USD20,860. Despite the absence of government interference, Hong

Kong’s economy was not left unattended. Since the 1960s, the colonial government

of Britain introduced the policy of “positive non-interventionism” to slowly tighten control over the economy. Essentially, the policy encompassed the ideas

of providing investors with a healthy investment environment, infrastructure, and various services, restricting the behavior of enterprises through legislation,

closely monitoring the banking industry, as well as regulating the financial market

and maintaining the valuation of the currency through macroeconomic measures. Sir Charles Philip Haddon-Cave, the Financial Secretary between 1971 and 1981,

disapproved of the policy, arguing that “the Government attempted to plan the

allocation of resources available to the private sector and to forcefully frustrate the operation of market forces.” Contradictorily, he admitted that “intervention

could be appropriate for the sake of Hong Kong’s economic stability” and believed that “moderate intervention conveyed a special meaning in view of an economic

system vulnerable to the influence of the global trade environment.” By the 1980s, both Hong Kong and Singapore started transforming from being entrepôts to industrial cities.

Singapore was also a free port as well as an international trade and financial

center in Asia, but the path of development the city-state had taken was different. After declaring its independence in 1965, the Singaporean government, in a bid to safeguard its national interest, actively intervened in domestic economic

development and employed an aggressive tactic to shape its economic and industrial structure. At the beginning, endeavors were made to draw in foreign

capital that would be dedicated to the development of labor-intensive industries

and infrastructure. Following Hong Kong and Puerto Rico, the Singaporean

economy developed rapidly under an export orientation. For a time, Singapore and Hong Kong functioned as two low-cost overseas production bases in the eyes of

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

American corporations. As of 1980, the total export value of Singapore was 20 times more than that in 1965. By the mid-1970s, the Singaporean government deliberately relocated labor-intensive industries overseas while developing domestic heavy

industries including petrochemical engineering and shipbuilding. This was how Singapore was progressively transitioned from an entrepôt to an industrial

city. Since the 1980s, the government, in order to elevate the economy, explicitly

combated and prohibited investment in labor-intensive industries. On the other hand, ventures in high-technology industries such as electronics and computers

were boosted through the introduction of preferential policies. Additionally, the

Singaporean government, in order to break the territorial constraints of being an island country, set up industrial estates in Indonesia, Malaysia, and Suzhou

where multinational corporations were introduced. These foreign manufacturers would closely coordinate with the high-technology industries of Singapore,

which altogether would give birth to a complete industrial system superior to the

domestic one. In this regard, we can conclude that the Singaporean government

exhibited a clearer planning and displayed a strong willingness to cooperate, when compared to the spontaneous set-up of industrial bases in the PRD region by Hong

Kong merchants. This explained why Singapore’s economy could yield more

money as well as why Singapore was able to become both an international trade hub and a key production base for the global electronics industry. As of 1996, the GDP per capita of Singapore outdid that of Hong Kong, reaching USD26,000, just behind Japan.

Since the 1970s, Thailand, Malaysia, the Philippines, and Indonesia were

correspondingly developed and were collectively called the Tiger Cub Economies before the outbreak of the Southeast Asian financial crisis in 1997. Members of

the Association of South East Asian Nations (ASEAN), these four countries were

formerly agriculture-and mining-oriented colonial economies. The fact that their

starting points for industrialization were rather low remained the same although they had declared independence. The industrial development in these countries

was minimal and the countries’ daily necessities were mainly supplied by their colonizers or other developed countries. Additionally, governments of the four

ASEAN countries devised their strategies in import substitution and started developing labor-intensive industries such as textile, garment, food production, cement, and ceramic industries, which laid a primitive framework for industrial

development. Since the 1970s, these countries also learned from Singapore’s success in being an export-oriented economy. As global raw material prices plummeted in

the 1980s, Southeast Asian economies were forced to shift to the export industry —

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The Use of Foreign Capital and Dual Transformation

Malaysia and the Philippines first took the initiatives, and Indonesia and Thailand

came after. Taking advantage of foreign capital and a cheap domestic labor force,

these economies easily entered the international market with their labor-intensive

products (such as garments and home appliances); industrialization was notably stimulated as well. Since the 1980s, these economies were progressively engaged

in manufacturing high value-added goods including capacitors, television sets, calculators, and watches, among which some required a rather high level of technological development. Indonesia was one of the examples. By the mid-1980s, the fourth Five-Year Plan was implemented to intensely develop the machine manufacturing industry and manufacture vehicles domestically with a target to deploy 50% of national raw materials to the production of cement, fertilizer,

sugar, paper, and facilities for the petrochemical industry. As for Malaysia, the

government announced a 10-year master plan for industrial development in 1986 to spearhead the advancement of seven resource-oriented industries and five non-

resource-oriented industries. In Thailand before the mid-1980s, the manufacturing

industry’s primary output was artificial flowers, plastic products, shoes, garments, leather products, and toys. Later on, the industry tilted towards electronic goods.

As of 1986, the export of electronic goods added up to USD440 million, and the value was boosted to USD USD2.9 billion in 1990. In particular, the export of integrated circuits made up USD800 million, while computers and computer

accessories accounted for USD12 million. By the late-1980s, an enormous amount of capital was invested in the exploration of natural resources including oil and gas in the coastal area of eastern Malaysia to develop heavy industry bases.

Although the aforesaid condition took place before the Southeast Asian

financial crisis, it could still reveal that the combination of foreign capital and import substitution was a common strategy. Even though in certain countries or regions, foreign capital occupied a smaller portion of overall investment, this

exotic element still played a crucial role. First, this tactic could replenish the lack

of capital; and second, not only capital but also advanced facilities and technology were also introduced, and so was a brand new concept of management.

The Use of Foreign Capital in China Foreign capital in the early years of the PRC To begin with, I have to pinpoint the ideological barrier on the issue. Socialist

regimes generally believed that capitalist countries would exploit backward

nations through exporting capital, and so they instinctively rejected, discriminated,

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

or stayed alert against foreign capital.

In fact, there had been a debate on whether Socialist states should utilize

foreign capital. Dating back to the foundation of the Soviet Union, Lenin proposed

the idea that the signing of concession contracts could utilize foreign capital. He also believed that if economic development of the Soviet Union was to be sped up, “capitalism should be made use of (especially in leading the economy onto a statecapitalist track)…capitalism should also serve as a means, path, and approach to enhance productivity.” However, some were apprehensive that Russians, who

had just managed to escape from being exploited by the bourgeoisie, would then be exploited by capitalism. Lenin’s reply was “to buy off the capitalists with

surplus profits. Capitalists would capture surplus profit — let such profit go, what we would obtain was even more.” So, would this lead to the revival or the spread of capitalism? Lenin answered, “Yes, this implied that capitalism would be developed, yet this was not dangerous for the regime was in the hands of workers and peasants, and so landlords and capitalists would never be resurrected.”

In China, Lenin’s argument above served as the rationale behind the country’s redemption policy over capitalists.

At the establishment of the PRC, Soviet loans were borrowed to execute 156

Soviet-assisted projects. Assuredly, foreign capital was involved in this case, just that the capital from a Socialist regime was deemed different from capital from capitalist countries.

During the Era of Stagnation afterwards, overproduction arose in steel and

mechanics production, so the Soviet Union decided to employ compensation trade as a means to import more than USD20 billion-worth of facilities and technology.

Meanwhile, a stable export market was created through paying off debts with natural gas and chemical goods as well as by the construction of long-distance

pipelines, railways, and chemical plants. This was also injection of foreign capital. Almost concurrently in China, the bulk import of complete sets of facilities was practiced under the insistence of Premier Zhou Enlai. This policy was known

as the “43 Plan.” In accordance with the plan, 13 sets of fertilizer facilities were purchased through installment payment under suppliers’ credit. The “43 Plan” marked the earliest utilization of foreign capital in China.

However, in political attacks, foreign capital was always a controversial issue.

In 1975, when Deng Xiaoping returned to power during the Cultural Revolution,

he proposed the ideas that imports were to be enlarged, new technologies were to be introduced, and foreign capital was to be put to use. He said, “We could also think over exporting coal or signing long-term agreements with foreign

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The Use of Foreign Capital and Dual Transformation

governments, so we could obtain their exploration technologies and pay by coal. By doing so, there were a number of advantages — first, exports could be increased; second, there would be technological advancement in the coal mining industry; and third, the employed population would grow. It was undeniably a great policy...Anyway, strive to export more in return for some sophisticated technologies and equipment, so as to facilitate reforms in industrial technologies and enhance labor productivity.”1 Pathetically, the anti-Deng campaign and the Counter-Rehabilitation of Rightist Personnel were later launched, and there were ridiculous arguments like that the Gang of Four were pro-Western.

The use of foreign capital after Reform and Opening Up By December 1978, the utilization of foreign capital was finally emphasized as a key measure in the construction of Socialism, after the Gang of Four was crushed and the policy of Reform and Opening Up was affirmed in the Third Plenary Session of the 11th CPC Central Committee. When Deng talked of aspirations like quadrupling the economy, he reiterated, “Upon the basis of standing on our own feet, we should also open up to the outside world, so foreign capital and technologies could be drawn in to assist our development.” He added, “Internally, we should invigorate out economy; externally, we should liberalize our economy. Instead of an ad hoc measure, this was more a long-term policy that would last for at least 50 to 70 years. Why? Because the first step was to realize the 20-year long process of quadrupling the economy which would be followed by another step that would take 30 to 50 years, most likely 50. Ultimately, we would be very close to developed countries. Altogether, the two steps would consume 50 to 70 years. By then, the policies would remain as rigid as they were. Even if changes arose, the direction would only be liberal. If not, the people would rebound.”2 With their particular features and independent patterns of operation, the use of foreign capital and the introduction of technologies were two different matters which could either be separated or merged. As mentioned, the “43 Plan” was formulated in the 1970s to counter the surpluses in the production of steel and mechanics. Subsequent to the opening of China, special economic zones were established and coastal cities were opened, which contributed to diversification in the forms of partnership with foreign merchants as well as in the ways to make use of foreign capital. Simultaneously, new technologies were brought into the country through channels like bulk facilities purchase, licensing trade, and technological consultancy. Since the policy of Reform and Opening Up was put into practice, it was

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

proven that the use of foreign capital had to be practical and realistic, and that there was not a fixed or standard approach as the forms of investment were decided upon different projects and circumstances.

Credit and loans (including government loans, bank loans, buyer’s credit, and supplier’s credit) Credit and loans were the most commonly used and easiest way to make use of foreign capital. Given a debtor-creditor relationship, we, as the debtors, just needed to repay the principal plus interest without forgoing the ownership rights over the capital and equipment. Additionally, a great deal of small-and medium-

sized enterprises, when bargaining over export credits, often suggested combining

the to-be-introduced technologies and equipment with their expansion or redevelopment projects.

Compensation trade In principle, compensation trade refers to repaying debts in kind. This approach

was frequently used in resource explorations such as coal mining and oil extraction, or in projects where exotic techniques were necessary to produce certain export goods.

Equipment leasing This was a method in which only the right to use instead of the ownership rights were leased out, and the rents were paid off with the profits generated. In fact,

an abundant amount of foreign capital was injected through this approach; yet

Western countries ordinarily believed that rents were different from debts. On the surface, equipment leasing operated the same way as seller’s credits did. Yet, through seller’s credits, we, as the borrowers, would buy off the equipment with loans and pay by installments. On the other hand, in equipment leasing, rents

were directly paid off with profits for the borrowers who could employ the latest equipment and facilities first; some borrowers may also enjoy tax exemptions.

In addition, if the borrowers found the equipment unsuitable, the lease could be ended. Despite the relatively higher costs, equipment leasing could first, introduce the latest and most advanced hardware, and second, allow a country to upgrade

its technological level in production without bearing the full cost of the facilities. This method was often applied to tools including planes, ships, mining machines, and heavy duty trucks. In a word, this approach allowed a country to promptly

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The Use of Foreign Capital and Dual Transformation

transform backwardness in national productivity by utilizing foreign capital and technological achievements.

Processing and assembly factory business (PAFB) The emergence of PAFB could be dated back to the 1980s during the early stage of Reform and Opening Up. It first appeared in Shenzhen and was later popularized

in the labor-intensive industries in the PRD region. A collective name of three ways of foreign investment, PAFB comprises materials and samples processing, components assembling, and compensation trade of limited scale (PAFB together with imported materials processing are collectively known as processing trade).

Back then, as the economy of Hong Kong was undergoing structural transition, the

cheap land prices and labor force in the PRD region became favorable factors. In addition to local workers, farmers-turned-workers also moved from other provinces

to the PRD region. Moreover, there were tax remissions in special economic zones and opened-up cities, which created space for generating more profits. Turning from the early-1980s to the 1990s, more than 20,000 factories were moved to the

PRD region while more than HKD400 billion-worth of capital was ventured in the region. On the whole, nearly all labor-intensive industries were moved inland.

In recent years there have been a number of changes in attracting investment.

On one hand, the international division of labor altered and manufacturing

industries of developed countries favored Asia as their investment ground. On

the other hand, China’s membership in the WTO also brought changes to the investment environment (primarily in terms of market access). In the PRD region,

prices of land and labor went on climbing as the region had been considerably

developed, and the income tax exemption period for enterprises in PAFB was about to be due, which posed challenges for the future development of the region.

Furthermore, more problems were revealed by the continual reliance on cheap

workers from other provinces. Nevertheless, given regional economic success, industries in the PRD region (including Shenzhen) initiated new adjustments that were targeted at high-tech industries, therefore labor-intensive industries gradually began to shift to other parts of the country. There will be elaboration on this in the following sections.

Contractual joint venture between Chinese and foreign investors In China, there was an urgent demand for certain goods which were at the same

time capital-and technology-intensive projects. In other words, it was necessary to

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THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

attract profuse capital, to introduce technologies on a large scale, to upgrade the

facilities, and to multiply the size of corporations. Therefore, this approach was constantly used for such goods. The good thing about contractual joint ventures was that it appealed to both domestic and foreign investors — both parties enjoyed ownership over their respective portions of capital while risks were as

equally shared as profits through joint investment and operation. One of the early examples was Shanghai Volkswagen — the joint venture between the Volkswagen

Group and the Shanghai Automotive Industry Corporation (SAIC) — which annually produced 20,000 sedans. The total investment added up to RMB387

million of which RMB160 million was equally injected by the Chinese and German investors and the remaining RMB220 million came from loans. Admittedly, the

SAIC was one of the pioneers in contractual joint venture in China. For a time, co-

investment and co-management became a dominant incentive for foreign capital. Back then, quite a number of people were concerned that foreign capitalists would

intentionally transfer the profits overseas and that the withdrawal of foreign capital would have an adverse impact on the nation. Frankly, these worries were

unnecessary. The very nature of capital is to accumulate profits. For loans from capitalist governments or the capitalists, we voluntarily offer interest in return.

Likewise, foreign investors of co-invested or foreign enterprises are willing to

forsake their profits. On the whole, these are the ransoms we have to pay for putting foreign capital into the construction of Socialism in China. Nevertheless, what foreign investors care most about are profits in the market. As long as the market is occupied by their products and profits are generated, foreign investors will consider furthering the scale of production and capital rather than remitting the profits, let alone withdrawing their capital.

Foreign sole proprietors Companies of this kind were independently run and solely funded by foreign investors, the only risk bearers. As the 21st century arrived, the capital of

manufacturing of developed countries was gradually shifted to the Asian market.

At present, in addition to joint ventures, sole corporations also emerged as a popular form of investment.

Up to 2007, the aggregate value of the actual utilization of foreign capital in

China reached USD776 billion, which rendered the country the second largest country in absorbing foreign capital, right behind the U.S. Data has shown that foreign capital, on average, contributed 1.4% to GDP growth over the past 29 years.

Among the total fixed assets in China, foreign investment accounted for roughly

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The Use of Foreign Capital and Dual Transformation

12%, and this mostly benefited ordinary trade and processing trade industries.

In the new century, the growth of foreign investment in China was favored

by the readjustment in the global setting of manufacturing industries. As of 2007,

the U.S., the Eurozone, and Japan made up 19.4%, 21.6%, and 10.2%, respectively,

of the global manufacturing industry — which saw respective decreases of 2.9%, 1.2%, and 1.7%, compared to 2004. As for East Asian and Pacific regions,

a key transitional base, the production industry took up 20.5% of the global manufacturing market, which saw 6.8% growth as opposed to 2004. Specifically,

the share of China’s production industry in the global manufacturing market was increased by 3.8%.

Between 2004 and 2008, China became the quickest developing country in

soaking up foreign investment with USD350 billion in foreign capital utilized. Out

of this enormous foreign capital, USD216 million, or 61.6% was absorbed by the manufacturing industry. In brief, China has taken on the role as a “world factory” as a result of the transformation of the global manufacturing market.

However, since the global financial crisis, foreign investment and hence the

use of foreign capital in China were challenged under new circumstances. For two consecutive years in 2008 and 2009, global investment contracted substantially which inevitably discouraged foreign investment in China. In 2009, the actual

amount of foreign investment was USD90 billion, which was slightly less than

that in 2007. It was reported that Zhang Xiaoqiang, the Deputy Director of the National Development and Reform Commission, revealed that by the end of 2009,

an accumulated total of 683,000 foreign-invested enterprises were approved to be founded, and that the actual foreign direct investment added up to USD945

billion. In the same year, foreign enterprises made up 28%, 22.7%, and 55.9% of the national output value, national tax revenue, and national export value, respectively. These enterprises also absorbed a total of 450 million people from the labor force.

In 2010, the economy improved. According to news released by the Ministry of Commerce, 27,406 enterprises in non-financial fields were established by foreign investors in 2010, which saw a year-on-year increase of 16.9%. Meanwhile, the

actual amount of utilization of foreign capital reached a record high of USD100 billion, which presented a 17.4% year-on-year growth as well as untwisted the 2.6%

decrease rate in 2009. Structurally, the abrupt growth in the actual utilization of foreign capital was much sought by the services industry and Central and Western regions, where increases of 28.6% and 27.6% were recorded.

With reference to statistics from the World Bank, the average growth rate

per annum of the export value of the manufacturing industry between 2005 and

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2008 was 25.1%, 11.9% faster than that of the global manufacturing industry in the corresponding period. As of 2008, export from the domestic manufacturing

industry contributed 93% to merchandise exports, which was 22.8% above the

global average. It was estimated that 1% growth in China’s exports would trigger a 0.38%-increase in the industrial added value, which contributed more than onethird of industrial growth. That said, if China’s economy is to achieve an annual

GDP growth rate of 7.18% and quadruple the GDP by 2020, foreign capital remains indispensable in driving domestic economic development.3

The “Dual Transformation” of Labor-Intensive Industrial Cities and Enterprises As mentioned, in the early stage of reform and opening-up, foreign investment

was the most active along the coastlines such as the PRD region. Amongst the coinvested and foreign owned companies in the coastal region, a substantial portion consisted of foreign-funded labor-intensive enterprises. One of the examples was Foxconn, a Taiwanese multinational electronic contract manufacturer which gained

some media attention. Within the PRD region, a number of cities like Shenzhen

and Dongguan achieved economic development and prosperity through the use

of foreign capital. However, new conflicts such as urban upgrading and industrial transition surfaced owing to the concentration of labor-intensive industries after

years of development. The Guangdong Provincial Government called such a goal “vacating the cage to switch birds (tenglong huanniao 騰籠換鳥).” As for the “dual

transformation,” it essentially refers to first, the upgrading of cities where laborintensive industries are located, and second, the industrial transition of foreigninvested labor-intensive enterprises.

Taking Foxconn as an example, its holding company Hon Hai Precision

Industry Company Ltd. was originally a second-or even third-tier electronic enterprise that specialized in the production of smaller components such as

computer adapters. In the late-1980s, Taiwan underwent a third economic

transition and industrial upgrading was the top priority, as the cost of labor went

on rising while the average income growth rate exceeded the economic growth rate and labor productivity. As a result, other original equipment manufacturers

(OEMs) like Foxconn — whose primary customers were famous brands —

started moving to Mainland China. For the comparatively mature industries such as garments, shoes, and toy producers, Taiwanese investors had copied their

businesses to Guangdong or other coastal regions of eastern China. Ultimately, this

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industrial relocation gave China the tag of being a “world factory.” In 1988, the

Hon Hai Group, after settling in Mainland China, built up its commercial kingdom

(Foxconn) in the PRD region, where Shenzhen was the center. At that time, Terry

Guo Tai-Ming, the founder of the kingdom, went onto a hilltop in Wuwu Village in

Longhua Town, Shenzhen, circling the land with his finger, and said, “I would get the land in my sight.” Thereafter, the destiny of this remote and backward village

underwent a metamorphosis. At one point, there were as many as nearly 400,000 employees working for Foxconn in Shenzhen, among which more than half were

stationed at Longhua Town. Given such an amount of people, the consumption in Longhua Town and the surrounding areas was stimulated. By 1992, Foxconn established its eastern China base which was centered at Kunshan. Near the end of

the 1990s, the third Foxconn base was constructed in cities around Bohai Sea with

Yantai as the center. Over the past decade, the fourth Foxconn area began to take

shape as the company gradually moved its focus to Taiyuan and Wuhan, spreading across inland cities such as Jincheng, Chongqing, and Chengdu. At present, 80

subsidiaries of the Hon Hai Group are scattered across the country, forming four areas which embodied Terry’s master plan of a business empire. For example, a

Foxconn subsidiary, the Foxconn International Holdings Limited (which provided contract manufacturing services to leading mobile phone brands like Nokia) had set up offices all over the world, with factories constructed in various Chinese

cities; around 50% of the group’s assets and sales revenue were contributed by

this subsidiary. Over the past two decades, Foxconn successfully developed its

production chain in Shenzhen, which gave birth to a group of small-and mediumsized enterprises that supported the chain. Additionally, the employment was

noticeably boosted and economic aggregates plus the total volume of trade were stimulated as well, which served as an indispensable driver behind the progress

of industrialization and urbanization of Shenzhen. In recent years, there were changes in the industrial structure of Shenzhen. The city, as an immediate venue

for capital from Hong Kong and Taiwan, encountered difficulties in sustaining the supply of land, energy, environment, and labor force. Now that a new round of

industrial upgrading was already in progress, the authorities would have to take

care of the quickest and the most massive urban transformation under immense pressure. In the meantime, Foxconn, a leading OEM, occupied a huge quantity of land in Shenzhen and attracted an enormous external population, intensifying

the pressure on urban management as well as urban development. Moreover,

regarding the development of enterprises, a lot of resources had been input but in

return, effective outputs such as tax revenue and breakthroughs in research and

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innovation were very limited, hence the Shenzhen government gradually paid less and less attention to Foxconn. At present, the government did not need to extend the discounts offered to Foxconn which were coming to an end and there were

even suspensions of the supply of electricity in factories on Saturdays from time

to time. Representatives of Foxconn had met with leaders of the provincial and municipal governments to exchange ideas, and two conclusions were drawn. First,

Foxconn would have to engage in research and innovation to stay in Shenzhen, and second, the expansion of industrial upgrading would have to take place in

Shenzhen. In the end, Foxconn management decided to leave only the research and development center and two high-tech business groups in Shenzhen, while the rest would be moved to the inland parts of China.

It was reported that Foxconn had planned to go from being a “manufacturing

Foxconn” to a “high-tech Foxconn” as early as 2003. The long-term purpose of the

Longhua Industrial Park was to accelerate the process of introducing R & D centers

from Taiwan, Japan, and the U.S. to Longhua so that the park could be positioned as “chiefly R & D with production of small quantity.” Also, the workforce of 100,000– 150,000 employees would be controlled. In practice, Qinhuangdao would serve as the

center for PCB businesses (mainly producing laptops, desktops, display cards, etc.),

while laser businesses would be relocated to Jincheng, and CP businesses (mainly manufacturing electronic consumer goods) in Shenzhen would all be moved to Yantai. This inland relocation plan was another large-scale transition after the last

time in 1988. As for the repeated suicides of Foxconn’s employees together with the

involuntary pay raise in the spring of 2010, they were merely the catalysts for the

relocation. Consequently, the urban transition of cities like Zhengzhou, Nanyang, Langfang, and Qinhuangdao was speeded up too. To the local governments of

these cities, the presence of entrepreneurs like Terry Guo or enterprises like Foxconn would be one of their great achievements. For the time being, Foxconn was having

exploratory talks with local governments — not concerning where cheap laborers were but looking for those who could offer the most favorable policies as well as

finding better alternatives. Surely, the inland relocation of Foxconn was but a mere

transfer of the existing industry, thus it could do nothing to its intrinsic backward growth pattern. Twenty-two years ago, Foxconn reluctantly moved from Taiwan to Shenzhen because of Taiwan’s economic transition and rising labor cost. However,

after 22 years, Foxconn, again, chose relocation rather than reformation as the solution to obstacles like economic transition and industrial upgrading of cities in the PRD region, where the “World Factories” were.

In urban development, the so-called transition and upgrading essentially

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refer to an orientation towards high value-added industries. Kaname Akamatsu,

a Japanese economist, put forward the concept of a “flying geese paradigm” as

an attempt to account for the hierarchical advancement of the Japanese economy.

Back to the primary stage of industrialization, Japan mainly exported consumer goods such as silk, cotton, and cotton cloth in return for the means of production

from industrially advanced countries in order to boost the domestic textile industry. Subsequently, imported textile machinery was massively reproduced

to foster the development of the domestic mechanical industry. Afterwards, the established mechanic industry promoted the development of industries such as

steel production and the production of electromechanical equipment. Overall, by digesting, absorbing, and popularizing the advanced technologies acquired through external trade, an independent technological base as well as a research

and development system could be developed. The entire process of different industries taking off successively was vividly termed the “flying geese paradigm.” Certainly, Kaname’s main idea was that the economic development of less

advanced countries should observe a pattern of “import–domestic production–

export” to initiate successive development of different industries. Yet, what the

paradigm exposed was that the industrial structure should move upward in a way

that low value-added industries would give way to the high value-added ones. Concurrently, however, enterprises would be pressurized by rising production

costs while low value-added industries could but shift their businesses to places where cheap labor and raw materials could be found.

After the Second World War, there were at least four global and trans-regional

large-scale industrial transitions. The first transition occurred in the 1950s,

when traditional American industries were relocated to countries like Japan and Germany. The second transition happened during the 1960s and 1980s, when

labor- and resource-intensive industries with lower added value in Japan and Germany were relocated to the Four Asian Tigers or other newly industrialized

countries and regions. The third transition began after the 1980s and lasted until the mid-1990s, when low-end industries and light manufacturing industries in

developed countries, regions, as well as the Four Asian Tigers were progressively

repositioned to China’s coastal cities or other developing countries and areas. The

fourth transition lasted for more than a decade between the mid-1990s till the new

century. Along with the end of the Cold War and the decline of the Soviet Union, the capital of developed countries was directed to the financial sector to develop

the fictitious economy, while the capital of the manufacturing industries was relinquished and redirected to newly emerging markets like China, India, Vietnam,

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etc. The targets of investment also changed from light manufacturing industry to

heavy industries. The turning points were the disintegration of the Soviet Union and the end of the Cold War.

These four economic transitions directly motivated and speeded up the

industrialization and urbanization of the transitional areas, hence boosting economic growth and consolidating comprehensive strength. A number of key cities and industrial areas were given birth to as well, and this became the momentum for the abrupt rise of developing countries and regions.

To summarize, there were two main causes behind global industrial transition,

namely decreasing costs, and market expansion. Reviewing the process, there were several features. First of all, the process generally began with labor-intensive industries, gradually towards capital-and technology-intensive industries. Next, transition was usually spread from developed to developing countries. Third, the transition often started off with PAFB before moving to the production of

semi-finished products and ultimately to finished goods. Last but not least, welldeveloped and standardized technologies were ordinarily the targets of transition.

Under the efforts of the Guangdong provincial government to replace old

industries and the inland relocation of Foxconn’s enterprises, there was the setting

up of Foxconn’s new industrial park in Zhengzhou, the closing of Intel’s factory in Shanghai and the construction of a production base in Chengdu, the establishment

of Hewlett Packard (HP)’s laptop manufacturing and export base in Chongqing,

as well as new construction plans of home appliances companies (e.g. Haier, Gree,

and TCL). From this, we can foresee the commencement of urban upgrading of different regions as well as industrial transition, which would spark off a new tide of economic transformation that would sweep over China. In some newspapers,

Foxconn’s relocation was portrayed as “a painful turn of the world’s factory.” However, Foxconn’s transformation not only represented a metamorphosis but also the “dual transition” — urban upgrading as well as the industrial transition

of labor-intensive foreign enterprises. Nonetheless, dual transition also provided a

glimpse for us to see the problems in the upgrading of the coastal industrial cities as well as in the inland relocation of foreign labor-intensive industries.

From the perspective of urban development, industrial transition took place in

two geographical directions: one from coastal industrial cities to the southeastern

parts of the country like Henan and Chongqing; and the other within provinces. For example, enterprises in northern Guangdong were spread towards the eastern and western parts of the PRD region; those in southern Sujiang were moved

northward; and some in Fujian and Zhejiang were shifted to neighboring areas.

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To entrepreneurs along the eastern shore, internal transfer in the province was the most preferable for it was a reliable and practical option. The primary cause behind

this internal relocation was provincial economic imbalance, and the “landlocked” areas would serve as immediate and essential choices for industrial transition.

Wang Yang, the Secretary of the Guangdong Provincial Party Committee,

metaphorically depicted the government’s strategy in industrial transition as

“vacating the cage to replace birds.” This policy of dual transition was chosen

to be one of the strategic options of the Guangdong government. The notion of “dual” refers to industrial relocation and transfer of labor. Specifically, laborintensive industries in the PRD region would be moved eastward and westward,

as well as to the mountainous areas in northern Guangdong. As for the labor force of these target areas, it would be diverted to the domestic secondary and tertiary

industries, while the more capable workers would be transferred to the prosperous

PRD region to support the sustainable development of Guangdong. Adhering to this principle, 33 provincial industrial transfer parks were set up in western and northern Guangdong to serve as connection points with cities in the PRD region.

At present, the policy of “dual transition” had gained initial success. According to statistics released by the Guangdong government, a gross industrial output

of RMB90.7 billion was yielded by the 33 provincial industrial transfer parks in 2009, which saw a growth of 17.08%. In terms of industrial increased value, it was increased by 21.2%, reaching RMB23.2 billion. This growth also brought about tax revenue of RMB5.3 billion, a growth of 33.99%. A total of 392,000 people in the labor force were absorbed, which made up 68% of the domestic labor force.

One of these cities was Dongguan, the beneficiary of the economic transition

of East Asian industries in the 1990s. Having come across crunches such as

industrial upgrading, innovation in development pattern, social transformation, and institutional changes, the city now had to experience “throes” as the city

would be, literally, hollowed out because of industrial transition. Shaoguan, a

prefecture-level city abutting Dongguan, welcomed the change and was willing to supply land and build industrial transfer parks, promising that the tax revenue

from Dongguan enterprises could be equally shared by the two local governments.

Being passive in the first place, the Dongguan government was reluctant to cast

out local enterprises, for they not only generated tax revenue but also revitalized the employment market as well as stimulated consumption. Furthermore, rural

villages on the periphery of Dongguan were no longer employed in agriculture and instead constructed plentiful factories for leasing. For non-local processing

trade enterprises that rented these factories, they submitted a portion of their

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revenue to village collective economic organizations when reaching certain output

levels. Nonetheless, this brought a realistic obstacle to industrial transition — villagers would have to bear great losses if these enterprises moved out at once.

Subsequently, under the urging of the provincial government, the position of Dongguan changed from passive to active. For instance, 180 enterprises (which

specialized in electroplating, bleaching and dyeing, decal, garment wet processing,

small scale paper production, and small scale production of leather) were shut down to accelerate their upward transition. In the meantime, efforts were made

to raise the statuses of potential industries including electronic information, garment production, wool spinning, furniture manufacturing, and metal mold

manufacturing. Moreover, the integrity and competitiveness of the whole

production chain was sustained through balancing the strengths of different industries, regardless of their scales. In June 2010, the third group of Dongguan enterprises was transferred to the Shaoguan Industrial Park.

To western cities, the coming of enterprises from coastal areas was a golden

opportunity. In the southwest, the vast economic hinterland with Chongqing as

the heart slowly became a major target of transition in the eyes of enterprises from

Dongguang and Zhongshan. As a result, the Chongqing government identified six key industries in which equipment manufacturing industry, material industry,

information technology industry, and the labor-intensive light textile industry were to integrate with the processing trade industry. Therefore, when soliciting businesses, the Chongqing government targeted the traditional manufacturing enterprises in Guangdong and Zhejiang.

From a corporate perspective, such industrial transition was conducted in two

forms. One was linear transition towards established regions. In 2010, there was

the sudden appearance of 2 out of the 100 national best industrial clusters in Hebei Provine, which were the phosphorus chemical industrial cluster in Yichang and

the nonwoven fabric industrial cluster in Xiantao. This success was indispensable to the coming of external enterprises. Take Yichang, a prefecture-level city as an example, there was the country’s largest phosphate refining manufacturing

enterprise and the world’s biggest manufacturer of sodium hexametaphosphate

— Hubei Xingfa Chemicals Group Co., Ltd — and related industries were drawn together. Another example was the global motorcycle industry, which included the relatively flourishing motorcycle industry in Chongqing, where the production

line was basically ready for use. Still, such a form of industrial transition did not guarantee low costs, as there could be inadequate supply of support facilities

which could result in increases in operation costs. For example, Wuhan was

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one of the largest textile markets which comprised more than 2,000 textile and

garment enterprises. As of 2009, the textile and garment industry stood out of other industrial clusters with a gross industrial output of RMB8.9 billion. Even so,

garment enterprises in Wuhan still had to purchase RMB2 billion-worth of fabrics

and accessories from Zhejiang. An enterprise from Guangdong to Hubei reflected 80-some questions to the local government, of which three-fourths were related

to industrial support — some were even as trivial as the absence of screws, and the solution was to get them from other places. Gradually, it was found that, in addition to the connection between local governments and transiting enterprises,

financial assistance was also determinative in industrial transfer. To small enterprises, if relevant financial support was absent, the operation costs would

be unbearable. This also justified why the “screws” did not come along with the enterprises.

Another form of industrial transition was an “airborne” pattern of linear

transition, which Huang Qifan, the Mayor of Chongqing described as “an all-in-

one processing trade pattern.” In Chongqing, there was the well-known story of HP. Supposedly, the name of Chongqing was missing on the global technological map. However, Chongqing got famous after Huang Qifan affirmed a 40 million-

laptop project with HP in 2008. An agreement was reached between HP and the

Chongqing government, which stipulated that the former would serve as the head responsible for the design and sales of products while the production would be

outsourced to Taiwanese enterprises including Foxconn, Quanta, and Inventec. It

was said that during the negotiation, Huang Qifan promised representatives of

HP that if local suppliers failed to contribute 70% to 80% of components in three years’ time, they could claim the transportation costs of additional components. Afterwards, Huang explained, “If we were to produce just four million laptops, which component supplier would come? I could literally jump off the Yangtze

River. However, with an aim to produce 40 million laptops, we could still earn

profits even if we just focused on the production of the screws for the devices. I am sure that everybody will come as soon as I cry for action.” Amazingly, Huang’s words came true: the three largest Taiwanese processing manufacturers — Foxconn, Quanta, and Inventec — did come to Chongqing because of HP’s order,

and the coming of leading processing manufactures, correspondingly, brought

along hundreds of electronic component manufacturers. Because of HP’s notebook computers production chain, the State Council approved the setting up of the two first bonded areas in inland cities which were even larger than those in coastal cities. On January 26, 2010, the second manufacturing base of HP commenced

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production in Chongqing. Later, the corporate even relocated its settlement

center (which annually processed USD100 million) to Chongqing. By February 26, 2010, Inventec, the biggest computer manufacturer in the world opened its

second production base in Chongqing, which attracted 70-some computer core

suppliers. Thanks to these suppliers, Acer also signed an agreement with the Chongqing government in December 2010, making a venture of USD150 million and establishing a production chain capable of outputting 400 million notebook

computers. Similarly, Acer brought in three giant processing manufacturers

and more than 100 components producers. The second operation head office of Acer was founded there as well, while the offices for settlement, research,

and development were moved to China. Given the success of HP and Acer, the Chongqing government also won the support of ministries and commissions in building the Chongqing New Europe International Railway.

Hence, the snowball kept on rolling. In May 2011, Mu Huaping, the Head

of the Chongqing Economic and Information Commission announced, “We

manufactured 200 million devices: 100 million notebook computers, 20 million

desktop computers, 30 to 40 million monitors, 30 million digital cameras and printers, plus another 10 million network switches, routers, and servers.”

Apparently, Chongqing had become an enormous manufacturing base for 20 million electronic devices. It was estimated that the global capacity of notebook computers would reach 30 million, and Chongqing would be the largest production

base in Asia that would supply one-third of the laptops in the world. Admittedly, it was miraculous that 3 or 4 of the world’s most famous brands, 5 or 6 of the largest

processing manufacturers, and 400 to 500 component suppliers all met in one

province. Within two years, the IT industry in Chongqing had given birth to the all-in-one processing trade mode, making the best use of its economies of scale.

Utilization of Foreign Capital and Economic Security Ever since 1978, the debate over the use of foreign capital has been ongoing, and the latest argument was on industrial and economic security.

Concerning the issue, an impressive notion was put forward by James Petras,

who published an article “Past, Present and Future of China: From Semi-Colony to World Power?” in the Journal of Contemporary Asia. He said:

Big foreign investors established manufacturing beachheads, and enclaves in key sectors, such as transport and other growth sectors...The

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MNCs have launched a multi-pronged economic offensive to: 1) capture control of the banking and financial system, 2) dominate the high and

middle sectors of the domestic consumer goods market, 3) penetrate

into the telecommunications sector, and 4) gain shares in the cultural, entertainment, publicity and commercial markets.4

Additionally, James doubted that, among strategic sectors (such as finance,

manufacturing, and export), whether the economies owned and manipulated by the Chinese authorities would grow faster than MNCs of imperialist states

and international investment institutes. Besides, according to James, “another questionable presumption was the notion that foreign investment and MNCs

are being subordinated or harnessed by the Chinese state to serve Chinese

strategic goals just as the U.S. used British investment in the railroads to expand US capitalism.” He also believed “the notion of ‘harnessing’ foreign investors

to serve China’s development strategy was losing relevance as MNCs captured the commanding heights of several sectors or at least led management in key

enterprises.”5 Regarding foreign investment, James wrote that “the lucrative

growth sectors could be passed on to foreign capital, while the Chinese treasury funded the high cost, long-term, large-scale, low-return infrastructure.”6 With

reference to his essay, “China’s productive grid was extremely limited to its port

regions, with links to mining enclaves in the interior.” As coastal areas were nearly occupied by foreign enterprises, “the most dynamic enterprises were not

Chinese.”7 James even asserted that “in analytical terms what was termed Chinese

growth was rather zones of expansion within which foreign-owned enclaves

operated.” Therefore, “China’s bid to become a ‘world power’ would be subverted. Instead China would become a gigantic proxy for imperial powers, who would increasingly compete for dominance, using different sectors of the political elite,

military, students and so on.”8 In the end, James described the policy of reform and

opening-up as “reinforcing the capitalist remnants embedded in the regime,”9 and

predicted that a political crisis was likely to occur. Apparently, James’s stance did

not differ much from that of the “leftists” who criticized the opening-up of China, yet it was worthwhile for us to take notice of the questions presented by this wellintended foreigner.

Another weighted argument was on the practical use of foreign capital.

During the several years around the 10th Five-Year Plan, foreign enterprises enjoyed a nearly absolutely dominant position in industries such as mobile

phones, computers, servers, and networking hardware, over which they had

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technological advantage. In fields of chemical industry, light manufacturing, and medicine, one-third of the market shares went to foreign enterprises too. At the

same time, mergers and acquisitions by foreign investors became more active. Before 2004, investment through mergers and acquisition accounted for only 5% of foreign direct investment, but the percentage, just in a year, surged to 20% by

2005. In 2007, 1,759 items in relation to mergers and the restructuring of listed companies were announced, which saw a 50%-growth compared with 2006. The

amount of capital involved was RMB450 billion, nearly double the previous year. The largest acquisition involved RMB398 billion. Extra attention should also be

paid to some multinational corporations and foreign equity investment funds for they had acquired key enterprises in certain industries. In the same period,

foreign sole proprietorships made up 67% of newly founded foreign enterprises.

However, on the other hand, Chinese enterprises, due to the discrimination from developed countries, failed to purchase foreign enterprises. To some people, the

overwhelming tendency of multinational corporations in China was threatening

to the national economic security, and so they believed that “the security of the majority of industries in China was in a critical condition.” Yet, the reality was that

some domestic enterprises, having a lack of vitality, were worried about lagging behind and having a hard time in market competitions. Instead, they made use of

industrial and economic security as an excuse to stop their fellow companies from

being merged. These viewpoints, certainly, exposed worries over the threats of foreign capital on domestic industries but also, to a certain extent, represented the rise of trade protectionism.

Under economic globalization, it is impossible to evade the issue of economic

security of developing countries. Of course, it is acceptable to draw attention to economic security in the discussion on foreign investment, but the key should

be on how we should counter the problem. In an article “Basis Points of Security of Industries” published in Beijing Daily in late-2007, Cheng Siwei wrote, “Given

the continual progress of economic globalization, no country could possibly

possess the power of grasping and developing every industry. Just as in the case

that the instability of several industries would unlikely affect the security of the entire industry, the security of the national economy would, similarly, remain

unaffected by the insecurity of several industries. The temporal insecurity of individual industries was not permanent.” To support his argument, Cheng

listed plentiful statistics, “According to a survey conducted by the State-Owned

Assets Supervision and Administration Commission (SASAC) on the nature of the top 6 enterprises of 95 major industries of the national economy, state-owned

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enterprises shared 67.4% (or 64 industries), privately-owned ones occupied 25.3% (or 24 industries), and foreign-invested ones made up 7.3% (or 7 industries).

With reference to the report released by the Ministry of Commerce on 22 key and competitive industries, 77% (or 17 industries) were domestic capital-dominated,

while 23% (or 5 industries) were foreign capital-dominated. The Bureau of Statistics also conducted research on the wholesale, retail, accommodation, and catering industries that were above the designated sizes, in which the share of foreign

capital to paid-in capital was 9.92%, 12.35%, 40.15%, and 23.05%, respectively, and which never went beyond 50%. Among cases of mergers and acquisitions, Chinese-funded parties served as the major shareholders in about half of them.”

He concluded, “From this, the notion that ‘the majority of the industries were in a critical condition’ was unfounded and exaggerated.”

In July 2011, Prof. Ge Shunqi from the Research Center on Multinational

Corporations of Nankai University published an article “How Threatening Could

a Foreign Capital Economy Be” in China Economic Times. In the article, Prof. Ge pointed out, “In a new historical era, the manifestations of the threats of foreign

capital would impossibly be extreme outcomes such as the manipulation of the

economic backbone, breakdown of the national economic system, distortion of

the national economic order, or interference in major economic decisions. At the most, multinational corporations would, owing to excessive pursuits of economic benefits, overlook their social responsibilities in China, upset the economic interest

of the domestic country, and fail to realize a win-win scenario...Harm of such kind could also be revealed by domestic dependence on multinational corporations as a result of lavish industrial control; the participation or manipulation in

strategic and sensitive industries; obstruction in absorbing advanced technologies

as a result of technological barriers, dominance, and blockades set by foreign corporations; the adoption of inappropriate behaviors in market competition or the

pursuits of market monopoly and channel control, or the exercise of commercial bribery or rent-seeking; as well as the emergence of discriminatory behaviors such as lowering the standards in social responsibility, use of technology, and

technological research and development to the degree below other countries.”

Given these grounds together with reference to statistics of 2007 (in which no

apparent changes were observed over the past two years), researchers analyzed the proportion of foreign enterprises above the designated size to Chinese industrial

enterprises in a total of 523 industry segments which covered the mining and manufacturing industries as well as the production and supply of electricity, gas, and water. They also evaluated the overall control of foreign enterprises on China’s

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economy. It was found that “there were 97 industry segments (or 18.5%) where foreign enterprises had no control on the economy (control force below 10%), 172 industry segments (or 32.9%) where foreign enterprises possessed certain

control on the economy (control force between 10%-30%), 149 industry segments (or 28.5%) where foreign enterprises had considerable control over the economy

(control force between 30%-50%), 77 industry segments (or 14.7%) where foreign enterprises had notable control on the economy (control force between 50%70%), and 28 industry segments (or 5.4%) where foreign enterprises had a tight

control on the economy (control force over 70%).” The conclusion which Prof. Ge

drew was that “the analysis indicated that multinational corporations had limited control over the industries of the country, and only a small number of sectors were absolutely controlled by foreign capital. On the whole, the market structure was

not of a monopolistic nature despite the foreign control on certain industries, as several hundred foreign enterprises coexisted in each industry segment. Moreover,

the industry segments controlled by multinational corporations were outside of the country’s strategic and sensitive industries. Therefore, we were of the view that although the scale of using foreign capital was relatively large in China and

multinational corporations wielded a lot of influence on domestic industries, the

overall impact was still within the acceptable range. To sum up, the notions that foreign enterprises exercised a lavish control over domestic industries and that the national economy was no longer secure were unjustified.”

As seen from these two essays and the statistics quoted, we could say that

the utilization of foreign capital in China, in a general sense, did not threaten

the security of the economy. Thus, we ought not to say that foreign capital had threatened national economic security merely because some enterprises

encountered difficulties in competition with foreign enterprises, and we should

remain vigilant about people who intended to retain their own interest in the name of protecting national interest.

Summarizing different opinions, the following will look into the perceptions

over the issue of economic security.

First, only an open country could bring about a secure economy. On the

surface, if a developing country does not adopt an open door policy, its economy

will look safe and seem to be economically secure. Yet, the true and greatest insecurity lies in the backwardness and poverty brought by a closed economy. One of the examples was the crumbling economy during the 10-year disastrous

Cultural Revolution, which proved the fact that an unopened country would yield the largest instability. A key indicator for the degree of economic security is

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the economic competitiveness of a country and the competitiveness of enterprise. According to the list of the world’s 500 largest companies released by Fortune, only

3 Mainland enterprises were on the list in 1996, but the number grew to 19 in 2005, and China ranked sixth in the number of enterprises listed. Over the past two

years, the number of Chinese enterprises on the list increased — from 54 in 2010 to

61 in 2011 — and China’s world ranking jumped to third place. On the other hand,

the number of American corporations on the list dropped from 139 in 2010 to 133, and that of Japan contracted from 71 to 68. Amongst the top 10 enterprises, the

Sinopec Shanghai Petrochemical Company, the State Grid Corporation of China, and the China National Petroleum Corporation ranked fifth, sixth, and seventh,

respectively. Even if excluding the pressure from rivalries, it was still difficult to boost the competitiveness of Chinese enterprises in just several years’ time. Indeed,

a great number of Chinese enterprises were developed through cooperation with multinational corporations. Briefly, the earlier an industry is opened and the more it is opened up, the stronger the industry will be.

Second, to keep strengthening the anti-risk capability, enterprises should

confront economic risks and make the best use of the circumstances. Irrefutably,

opening up the economy is full of risks. The purposes behind the prompt action

taken by developed countries to popularize economic globalization were to spread their capital in the world as well as to maintain and bolster their superior

positions in competition. Through economic globalization, developed countries could, on one hand, accelerate their economic penetration by forcing developing countries to open up, and so they could scramble resources and markets there. On the other hand, developed countries ached for reinforcing their supremacy in

the fields of culture, politics, military, and economy through globalization. To put

such a strategy into practice, developed countries adopted three approaches: first, in a system of international division of labor (where the center was upheld and

the periphery was consolidated), developed countries would put themselves in the higher positions while pushing down developing countries to the middle-and lower levels with their economic and technological advantages, paramount place

in innovation, and dominance of international rules. Consequently, a pattern of

international division of labor that poured interest to developed countries would

be formed, and developing countries would, economically, highly depend on

developed countries. Second, developed countries would exercise technological

seclusion so that advanced technologies could be kept private and would not go

into the hands of developing countries. It was reported that only 10.6% of the world’s 569 largest enterprises (mostly owned by developed states) were willing

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to deploy new technologies overseas. Third, throughout the course of economic

globalization, developed countries would take hold of the power of formulating

the “game rules,” which would hence favor the interest of developed countries while neglecting or even harming the interest of developing countries.

Nonetheless, in the era of economic globalization, there is no such thing as

absolute economic security, even in developed countries. Still, countries at the

middle and lower levels within the international system of the division of labor are the most vulnerable. In short, concerning economic security, developing countries should face the potential risks in their economies while striving to get rid of hidden threats and step up their anti-risk capability.

Third, the key of whether developing countries could maintain economic

security under economic globalization lies in their control over the global flow of

their factors of production. Primarily, such control was embodied by the ability to absorb and guide the use of scarce factors of production (long term capital, technology, and human resources), the ability to manipulate or minimize the

outflow of such factors, as well as the ability to control hot money. The way

out to magnify these abilities rests with neither the superior natural conditions nor any preferential policies but the efficiency of the market and the standard of public environment. Accordingly, the essence in safeguarding the economic security of developing countries should constitute the maintenance of a stable social environment, the creation of an efficient market mechanism, as well as the upholding of quality public environment.

Fourth, from a global perspective, 60% of the international trade in goods was

undertaken by existing multinational corporations, which concurrently made up

70% of international trade in services, and 80% of international trade in technology. If an enterprise has to open up to the world, it must undergo the stage of foreign merger. For one thing, there was limited room for the real economy to grow in the global economy, and financial capital, owing to the thriving capital market

and fictitious economy, had taken on a leading role, which rendered mergers and

acquisitions the mainstream form of foreign investment. As of 1990, mergers and

acquisitions of global corporates valued just USD400 billion, rising to USD3.3 trillion in 2002 to reach a record high of USD4.3 trillion in 2007. As the global

financial crisis worsened in 2008, the volume of mergers and acquisitions slumped to USD2.8 trillion, slumping to USD1.9 trillion in 2009. As the economy recovered

in 2010, mergers and acquisitions became active again, and the transaction climbed to USD2.4 trillion. Still, it was below the pre-financial crisis level. Still, some Chinese enterprises were amongst the corporates which performed multinational

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mergers and acquisitions. With reference to a survey done by JPMorgan Chase,

China ranked second in the volume of mergers and acquisitions as the acquirer in

the first half of 2010, right after the U.S. At present, the volume of China’s external direct investment had exceeded USD40 billion, as opposed to USD2.8 billion in

2003, which indicated that the average growth rate of external direct investment

in China was more than 70%. Moreover, the position of Chinese enterprises in the global market was slowly transformed from the acquired to the acquirers; mergers

and acquisitions had become an essential means of multinational development. Nonetheless, opening up is reciprocal — now that Chinese enterprises started

purchasing overseas companies, the domestic market should, correspondingly, be opened too.

Another thing is that foreign acquirers were mostly private enterprises,

whose main purpose was to capture more profits in China and so they did not

always have the interest of their homelands. Additionally, foreign investors, being

competitive with each other, did not stay as a “monolithic block.” To the majority

of foreign investors, the fundamental concern was not economic interest but

rather political ends, thus their commercial activities should not be politicized or magnified as threats to the domestic economy. We need to be objective. We could not lose our vigilance, nor should we consider foreign investments monstrous.

Fifth, large market shares are different from monopolies. In certain industries,

foreign enterprises did enjoy large market shares for the time being, but the

extent did not constitute monopoly, and it was unlikely that a particular industry

would be monopolized by one or two foreign enterprises within a short period of time. Contrarily, theorists believed that the real monopoly was created by state-

owned enterprises. Therefore, we could not arbitrarily conclude that the obstacles encountered by some enterprises or industries in market competitions are an issue of economic security, as this touched upon the competitions amongst enterprises

of different ownerships as well as the efficiency and healthiness of the economy and operation mechanism. In brief, we should not nominally protect the country’s economic security but exercise corporate protectionism in reality. Furthermore,

protection does not guarantee the enhancement of enterprises’ international

strength. Instead, a proactive attitude is necessary to open up domestic markets and lead domestic enterprises to take part in global competition.

Sixth, a superior mindset was needed over foreign mergers and acquisitions.10 Concerning trade liberalization and foreign acquisitions, if we consider ourselves in an inferior position, it would be difficult to take even a single step forward. We should have confidence in our country that the government would lead

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and regulate the role of foreign enterprises and should view China’s integration

into the global economy with a superior mindset. Essentially, a country’s

competitiveness rests with the ability to utilize international capital, technology,

and the like. In this regard, China has attained considerable progress. Besides, the motive behind the acceptance of mergers and acquisitions was the introduction

of strategic investors, which would propel Chinese enterprises to progress in the market and in technological and management terms. Through the process of

mergers and acquisitions, the stock of assets could be revitalized, competitiveness

could be enhanced, entrepreneurial management could be strengthened, business performance could be bettered, and the value of the enterprises will naturally

go up, which, ultimately, would create a win-win scenario. For example, several Chinese commercial banks successfully boosted their stock premiums by inviting

a number of strategic investors and went on to be listed in Hong Kong. As a result, foreign investors, who occupied a quarter of the shares, made a fortune, while

the remaining 75% shares were owned by Chinese investors, meaning that the premium they captured was three times that of the foreigner shareholders.

Seventh, the economic security of developing countries is in fact a long-term

and multidimensional problem. As mentioned, no country could fully grasp

the control and power to develop every industry. Therefore, it is necessary to distinguish the problem of national security aroused by enterprises. No matter

how unimportant an industry is, it still contains key enterprises which are linked to national security. Thus, when talking of national economic security, we should focus on particular enterprises instead of staying at the industry level. Usually,

these particular enterprises were small in quantity. In a word, “we should not practice protectionism or establish barriers to entry in certain industries based

on the claims that a few enterprises in an industry are threatening or worth safeguarding.”11

For sure, enterprises in the world take precautions against mergers and

acquisitions. There is room for such activities but supervision exists as well.

There is encouragement and restriction. Liberalization of investment and trade

is advocated while legal regulations are reinforced to devise a risk alert system and precautionary measures. In a mature market economy, it is not a conflict to

adopt an aggressive policy of using foreign capital while restricting the entrance

of multinational corporations and strengthening censorship on mergers and acquisitions. No countries would let transnational corporations acquire whatever they want to. For considerations such as national security, public health, and environmental protection, every country would check and monitor the admittance

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and merger of multinational corporations, particularly towards sensitive industries

including finance, energy, transportation, culture and communications, military, heavy equipment manufacturing, or over leading enterprises — where relatively

restrictive monitoring would be practiced so that malicious acquisitions could be

averted. In some industries, the injection of foreign capital was even forbidden.

In the hopes of protecting their own economies, governments all restrain foreign

mergers and acquisitions through legislation. For instance, in 1988, President Regan announced Executive Order 12661 which delegated the Committee on Foreign Investment in the United States (CFIUS) to review potentially threatening

foreign investment projects. In Europe, the Council Regulation on the Control of Concentrations between Undertakings was announced by the European Union and

effective since September 1990, which stipulated that corporations should file applications before they were merged with other corporations. In Japan, the Antimonopoly Act was enacted to overlook undertakings of enterprises.

In recent years, the Chinese authorities began to take notice of regulations

and checked over mergers and acquisitions of foreign enterprises. Accordingly,

in 2002, the SASAC was established to readjust the layout of the state-owned

economy with emphases on fostering the rebalancing of government capital as well as the restructuring of state-owned enterprises. It was also stressed that government capital should be poured into fields concerning national security

and the backbones of the economy, so that diversification in property rights of

state-owned enterprises and the vitality as well as strength of enterprises could be achieved through reformation in the shareholding system, introduction of

strategic investors, and listing. Regarding key industries including the seven

largest industries (military, electricity, oil and petrochemicals, communications, coal, civil aviation, and shipping), the grip should remain as firm as possible. As

for fundamental and backbone industries (including equipment manufacturing,

vehicle production, construction, steel production, non-ferrous metal production, chemical industry, prospection design, and technology), the control should remain

relatively strong. By August 2006, the Ministry of Commerce, the SASAC, the State

Administration of Tax, the State Administration for Industry and Commerce, the China Securities Regulatory Commission, and the State Administration of Foreign Exchange jointly issued the Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors, which stated:

If foreign investors merge a domestic enterprise and obtain the actual control over the enterprise, and if such merger involves any critical

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industry, affects or may affect the security of the national economy, or

causes transference of actual control over the domestic enterprise who possesses a renowned trademark or China’s time-honored brand, the

parties to the merger shall apply to the Ministry of Commerce. Where the

parties thereto fail to make an application and the merger materially affects or may materially affect the security of the national economy, the Ministry of Commerce may, together with other relevant authorities, request the

parties to stop the transaction, assign relevant equity or assets, or take any

other effective actions, to eliminate the effects of the merger on the security of the national economy.12

Endorsed by the Standing Committee of the National People’s Congress in

August 2007, the Anti-Monopoly Law was effective from September 1, 2008. It stated

that:

With respect to the industries which are under the control of the State-

owned economic sector and have a bearing on the lifeline of the national economy or national security and the industries which exercise monopoly over the production and sale of certain commodities according to law,

the State shall protect the lawful business operations of undertakings in these industries, and shall, in accordance with law, supervise and regulate

their business operations and the prices of the commodities and services provided by them, in order to protect the consumers’ interests and facilitate technological advance.13

From now on, more laws would be enacted and perfected to ensure that

foreign investment activities could be conducted in accordance with law.

Additionally, mergers and acquisitions that are beneficial to our economy should be promoted but industrial and economic security should also be protected.

During the 17th National Congress in 2007, Hu Jintao (serving as General

Secretary of the CPC from 2002 to 2012) pointed out, “[the policy of] Reform and Opening Up represented a great new revolution that was carried on by the people

under the Party’s leadership in a new era...We will make innovations in the way of using foreign capital, improve the structure of the utilization of foreign capital, and let foreign capital play a positive role in facilitating independent innovation,

industrial upgrading, and balanced development amongst different fields.” In a visit to the National University of Singapore in July the same year, Wen Jiabao (as

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the sixth Premier of the State Council of the PRC) delivered a speech, expressing that “Reform and Opening Up was the fundamental policy of our country rather than a temporary expedient...only by being open and broad-minded could a country become wealthy and strong.” More than 30 years have elapsed since the introduction of Reform and Opening Up, and our country has become the second largest country in absorbing foreign capital. Even so, our economy remains secure. So, we should bolster our confidence; only if the policy of Reform and Opening Up proceeds could the economic and industrial security of the nation be secured.

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10

Chapter

Knowledge Economy and Human Capital from the Perspective of Venture Capital

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: The Injection of Venture Capital into Apple and the Founding of Microsoft by Bill Gates This chapter will discuss venture investment in high-tech startups and the

functions of human capital and knowledge economy, especially technologies,

management, and other forms of intellectual capital. Let us begin with the stories of Steve Jobs and Bill Gates.

In the fall of 1976, Steve Paul Jobs, then 21 years old, and Stephen Gary

Wozniak, 26, together invented the new-generation personal computer — Apple I. The highly-praised computers, however, did not bring much business to the two

young men. Only one computer retail store saw the potential of their product and

risked ordering 50 sets. The two men sold everything they had but only raised

USD1,300 as seed capital. They had to lobby electronic components suppliers for sales on credit, owing to capital shortage. This was the hardest times the

two young men had ever experienced. They even thought of transferring their invention patent to large companies, including the HP Company where Wozniak

was employed, but no one was interested. After all that, Jobs started Apple Computer in his parents’ garage.

The problem was where the start-up money came from? Bushnell, who was

the former boss of Steve Jobs, recommended Jobs to a risk investor, Don Valentine. After investigation, Valentine did not invest in the company. Valentine put Jobs in touch with Markkula, the former marketing manager at Intel. Retired at 38,

Markkula was already a millionaire. He was interested in buying into Apple, and

he spent two weeks with the two young men to work out a business plan for the company. The millionaire invested USD91,000 in Apple, collected USD600,000 in

venture capital from the risk investors he knew, and even accumulated a line of credit of USD250,000 from Bank of America. Markkula became Chairman of the company, Michael Scott, who was Director of Manufacturing at Semi-Conductor Inc., became President of Apple, and Jobs and Wozniak were the Vice Chairman and Vice President, respectively.

In 1977, the company succeeded in developing Apple II. The new computer

only weighed 12 pounds and had a RAM of 4 kilobytes. It looked like a typewriter

and users could use their televisions as monitors. Distinct from earlier “personal” computers which were cumbersome, Apple II was compact, lightweight, easy to

operate, and suitable for home use. The impressive launch of Apple II helped the company cultivate an output value of more than USD1 million in that year.

On December 12, 1980, Apple Computer went public. Within less than one hour,

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Knowledge Economy and Human Capital from the Perspective of Venture Capital

4.6 million shares of the company were sold out and the stock closed at the price of USD29 per share the first day of trading. This listing created four billionaires and

more than 40 millionaires. Arthur Roch, who invested in the company at the early

stage with venture capital of USD57,600, earned a market value of USD14 million through public offering, an increase of 243 times. Jobs appeared on the cover of Time

magazine for the first time. The Wall Street Journal printed a full-page advertisement which said “Apple is the 21st century bike.” After listing, Apple became the fastestgrowing computer company in the United States.

Five years later, Apple was a Fortune 500 company. At the beginning of 1983,

Jobs declared that the Apple company had created 300 millionaires and his own

equity value was USD284 million. In 1984, Apple grew into a large company

with 4,000 employees and an asset of over USD2 billion. At the same year, the

company launched Macintosh products, which eventually led to the famous Apple MacBook. In 1985, Steve Jobs was awarded the National Medal of Technology by President Reagan. This was, however, just the beginning of the company, and in the following years, it experienced many difficulties and frustrations.

From this story, we can see the hardships in starting a new technology

enterprise. The biggest challenge is how to raise capital. Large companies might not purchase your patents and venture capitalists might not necessarily make an

investment in your company. Valentine, who was the first risk investor to get in touch with Apple, was afraid to be the first mover, and thus missed his window

of opportunity. Fortunately, he introduced the venture capitalist, Markkula, to the two young men. Markkula invested in not only venture capital but also management. Here, the true function of venture investment is to help the inventors establish a company and fortune.

Uncertainties are ubiquitous in the age of dramatic growth of high and new

technologies. Only the first mover has the chance to make history. Someone therefore makes a judgment: It is the hero who creates the history of wealth. The

largest challenge is risk. People often say that among 1,000 companies which are seeking venture capital, maybe only one can receive angel capital; and among 10,000 venture capital projects, perhaps only a few could successfully seize the market. Accordingly, the real risk lies in: Do you have the confidence to be one of the few real winners?

On October 5, 2011, Steve Paul Jobs lost his battle with cancer and died at the

age of 56.

The second story is about Microsoft creator Bill Gates and it illustrates well

how human capital creates the world’s richest person.

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In January 1975 two Haward students, Bill Gates and Paul Allen, read an

article about the Altair 8800 microcomputer in Popular Electronics under the title

of “World’s First Minicomputer Kit to Rival Commercial Models.” From this cover story, the two young men saw the opportunities of their future career

and life. The two ambitious men contacted Ed Roberts, Chairman of MITS (the

makers of Altair), and offered their services to write a version of the new BASIC

programming language for the Altair. One month later, the two men completed the development of BASIC and sold it to MITS at the price of USD3,000, together with royalties as high as USD180,000. Gates earned his first pot of gold from compiling

a version of BASIC. In 1976, Gates and Allen registered the trademark of Microsoft. In January 1977, after dropping out of Harvard, Bill Gates founded Microsoft and

moved to Microsoft’s headquarters in Albuquerque, New Mexico, near the Altair manufacturing plant. He got programming work from Ed Roberts who paid Gates USD10 per hour. In December 1978, the annual sales of Microsoft exceeded USD1

million. In 1980, the fledgling company signed a contract with IBM and agreed to provide an operating system, DOS, for a new personal computer, or PC, being

developed by IBM. Since August 1981, IBM started to sell the PC equipped with MS-DOS 1.0, and constantly launched new versions of the system afterwards. Then, Gates turned his focus to application systems. Microsoft unveiled its version of a graphical user interface (GUI) with the first release of the Windows

application system (the successor to DOS) in November 1983. Ever since then, Microsoft became the leading manufacturer and standard setter in the field of

application software. In August 1989, Microsoft released Office business software and in August 1995, the company introduced its Internet browser, called Internet

Explorer. By 1985, the sales volume of Microsoft had reached USD162 million after a decade’s efforts.

On March 13, 1986, Microsoft was publicly traded on NASDAQ at the

offering price of USD21 per share and it successfully collected USD61 million. The

company’s shares closed at USD28 per share at the end of the day and its founder,

Bill Gates, became a billionaire. Calculated based on the IPO price at that time, the personal worth of Gates was about USD234 million. One year later, the share price of Microsoft surged up to USD90.95, an increase of more than 400%.

By July 17, 1995, Gates was worth USD12.9 billion, and Forbes magazine had

crowned him the wealthiest person in the world. In that year, the revenue of Microsoft amounted to USD5.9 billion and the company had more than 17,801

employees. In the “Dot Com” boom, with his paper wealth as high as USD100 billion, Gates’ fortune attracted speculation from many as to his real wealth.

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On August 24, 1995, Microsoft released Windows 95. Compared with the

previous Windows 3.0, Windows 95 had built-in dial-up networking for the Internet. This meant that Microsoft had made efforts to position itself on the

“information highway.” The first-day sales of Windows 95 reached 300,000 units, and exceeded 1 million within just four days.

In the fall of 1993, Gates created the William H. Gates Foundation, with USD94

million worth of company stock. In 1999, this became the Bill & Melinda Gates Foundation. In 2003, Bill Gates announced that he was giving away 98% of his wealth during his lifetime to the charitable foundation. Mrs. Gates said: “We’ve

chosen not to pass it [fortune] on to our children; We want to give it back to society

in the way that it will have the most positive impact.”1 Gates openly declared: “I’m

not leaving the money to my kids...it wouldn’t be good for them or society.”2 He committed himself to donate the USD58 billion to charity.

The electronics market was very competitive. Gates’ decision to incorporate an

Internet browser in the 1995 version of Windows led to a lawsuit. In 2000, Federal

Judge Thomas Penfield Jackson ruled that Microsoft was a bullying monopolist and must be split in half. In 2001, The U.S. Court of Appeals for the District of

Columbia Circuit affirmed the monopolization claim, reversed other conclusions by Judge Jackson, and believed that the decision of breaking Microsoft in two

was too harsh. Eventually, Microsoft escaped from being forcibly broken into two separate companies.

In June 2007, Gates received an honorary doctorate in law from Harvard

University after dropping out of school 30 years earlier. During his university

years, he preferred playing poker and computer programming over attending classes.

From 1995 to 2007, Bill Gates headed the Forbes’ list of world’s wealthiest

people for 13 years. Until 2008, Gates ranked third in the list with total assets of USD58 billion, and Warren Buffet, the wizard of the stock market, came out on top.

In July 2007, Bill Gates stepped back from the daily management of Microsoft.

He said: “33 years ago, I came to realize the importance of software, and founded Microsoft. In the next 10 years, the value of software and its platform will be

greater than ever before.” Gates thought that with software we could complete a lot of things, and that the software revolution was still at its primary stage.

In 2008, Dan Tynan, a reporter from PC World magazine, wrote a report about

Bill Gates, and ended his article with the following words: “Remember kids, stay

in school. And if you can’t manage that, starting your own software empire and dominating the world for 30 years isn’t a bad fallback plan.”3

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The Development of High Technology Gives More Importance to Knowledge Economy and Human Capital Hi-tech development drives the entrepreneurial aspirations of scientists When we investigated the innovations in the capital formation mechanism,

venture investment displayed the most outstanding performance in supporting hitech enterprises. With its further development, knowledge economy and human

capital came into being, and technology and management were turned into production factors, participating in profit distribution the way physical capital did.

The innovations of venture investment provided not only financial tools

but also forms of capital. It, together with the growth of second board market (growth enterprise market) formed a simple financial system of hi-tech innovation

services, and thus enriched the capital culture. This, however, related to the special historical background since the 1970s.

After the 1970s, there were two changes in China’s economy: High technology

developed rapidly, and penniless entrepreneurs was desperately in need of start-

up capital; on the other hand, there was a large capital surplus in society, the development of production brought about excess capacity and oversupply of

general products under conventional technologies, and banks and other traditional financial channels in the capital market were unwilling to take the risks to make

either loans or investments. Following the new trend, a relatively simple financial system, comprised mainly of venture capital firms and growth enterprise market

(GEM), was formed to support the ventures of scientists. It innovated the capital formation mechanism and fueled the hi-tech development.

People usually call the investment in high and new technology venture capital,

but this term is not accurate. In fact, venture capital, in the strict sense, not only

relates to technological innovations, but also specially refers to the financial capital used to turn scientific and technological inventions into products and enterprises for the first time.

In the economic development of advanced countries, the technology content

was not high in the early years. At the dawn of the 20th century, the contribution

rate of science and technology only accounted for 5%. After World War II, the

rapid development of new and high technology directly pushed forward the social and economic prosperity. The developed countries have set up a series of

high-tech industries, such as microelectronics, computers, nuclear power, lasers,

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robotics, automation, optical fiber communications, aerospace, biotechnology, and new materials, on the basis of the most advanced scientific and technological achievements, and thus created a lot of new technologies, new materials, new

processes, new equipment, and new products. To date, mankind has experienced four major technological revolutions, from the invention and utilization of the

steam engine, to the discovery and application of electricity, atomic energy, and electronics, the popularity of computers and information technology (IT), and the scientific breakthrough featuring biological engineering. Statistics showed that

the scientific and technological contribution averaged out to 49% between 1950s and 1970s, and in some countries the rate was as high as 60% to 70%. After the

1980s, high and new technology developed rapidly, and the world entered into

the era of what Deng Xiaoping called “Science and technology being primary productive forces.” In the late 1980s, the average contribution rate of science and

technology reached 80%, and the age of the knowledge economy had arrived. The knowledge economy is characterized by a shorter cycle from scientific discovery

to technological inventions and applications. The so-called high technology, which integrates science and technology, emerged. It includes information science, life

sciences, new energy and renewable energy, new materials technology, space science and technology, marine science and technology, environmental science and technology, and management science, among others.

The advance of high technology significantly reduced the time required to

turn basic research results into products through technology development. New technologies constantly eliminated old ones, and thus the technology lifecycle, namely the expense from theoretical assumptions, experiments, creation, and

invention, application and promotion, to the obsolete phase, is becoming shorter

and shorter. Statistics showed that the technology lifecycle from the research and

development (R&D) phase to the decline phase was around 40 years in the early 20th century, 25 years in the 1930s, 15 years in the 1950s, less than 10 years in the 1970s, and only 3 to 5 years in the 1980s.

A shorter technology lifecycle also reduced the product lifecycle from the

product design, mass production before the introduction to the market, acceptance

in the market, to the decline and stagnation. New products will generally undergo the stages of introduction; growth; maturity; decline; and death. The increasingly frequent upgrading of products aroused modern enterprises’ awareness of product

renewal. For instance, chemical fiber replaced plant fiber; wooden doors and windows were replaced by steel doors and windows which were substituted with

plastic and aluminum ones; vacuum tubes were replaced by transistors which

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were taken over by integrated circuit chips; tapes and tape recorders replaced gramophone records and gramophones, then video tapes and video recorders

appeared, followed by floppy disks and floppy drives, and later CD, VCD, DVD,

and a full set of electronic audio and video equipment was invented. The reduced

technology lifecycle and product lifecycle caused the shrinking of the service life of products. In general, the steam engine was expected to be used for 80 years,

motors for 65 years, telephones for 50 years, vacuum tubes for 30 years, aircraft for 20 years, atomic bombs for 6 years, transistors for 3 years, and lasers for 1 year.

The speedup of technology and product cycles encouraged scientists to

turn their scientific achievements into products and businesses, and stimulated

their demands for technological innovations and business startups. Emptyhanded inventors sought all around for initial capital and tried to realize the

commercialization, enterprization, and industrialization of the high technologies within the least time. Different from mature technologies and traditional products, technological innovations, have some features and the laws of motion unfamiliar to most people, and thus require new breakthroughs in the capital formation

mechanism. As a result, venture capitalists in Western countries immediately took

this opportunity, which promoted the rapid rise of the venture capital industry and paved the way for the expansion of the high technology industry.

Technology and management becoming production factors, and the issues of knowledge economy and human capital A dramatic change in the late 20th century was the rapid development of modern high technologies, and technology and management played more and more

important roles in people’s economic lives, which made people believe that we had entered the era of a knowledge economy. This change was manifested in two aspects: First, the development of new and high technologies led to the constant elimination of old technologies by new technologies. Many new technologies,

materials, processes, equipment, and products emerged. The rise of venture investment provided the penniless inventors with opportunities to achieve the

commercialization, enterprization, and industrialization of high technologies at

the fastest speed, and therefore made up the initial forms of knowledge economy

and human capital. Second, the separation of management and ownership made operators become professional managers, and the managers for the first time realized their value as human capital, which greatly enhanced the value of management. The computer software technology, especially computers and

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information technology, created by Bill Gates, benefited all sectors of the society. It enabled remote transactions and instant settlement, facilitated the growth of marketing and management technologies, and “made what is expensive and

scarce become cheap and common, and the added value of the technological application become far larger than the value of technology creation” (Greenspan,

2000). In this way, the roles of knowledge economy and human capital became

increasingly prominent. One typical example was Bill Gates who brought benefits to the whole IT industry by inventing computer software technology and so he

was able to turn himself into the world’s richest man. Wal-Mart opened its chain stores in 15 countries around the world by taking advantage of a private satellite

network and computer information technology. It owned over 8,000 supermarkets

and employed around 2.1 million employees, and served 200 million customers per week. Relying on its innovative management concepts, Wal-Mart reshaped the

retail industry and topped the list of Fortune magazine’s “Global 500 companies”

for three consecutive years.

The knowledge economy brought about the idea of human capital.

1. Intellectual property rights or technologies are appraised as capital stock.

Western countries placed a high value on the legislation of intellectual property

rights. In newly-founded technology companies, the technological inventions

of technological experts can be appraised as capital stock. Similarly, after the Reform and Opening Up, China also allowed scientific and technical personnel to

contribute their technological inventions to companies as equity investment. At first, this policy was specified in the pilot project of joint-stock companies in 1990

that investment in the form of proprietary technology should be limited to 20% of the total registered capital, and not exceed 40% under special circumstances. Later

in the Company Law, the maximum proportion was redefined as 20%. In late 1999

when the National People’s Congress (NPC) Standing Committee modified the Company Law, it decided to extend the proportion of technology investment in high

technology companies, and the specific measures shall be prescribed by the State Council.

To permit technology investment is not only an acknowledgement of

technology as complex labor but also a recognition that the primary productive forces of science and technology, the same as material capital, could be invested.

In this way, science and technology personnel would share profits according to contribution on the basis of technology investment and become men of property.

2. Managers are allowed to enjoy property rights by virtue of their excellent

management activities. In Western countries, business managers held shares

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through leveraged buyout at first, and since then, managerial and employee

ownership as well as many other incentive mechanisms prevailed in the business community. This was a recognition that management, the same as material capital and technologies, could be invested in a company as a factor of production and

also add to the distribution of profits. In 1999, the Fourth Plenary Session of

the 15th Central Committee of the Communist Party of China (CPC) officially acknowledged the start of the pilot program of incentive compensation and managerial ownership. It was the first time that the Chinese government allowed managers to enjoy the property rights with their excellent management and equated management with material capital in the profit maximizing distribution.

What is equally important are the new mechanisms of investment and income

distribution in terms of human capital in America’s new economy. For one thing, there were technology investment and stock option plans, which encouraged

technological innovations and motivated entrepreneurship of scientists; for another, a large group of senior management in the listed companies was granted

the share options in the hopes of encouraging innovations in management.

Outstanding management was regarded as capital to share the fruits of profit maximization, and it not only stabilized the talents, but also fully motivated

excellent management personnel. In this way, preeminent technological and management innovations indeed turned knowledge into capital. This, however, depended on the profit-making capacity of knowledge. In 2000, during the

Internet bubble, people hyped “knowledge economy,” “knowledge owners,” and

“distribution according to knowledge.” In fact, knowledge cannot be converted into capital in just any case, and if knowledge fails to become capital, it is worthless. And “distribution according to knowledge” was just wishful thinking.

The role and function of human capital in the economic system The fact that technology and management can not only promote economic

growth but also participate in profit distribution compels us to focus on the value

of human capital and enhance the impact of people’s ability and quality on the economy. It also impelled us to consider the role of human capital including

technology and management, as distinct from that of physical capital, in the entire economic development.

Admittedly, when Theodore Schultz, the President of the American Economic

Association, delivered his inaugural address “Investment in Human Capital” in

1960, his speech laid a foundation for promoting the research on human capital.

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Schultz has therefore been hailed as “the father of human capital theory,” and he won the Nobel Prize in Economics in 1979.

Actually, Schultz was not the first one to raise the concept of human capital.

At the dawn of modern economic science, classical economists had affirmed the decisive position of human labor in wealth creation. For example, the famous words of W. Petty — “labor is the father and active principle of wealth, as lands

are the mother”4 — in fact confirmed the special status of human resources in

economic activities. Later, Adma Smith and David Ricardo affirmed this idea as the labor theory of value, and after that Western classical economics reached its peak.

Marx inherited and developed the labor theory of value from classical economics, and gave unprecedented significance to the role of human labor in economic

activities. Marx himself even called his economic theories an “economics of labor.”

For a long time, the field of mainstream economics did not accept human resources as a kind of capital. Despite the fact that many economists distinguished between

simple labor and complex labor, the labor force mentioned in classical economics

only refers to the natural form of labor excluding either knowledge or skills, and “just the sum of the time and amount of simple labor” (Chen Yu, 1994).

After World War II, the economy posed many new problems to us. The

growth of national income outpaced the growth of resources input (including

natural resources, material capital, and man-hours) by the country. Countries

which had incurred huge material capital losses in the war, such as Germany and Japan, quickly recovered from the economic slump; and other countries

with disadvantaged resources (such as Denmark and Switzerland) completed their economic take-off as well. Schultz believed that natural resources, physical

capital, and labor force, cannot constitute all the reasons for the increase of productivity. Apart from these known factors, there must be another important production factor that we have left out. The factor is human capital. Schultz found

that the larger the stock of human capital of a country and the higher the quality

of human resources (education level, technological and cultural knowledge, and

production capacity), the greater the output per capita and labor productivity of the country.

The contribution of Schultz lies in that he pointed out that manpower was the

decisive reason for social progress; however, manpower could not be obtained

without a price. Human capital, including the knowledge and skills of people,

are the products of investment, and not all human resources are important for production. Only when the human resources are invested through certain ways,

and equipped with knowledge and skills, will they become the most important

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production resource. So, this kind of human resources, i.e. knowledge and skills, which is a form of capital, is referred to as “human capital.” Schultz believed that the investment in human resources included the following five aspects: Health

facilities and services, on-the-job training, formally organized education, study programs for adults that are not organized by firms, and migration of individuals and families to adjust to changing job opportunities. Whereas human capital refers to physical forces, brain power, and skills that have been invested in human beings.

In other words, human capital is the acquired capabilities through investment.

Schultz calculated the contribution of education expenditure, the most important factor in human resources investment, to the economic growth of the U.S. between

1929 and 1957 through the method of rate of return, and the proportion was as

high as 33%. This data has been widely cited by scholars from all over the world to

prove the huge impact of human capital on economic development. According to a

study by Donal O’Neill, the contribution of education to GDP growth amounted to 64% in developing countries between 1967 and 1985. Schultz stressed that to relate

knowledge and capability to capital and wealth was not a denial of the primacy

of human beings, but for the purpose of creating more wealth for the people in a better way.5

Economic theories ought to stem from the place where the economy is the most

active, and this seems to be a law. Accordingly, the theory of human capital was

born in the U.S., and that was also why the center of economics moved from the U.K to the U.S. Schultz’s theory on human capital brought to him the Nobel Prize, and

Schultz, Becker, and Nielsen further expanded the human capital theories into an

independent school, so after the 1980s, multi-national companies and other large enterprises set up Human Resources Departments as substitutes for Personnel

Departments. At this time, the staff, for the first time, ceased to be “labor” and evolved into “human resources” (i.e., talents). Nonetheless, human capital theories

did not win a place in mainstream economics and economic analysis, and only became a branch of micro-economics in relation to human resources.

Although the concept of human capital was proposed, humans as factors of

production were excluded from the concept of capital. Mainstream economics

held this bias because its extreme authority endowed it with inertia. On the one

hand, mainstream economics got used to regarding humans as labor forces,

namely, innate ability and production factors unrelated to physical capital. These traditional economic methods indeed simplified the structure of economic theories and were easy for general economic analysis. On the other hand, the theories of

human capital created by Schultz stood out when the influence of technologies,

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management, and other human factors on economy were not very prominent. When it came to the 1990s, high and new technologies advanced rapidly.

Expensive and scarce resources were turned into something commonplace. Economics, boasting itself to be the most accurate social science, was elevated by

the most prestigious and respectable economic gurus to a paramount position in a scientific and systematic way, and as a result, the domain of economics became a

“sanctuary of gods,” which was controlled by authorities. Mainstream economics

was blind to many unexplainable theoretical difficulties. The economic authorities remained silent to those puzzles while they also did not allow others to join the discussions. Just as a Chinese saying goes, “thunder rises from the silent place,” and there will be a revolution in the economic field.

Venture Investment Makes the First Move to Value Human Capital Now, Let us begin with the operation of venture capital. The reason why I said

venture investment made the first move towards human capital is because the operation of venture investment attaches particular importance to human capital.

The idea is reflected in two aspects: Generous rewards will stir not only financial genius but also entrepreneurial technology experts to take risks.

Two different mindsets: Investment in technological innovations and investment in mature technologies In real economic life, venture capital in high and new technologies may find it hard to either get a bank loan, or receive support from common financing channels. That

is because people are used to the conventional economic life, and there have been two different kinds of mindsets considering technological innovation investment

and mature technology investment in terms of their markets, resources, and products. I condensed the ideas of these two modes of thinking into two formulas.

People usually adopt a conventional thinking towards mature technologies

and products, and the formula is:

Market → Resources → Products

People will first consider whether a product — for instance, a color TV — has

a market and how much the market capacity is, then find corresponding resources

within the existing market capacity before manufacturing the products to grasp the market. Because it is a mature technology and product, entrepreneurs dare to make

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an investment, banks dare to make a loan, and shops dare to sell the product. They all believe that there is no risk or the risk is very low. In fact, there are certain risks. The risks come from the changes in the market, and once the product is needed, there will be a price war which will entail potential risks.

The venture investment in new technology industries breaks the conventional

thinking, and its formula follows:

Resources → Products → Market

Since there are no ready products or markets, venture investment has to put

the inventions and creations of scientists into practice by innovating existing

technologies. At the beginning, venture capitalists will search for resources, including new technological inventions, new materials, new equipment, and

new processes, according to certain technological inventions or assumptions, before making new products and exploring a new market. At this point, whether the company will be successfully founded is still unknown. This formula breaks

through people’s conventional mindset towards the creation of a mature product and therefore neither entrepreneurs nor banks dare to make an investment or loan.

It is rumored that when the Xerox 914 photocopier came out in 1959, it once sought business cooperation with IBM. IBM thought that this machine was unlikely to

have a large sales volume and the market risk was high, so IBM turned down the Xerox which turned out to be a large profitable company with an annual sales of 100,000 machines and a profit of USD1 billion for 10 consecutive years.

Due to the high risks, people called the technological innovation investment in

the high and new technology industry venture investment. However, everything has two sides. The investment in technological innovations demands a large

amount of capital and has a high failure rate of 60%–80%, but if the business becomes successful, it will bring substantial profits. So it is in fact an investment combining both high risks and high returns.

What are the risks accompanying venture investment? The risks originate

from three aspects: First, technical risks. Is the technological innovation certain to succeed? Can the technology be transformed into an enterprise and realize product manufacturing? Will there be technical failures which lead to economic losses?

Second, market risks. Can the new product be accepted by the market? When will the product be accepted? At what speed will the new product and new technology

be diffused (including the emergence of imitation)? What is the competitive edge of this product? Third, financial exposure. The first question is whether the venture capital is guaranteed? Then, are the costs and profits high? Finally, can the investment be recovered? All these risks boil down to the risk of investment losses.

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Risk investors: Generous rewards will stir financial genius to take risks During this period, the co-existence of scant high technology investment and excessive capital seeking for investment opportunities provided favorable opportunities for financial genius. Meanwhile, a group of businesses which created

profits from capital operation emerged in the capital market. In particular, the companies which were engaged in venture capital funds and venture investment,

offered excellent opportunities for the wealth-creation in the industrialization of high and new technologies.

The financial experts of venture capital are special talents who are sensitive to

investment opportunities, have a gift for or are accomplished in controlling capital

and seeking profits, and are able to win the trust of society. They demanded that if they can make a fortune out of excessive social capital, high rewards should be paid to them. Taking venture investment funds as an example, companies involved

in this business are usually organized through limited partnerships. The features

of the operation are that excessive social capital is collected in the proportion of 1:99 — the venture capitalist accounts for 1% and is called a “general partner” with unlimited liability while the remaining 99% comes from institutional investors of

enterprises or financial insurance companies who are known as “limited partners.” Limited partners, like shareholders in a joint-stock company, will shoulder limited liability. The rights and obligations of a general partner include: 1. A General

partner takes advantage of his talent to be fully responsible for the use, operation,

and management of funds; 2. A general partner receives an annual management fee equal to up to 2% of the committed capital; 3. Most funds end up operating for

15–20 years. Financial experts will apply those funds to a great variety of venture investments in order to seek high yields, and will distribute the profits at a ratio

of 1:4. When the investment contract expires and returns are doubled, a general

partner is able to get 20% from the gross income while the other investors can receive 80%. This is the first refection of generous rewards stirring financial genius to take risks in the financial management of venture investment.

Venture capital first rose in the U.S. between 1979 and 1985, the total volume of

venture capital grew from USD25 billion to USD115 billion, and the number soared

to USD400 billion in 1995, among which 70% were invested in the high technology industry. At the end of the 20th century, some media reported that there were more than 4,000 venture investment companies in the U.S., and they provided tens of

thousands of high technology enterprises with start-up capital. At that time, the output value of the U.S. high technology industry accounted for around 15% of the

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Gross Domestic Product (GDP) and the proportion of the employment in the high

technology industry was between 3% and 6%. High technology export products made up 43% of the total exports in the U.S. and became a major pillar for the balance of trade of the country.

Japan owned over 1,800 venture capital companies in 1986 with the total

venture capital exceeding JPY900 billion. In July 1995, the Ministry of the Treasury of Japan set up a venture capital market to support the technological innovations of potential small- and middle-sized enterprises.

The United Kingdom was the first country in Europe to initiate venture

investment with the fastest development. In 1979, the total volume of venture

capital in the U.K. was only GBP20 million, and the figure swelled up to GBP2.07 billion in 1994. In the meantime, Germany, France and other European countries also started to develop their venture investment industry.

Human capital: Generous rewards will stir entrepreneurial scientific experts to take risks Certainly, although venture investors have gathered venture capital, the key is

how to use the capital. For venture capital investment funds, the most important thing is how will the venture capitalists support entrepreneurship through the right channels, promote the industrialization of high technology industry, and create the investment opportunities with the highest rate of returns. At this time,

the old products and technologies in the traditional economy became “sunset industries.” If the surplus capital wants to generate a high profit, it has to run high

risks to invest in high technologies. In the traditional economy, the most common way for industrial enterprises to invest in technologies was to purchase patented

technologies or offer high payments to hire professionals. However, what we face now are totally new high technologies, and to turn to invest in new technologies is

like giving up the fixed-line telephone technology to chase after the mobile phone

technology. As to the questions of whether the mobile phone technology can be turned into products, seize the market, and make a profit by reducing costs, no one knows for sure.

In the face of the high risks accompanying high technologies, even venture

capitalists dare not to gamble. They will not venture to purchase patented technologies easily, nor will they offer high salaries to hire professionals. Instead,

they try to encourage and motivate human capital to maximize profits by virtue of monetary capital (this is the most necessary capital). This is also an example of

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generous rewards stirring people to take risks. But at this time, the person who

takes the rewards can switch to be the person who offers the rewards. Venture capitalists make an offer to the impecunious technological inventors: Since you

own high and new technologies (new technique, new materials, new products,

new visions for enterprises, and new business plans), we can provide you with start-up capital and do not demand absolute shareholding of the company; you

can invest in the company by means of management and technologies and receive

share options, but you must unite to perfect technologies, manufacture new products on a large scale, exploit new markets, and then strive to get the company listed in the GEM board in order to multiply the original capital. Scientists and technical experts may become millionaires, and venture capital will obtain high

financial returns and a channel for exit. This is a new win-win approach which combines monetary capital and human capital.

Here, let us talk about technology investment. The founding of a high

technology company requires close cooperation between venture capitalists and

scientists, and the key is to properly handle the issue of intellectual property, namely, the contribution of technology as capital stock. Western countries have

set up laws to protect intellectual property. In new technology enterprises, the technological inventions of technical experts can be appraised as capital stock

which is generally between 20%–25%. In the interest of certain special inventions, some countries allowed technical professionals to hold 51% of the company’s

equity (including the technology investment of 20%–25%); and when the company came to a stable development stage, the technical professionals had the rights to

buy back the remaining 49% of shares based on the prior contract. The function of venture capital companies is to help the experts with technological achievements

to set up high technology enterprises. Venture capital companies will raise start-up capital, look for management specialists, establish corporate images, and occupy the market for the technical experts.

How do venture investment companies make decisions and operate? Venture capital companies and risk investors are very prudent and rigorous in the selection, decision-making, and operation of venture projects. Generally speaking, a venture capital firm applies for the participation in the investment of around

10,000 projects per year. After selection, the venture capital firm makes the initial

contact with about 150 projects, 1.5% of the total applied projects. Among these 150 projects, 24–25 undergo in-depth discussions, while the firm only formally sign

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the contracts with approximately 10 projects, less than 0.1% of the total applied projects. In the performance of contracts, one or two projects are suspended due

to the unsatisfactory investment returns and development prospects. The final

surviving projects are the real blue-chip enterprises. These successful enterprises, after two or three year’s operation, eventually reveal high-growth benefits. At

this point, venture capital firms can recover their investment in two ways: First, to

find a large enterprise with comparative edges to buy the invested company, and

recoup the capital outlay by equity transfer; second, to help the invested company get listed in the securities market and sell its stocks to get the money back when

the company’s shares appreciate by 10 or even 20 times. At this stage, the invested high technology enterprise in fact has gotten through the risk stage and become a high-growth enterprise.

People like to hear the billionaire creation tales from Silicon Valley. Actually,

what is behind those stories is the aforementioned generous rewards which stir

both financial genius and entrepreneurial technology experts to take risks. It forms a new mechanism of investment and distribution for the operation of venture capital funds and venture capital, and therefore initiates high-level financial

management and wealth creation in promoting the industrialization of high and new technologies and the rise of high technology industry.

High technology industrial parks: The most important achievement in the industrialization of science and technology in the 20th century Silicon Valley in the U.S. is the best example in this regard. Silicon Valley and many

other similar industrial parks have become a new kind of social organization, and

attracted venture capitalists and all the entrepreneurial scientists and researchers to work there. At the same time, the science and technology industrial parks can

provide high technology enterprises with information, technologies, capital, market,

and all the other services necessary for founding a business, and truly become

bases for incubating, nurturing, and supporting the growth of high technology enterprises. As a result, in the 1980s–1990s, countries around the world emulated Silicon Valley by setting up various kinds of high technology industrial parks.

It needs to be mentioned that the success of Silicon Valley should be attributed

to not only capital, talents, technologies, information, management, and market, but also a set of systems which comply with the high risks of high technology

enterprises, especially the institutional system. For example, entrepreneurial enterprises, like venture capital firms, did not implement a standard modern

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corporate system at first, but adopted a partnership or limited partnership (the U.S. has done lots of work to regulate and innovate the legal and tax systems of the

partnership and limited partnership) and a set of simple financial systems resulting from the accumulation and application of financial innovations, which is also an important factor for success. Many countries just imitated the facilities of Silicon

Valley but took no account of the policy and institutional environments when they

initiated their science and technology industrial parks. That is why some industrial parks resemble Silicon Valley only in form rather than in nature.

Technological Innovations Entail a Simple Financial Service System The industrialization of high technologies requires not only venture capital firms and venture capital funds, but also a modern capital market which acts like a

catalyst. General financial markets and securities markets overemphasize standard

operation and cannot get used to the high risks of new and high technologies, so constant financial innovations are necessary in order to form a simple financial service system dedicated to the gathering of new and high technologies and the accommodation of funds.

To establish a simple financial system for the start-up financing of high technology enterprises Generally speaking, the role of a financial system is to transfer the savings of

people into the investment in the real economy. The commonly-known financial system usually includes the indirect financing of banks and the direct financing in the capital market.

The earliest financial system under the market economy was an indirect

financing system centering on commercial banks whose main businesses were to absorb deposits and grant loans. This system pursued the efficiency, safety, and

mobility of operation and emphasized the correspondence between assets and debts. It was a comparatively safe and conservative financial system and suitable for the traditional economy and products, so it belonged to the traditional mode

of operation. Once the market was saturated, enterprises came to a standstill, technologies underwent a major breakthrough, and banks encountered new

challenges that they could not handle, the results would be prudent lending, credit crunch, lending fears, and denied loans. Under such circumstances, the financial

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market on the basis of the indirect financing of banks could hardly satisfy the production needs of enterprises. This was the first stage in the development of finance.

The second stage in financial development was marked by the opening of

the capital market which focused on direct financing. This led to the emergence of the bond market, fund market, stock market, and financial futures market,

which constitute another system of finance. This financial system featured the fictitious capital constituted by a large amount of negotiable securities at the very

start. It emphasized standard financial products and public mode of trade, and eliminated banks as intermediaries by the direct dealing between investors and

capital users. It also focused on the correspondence between risks and returns in

the capital operation. Compared with the previous bank-based financial system which stressed safety, this direct financing was more risky and paid more attention

to the constant standardized operation and outstanding business performance of enterprises, so it was still hard for enterprises to enter the capital market.

The next challenge for the market economy was to raise start-up funds

necessary for the high technology enterprises which were at the initial stage and operated in a non-standard way with unstable performances. At this time, the

standardized operation and comparatively high barriers to entry of the existing financial system kept high technology enterprises away while the high risks of these enterprises also drove away commercial banks and the standard capital market. Therefore, there was a need for a convenient financial system which was

mainly composed of venture capital funds, venture capital firms, investment guarantee agencies to support the development of small- and medium-sized enterprises, especially the high technology start-ups. The characteristics of this convenient financial system were low entry barriers and the ability to not only adapt to the high risks of high technologies but also mitigate the high risks through

various financial innovations in order to realize risk transfer and compensation. The operation mode of this simple financial system still emphasized the

correspondence between risks and returns, and pursued high risks as well as high returns. Accordingly, the system focused more on the growth potential of products, technologies, and enterprises, or to be more specific, advantageous growth.

How did the simple financial system innovate the capital formation mechanism? The function of venture investment on technological innovations can be

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summarized as leveraging a small investment into large profits. A financial system which is suitable for providing start-up capital for technological innovations is the basis for the small investment. This financial system, combining the services of capital financing, venture investment, tax credits, credit guarantee, initial

public offering (IPO), and other services, has formed a venture capital formation mechanism especially suitable for technological innovations.

First, venture capital experts organize venture capital companies which

specialize in the venture investment in new and high technologies.

Second, the venture capital companies raise venture capital funds to provide

start-up funds for entrepreneurial enterprises, and the venture capital funds are categorized as private equity funds.

Third, venture capital companies cooperate with the scientists who own

new technologies and new inventions, and the later invests in the enterprises

by virtue of the technologies they possess while the former participate in equity investment. Ling Zhijun mentioned in his book New Revolution in China about how

Sohu and Sina looked for venture investment in the U.S. It was said that Zhang Chaoyang, the founder of Sohu, used his business plan for Sohu to persuade

Nicholas Negroponte, whose book Being Digital was very influential in China, into investing USD225,000 in Sohu in 1996. On the other hand, in 1995 when Wang

Zhidong initiated Stone Rich Sight Information Technology Ltd (SRS) as a software company, Duan Yongji invested HKD1.2 million to obtain 79% of the shares; but

between 1996 and 1997, when Wang Zhidong transferred SRS into a joint venture

by absorbing U.S. venture capital from Walden International Group, Ivanhoe Group, and Robertson Stephens, Wang Zhidong exchanged 40% of the shares

for USD6.5 million which meant the total value of SRS had grown to USD16.25

million. As other people asked him how his company could be worth that much money, Wang Zhidong could not give a sure answer. He simply replied that it

was attributed to the brains of his colleagues and him. Actually, the over one-year

negotiation was really hard. At first, he just wanted to run a software company, and it was by virtue of the USD6.5 million investments that Wang Zhidong was able to engage in the Internet business. After plenty of efforts, Wang consolidated

SRS (at a price of USD30 million) with Sinanet of Jiang Fengnian to form Sina.com. In 1999, SINA Corporation went public with a listing on NASDAQ.

Fourth, a corresponding market aiming at nurturing small- and medium-

sized enterprises (such as the NASDAQ in the U.S.) is necessary for successful hi-tech start-up enterprises to go public. Through the appreciation of stocks, the initial investment can be recouped. In this way, it not only brings high returns to

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the scientists and investors, but also compensates for the investment losses of the venture capital firms in other venture capital projects.

Fifth, governments should offer investment and tax incentives, and investment

guarantee agencies will provide guarantees.

GEM is the finishing touch In the financial service system for start-up businesses, GEM or the second board is the most crucial component.

To facilitate the IPO of small- and medium-sized enterprises and high

technology enterprises, many countries have opened a second board market. The key difference between the main board and second board lies in that the later sets

lower listing requirements for enterprises going to be listed in terms of total assets,

net assets, annual profits or annual income, and public float in order to create a social financing channel for growth companies that do not fulfill the requirements

of profitability or track record. The U.S. NASDAQ is such a kind of enterprise. In 1998, the high technology NASDAQ-listed companies accounted for a significant

proportion of the total listed companies in the same industries: the software

industry took up 95%; biotechnology industry, 83%; computer manufacturing,

81.4%; telecommunications equipment, 83.6%; electronics industry, 79.7%; and communications industry, 65%.

In the United States, NASDAQ became an important financing channel for

high technology enterprises. It enabled some high technology enterprises which

were ineligible to be listed on the main board for the lack of huge capital and

constant operation and profitability for three consecutive years to be listed on the market with lower entry. So the companies could break the limitations of primitive accumulation and angel capital, and raise sufficient capital by relying on business prospects for growth. This market not only provided the necessary conditions

for business expansion, but this also created an exit option for venture capital. So many high technology enterprises nurtured by venture capital firms and venture

capital funds viewed the listing on the NASDAQ as a target. It was obvious that the NASDAQ played a crucial role in promoting the growth of the new economy in the U.S.

The rapid development of the high technology industry in the U.S. was

inseparable from the growth of the stock market, and the Dow Jones and NASDAQ stock indexes once rose dramatically. The prosperity in the U.S. stock

market diverted most of the hot money from all over the world to the U.S., and

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motivated more than a half of American families to participate in the stock and

fund investment. In addition, the wealth effect of the rising stock prices stimulated the household consumption which in turn promoted the investment, production,

and distribution of enterprises and increased job opportunities, thus strengthening

the business operation. The second board also encouraged a large number of high technology enterprises to raise funds through going public, and supported

and promoted the industrialization of high and new technologies, which further facilitated the application of high technologies in the traditional economic domain.

How should governments support venture investment? In this simple financial service system, what role should governments play?

Western countries paid attention to the support of the high technology industry

since 1950s. Some of the most cutting-edge technologies, such as nuclear energy, computers, aerospace, lasers, and new materials, were funded by the governments

as expenditures for national defense and military research during the Cold War. Since the development of many technologies and products in the national defense and military research relied on the participation of civilian enterprises, the

governments set aside a certain portion of funds from the research outlays to fund those civilian enterprises.

Besides, the governments established credit guarantee companies and credit

guarantee funds. Venture capital firms or financial institutions which offered

loans for high technology start-ups, could insure their start-up investment in

new technology products with credit guarantee companies. Credit guarantee companies were backed by government funds, and once losses were incurred,

credit guarantee companies would be responsible for 70%–80% of the total damage while the start-up enterprises and financial institutions would shoulder 20%–30%.

Additionally, the governments provided preferential tax policies for high

technology enterprises. For example, the investment in new technology start-up

companies could enjoy investment tax relief, and the production and sales of new

technological products could receive reduction or exemption of income tax and other taxes.

In short, this convenient financial service system made two breakthroughs in

the innovation of the capital formation mechanism.

First of all, venture capital firms which take up a special mode of capital

operation to cater to the development of the high technology industry, undertake high risks to provide capital for impecunious scientists with no mortgages,

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guarantee, and capital in order to support their inventions and innovations.

Next, the second board market which has lower listing requirements allows

companies to list, finance, and expand their capital solely based on their growth potential and expected yield. It also provides an exit path for venture capital.

Fund procurement and investment recovery are the keys in start-up investment The most important tasks in the financial service system are to raise funds and recoup investment.

In most industries (mature products), it is usually the entrepreneurs who

are familiar with the product technologies that make investments and the initial

capital is raised and managed through conventional financing channels. In this case, banks only care about the repayment of loan principal and interest, investors

consider the return on investment while taking no account of investment recovery, and the capital of the enterprises will be constantly recouped in the form of depreciation in the long-term operation.

However, things are different for the innovations of new technologies. There

are high barriers to entry for new technology enterprises since both cutting-edge

technologies and large start-up investment demand will create barriers for the high technology start-up enterprises.

Here, the significant distinction between venture capitalists and general

entrepreneurs lies in: General entrepreneurs realize the reproduction of capital through the reproduction of products in their investment in factories; venture

capitalists achieve the reproduction of venture capital by means of constantly holding shares of venture businesses and then selling the equity of the successful start-ups. This venture investment, from injecting capital for business start-ups

to recouping the investment after the company is listed, operates all along the

capital by ruling out risks amid high risks and enhancing the capital efficiency. It

can manage well the relationships among venture capitalists, scientists, investors, managers, and governments to form a capital formation mechanism which is able to motivate all parties.

The development of every business requires different investing and financing

modes suitable to the features of different businesses. For instance, to manufacture

large-sized complete sets of equipment requires export credit and buyer credit from governments and financial institutions; long-established enterprises have to use

capital lease (usually with a preferential surtax) when upgrading large equipment,

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such as vessels, vehicles, and aircrafts; the purchase of consumer durables, such as automobiles, demands consumer credit and consumer finance; and home buyers

usually need mortgage loans to buy a house. The venture capital system is a kind of start-up capital formation mechanism by taking advantage of the high risks of

the new technological industries which general financial institutions usually stay away from, and it becomes a propeller for promoting the development of the high and new technology industries and driving technological advances.

Venture capitalists: The soul of venture investment In Western countries, private-run venture capital firms comprise the overwhelming

majority. There are also small business investment companies (SBICs) founded by governments, and these companies played a leading role in investing major risk projects.

The focus of venture capital firms is to attract a group of entrepreneurial

venture capitalists. In general, there are two kinds of talents that venture capital

firms are interested in: One is technological experts, including authoritative consultants in certain fields. Their tasks are not to directly engage in technological inventions, but to judge whether an invention is worth being transferred into

products or industries. The other kind is the professionals who know the market, finance, and management, and their works are to cooperate with technological

inventors to realize the commercialization and industrialization of technological inventions.

The main jobs of the venture capital firms are to rely on the venture capitalists

to gather and manage venture capital and organize entrepreneurial activities based on technological innovations. The unique feature of venture capitalists is that they

are willing to take risks to bring new inventions and ideas into economic activities. It can be said that without the technological inventions of scientists, there will be

no new technology industry. However, if there are no venture capitalists who can

turn technological inventions into products and industries, excellent inventions are just empty talk.

Another characteristic of venture capital firms is that they implement a

high compensation system, which closely relates to the performance of venture investment and they are thus able to motivate the managers of venture capital.

This high compensation system works like a magnet with great cohesive force and attracts various high-level management personnel.

Venture capital and second boards are indispensable for supporting high

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technology start-up companies. There is, however, just one step from truth to absurdity. The new economy boom in the 1990s, especially the emergence of the

Internet, played a significant role in enhancing productive force, and thus deserves

much space in the history of the economy. The illusions of the new economy, at that time, aroused excessive private equity funds to enter the IT industry in the

form of venture investment. Like gambling, they even bet on some loss-making Internet companies which had only a single business plan, and hoped to get those

companies listed in the stock market at a price of hundreds of times of priceearnings ratio (P/E) before cashing out. Later, the new economy boom faded

away and left over only economic bubbles. The Internet bubble burst in 2000 with the NASDAQ dropping dramatically from 5,400 to 1,000. This historic tragedy debilitated the NASDAQ and it took a long time for the NASDAQ to recover.

The Status Quo and Strategies for China’s Venture Investment Venture investment started comparatively late in China. In March 1985, the Central Committee of the Communist Party of China issued the Decisions on the Reform

of the Science and Technology Management System, and it pointed out that “venture capital can be set up to support the development of the high-risk and fast-changing high technologies.”

In 1992, the State Council approved to build national high technology

industrial parks with the view to supporting the growth of high technology industries. Between 1992 and 2006, the annual growth rate of major economic

indicators in 53 national high technology industrial parks exceeded 50%.

During the Tenth Five-Year period, the national high technology industrial

parks maintained a rapid growth and the major economic indicators continued

a growth rate of over 30%. According to China’s Latest Economic Indicators in

2005, the national high technology zones recorded a total revenue of RMB3.44 trillion, industrial output value of RMB2.89 trillion, and industrial added value of RMB680.28 billion (accounting for 9.3% of the national total).

The size of the high technology industry occupied a large portion against other

industries. A considerable number of national high technology zones turned out

to be new sources of economic growth in different cities, and the industrial added value of these zones took up 20% of the total value of the respective city, thus

becoming major forces in driving local economic advances. In 2005, the national

high technology zones created RMB111.65 billion of foreign exchange through

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exports, accounting for 14.6% of the national total exports.

In comparison to the national high technology zones, China’s venture capital

industry started even later. It was reported in 2006 that the aggregate amount of China’s venture capital outnumbered RMB58.39 billion, and the venture capital of

that year reached RMB14.36 billion, the highest in history; and the growth rates of both that year’s venture capital and aggregate venture investment exceeded 20%.

The foreign venture capital of China in 2006 was only USD1.76 billion whereas the

number was USD26.5 billion in the United States. The major problems in China’s

venture investment are the following three things, according to Zhu Baocheng

in his book Current Situation and Strategies of China’s Venture Investment: First,

limited sources of funds, and a lack of comprehensive venture investment network attracting the forces of individuals, private enterprises, financial institutions, and

foreign capital; Second, an unreasonable compensation system in which risks

and profits are not balanced, and are thus unable to keep visionary investment professionals; Third, an inadequate financial system and an incomplete capital

market which are short of effective exit channels. China’s securities market was not perfect, GEM starts late, and the property rights could not flow freely. overthe-counter (OTC) trading, mergers and acquisitions, and other methods had not become the channels for venture capital withdrawal, and most of the venture capital was retained in the invested companies and unable to exit.

Fortunately, this situation began to change after the equity division reform in

2005 and the opening of GEM in October 2009. According to the statistics of China

Venture Capital Research Institute (CVCRI), the total venture capital of 136 venture capital institutions or venture capital funds which had finished the fund raising,

reached RMB96.33 billion in 2009, 94.56% of the total amount of 2008; and the average venture capital size of each institution or fund was RMB708 million, 1.33 times that in 2008. The venture capital industry showed some new features: 1. The proportion of local venture capital institutions outnumbered foreign-funded ones

by 57.84% to 42.16%. 2. Venture capital joined earlier in new companies, and about one-third of venture capital was injected into entrepreneurial companies at the start-up stage. The investment for enterprises at the growth stage accounted for

29.60%, and that for enterprises at the expansion stage was 25.08%. The investment focus had changed compared with the situation in 2008 when investment in

enterprises at the expansion stage was the majority. 3. As for the distribution of investment, although traditional industries, narrow-sensed IT, and energy and

environmental protection industry were the most popular industries for investors in 2009, energy and environmental protection, health care, and consumer services

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were the most potential industries for investment institutions according to other investigations.

According to the statistics from the Ministry of Science and Technology, in 2010

China added 27 new national high technology zones to make the total number reach 83; the main economic indicators realized an average annual growth rate of over 20%; and 28,262 companies were approved by the government as high technology enterprises.

According to the 2010 China Venture Capital Market Statistical Analysis Report

released by ChinaVenture, there were 804 cases of venture capital projects and the

total investment reached USD5.67 billion, up 65.1% and 93.3%, respectively, when compared to the data of 2009. And both the total project number and the total investment exceeded the record high of 721 cases and USD5.33 billion in 2007.

The venture investment in 2010 displayed the following feature: Large amount

of Yuan-denominated funds was active in the equity market, but in comparison to dollar-dominated funds, there was still a noticeable gap. After the global economic crisis in 2008, foreign capital turned to be prudent and made investments in

a conservative way. In 2010, venture investment got involved in 20 industries including manufacturing, Internet, IT, and health care. Among these industries, Internet projects obtained the most venture investment with the total financing of

USD1.83 billion, accounting for 32% of the total start-up capital. It was reported

that e-commerce would be the next costly industry next to the Internet and online video industry.

The Planned Economy Allows No Room for High Technology Innovations Inspired by the Tragedy at the Dawn of the Information Age: A Reflection on the Ending

of the Soviet Union Model written by Tao Wenzhao, I would like to talk about the relationship between the planned economy and high technology innovations.

The Soviet Union once was a leading country in science and technology, and it

sent the first artificial satellite to space in 1957. The country paid great attention to the development of science and technology. Joseph Stalin upheld the idea that “science and technology decides everything, and Leonid Brezhnev regarded

“technological revolution” as the strategic core of the Soviet Union. By the 1960s,

the number of scientists and engineers in the Soviet Union outnumbered that in Western countries. But why did the country lag behind Western countries after the

1970s, not only in the field of information technology, but also in high and new

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technology industry. After a thorough analysis, this situation was a collective work

of both the advantages and disadvantages of state-owned economy and planned economy.

The Soviet Union led the world in technology and it successfully sent an

artificial satellite to space as early as 1957. That was because the planned economy, primarily the state-owned business, had one obvious advantage: The economic system enabled the country to collectively use the nation’s limited resources

(including capital, materials, and talents) to develop its priority industries. The

best example was the strategy proposed by Stalin — “priority development of heavy industry.” Under such a strategy, the development order of the

industrialization in the Soviet Union was: Agriculture gave way to industry, light industry made a place for heavy industry, and general heavy industry yielded place to military industry. As a result, the highly-concentrated planned economy

diverted a large amount of capital and talents to the development of heavy

industry, especially the national defense industry. The enormous arms industry of the Soviet Union united the most talented scientists, engineers, and technicians

(with the high compensation system), owned its own research centers, as well as the best technical equipment and physical materials, and enjoyed the preemptive

right in import quota. This led to a severe imbalance in the national economy (this

is what we often criticized — the inherent defect of the planned economy), but it indeed guaranteed the priority development of heavy industry and military

industry and ensured the launch of artificial satellites in 1957. In the 1980s, the

defense expenditure of the Soviet Union accounted for 15% of the nation’s GNP, two times higher than the proportion of the United States. Around 40% of the

industries were related to national defense. When we looked back at China, the country also successfully exploded its first atomic bomb in 1964 and launched its first man-made satellite in 1970 by taking advantage of the collective forces of

planned economy to develop the heavy industry and defense industry and invest

in nine kinds of large mechanical equipment, after Khrushchev withdrew the Soviet experts from China. It has to be admitted that the collective force is one of the virtues of a planned economy.

Then, why did the Soviet Union which once led the world in science and

technology lag behind Western countries in the fields of information technology and other high technologies after the 1970s. The root cause lied in the inherent defect of the planned economy, namely its conservativeness. There was one

popular saying in the planned economy: “The plan is the law,” and the planned economy allowed nothing unplanned. Although the planned economy could

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concentrate outstanding scientists, engineers, and technicians to develop mature technologies, it made no room for technological innovations.

First, the planned economy can only permit planning officers to prepare plans

in advance for the industries, products, and technologies that they are familiar

with. But technological innovations result from market demands, which cannot

be predicted or planed in advance. All the major inventions in human history, from the steam engine, electric motor to the phone and aircraft, are outcomes of the market competition and developed spontaneously based on the market needs,

rather than being planned or determined beforehand. In addition, technological innovations contain risks — including technical risks, market risks, and financial risks — which cannot be foreseen. The bureaucratic decision-making system of the planned economy tended to avert risks. In the Soviet Union, only when technical

inventions did not clash with the industrial system, could these inventions be accepted by the planned economic system. This kind of innovation was at most

piecemeal reforms under the existing system. The high technological innovations, which were obscure at first but likely to form new technology systems and

burgeoning industries, were bound to be repulsed and stifled by the carefully planned large industrial system.

Second, under the planned economy, science and technology funds were born

by national budget allocation, and the system of gratuitous transfer of technology made research institutions free from the pressure of market competition. In

addition, economic benefits were not pursued, and technological innovations were not rewarded; and neither the restraint on budget nor the stimulus to the

economy was adequate. Both the industrial production sector and the scientific research system followed the old routine, and fell short of internal motivation

for technological innovations. Under the economic system of the Soviet Union,

although in just a small number, the scientific results could hardly be transferred

into productive forces. As a result, the technology adoption rate was only between

25% and 30%, and the technology transfer cycle generally needed 10–12 years on average. By comparison, the scientific achievements could be turned into productivity within five years in the United States.

Finally, the reason why the Soviet Union lagged behind Western countries in

the IT development was an inner clash and contradiction between the economic pattern of the Soviet Union and the IT revolution. Joseph Nye pointed out that the planned economy of the Soviet Union was helpful in the development of heavy

industry in the first and second industrial revolutions. After the world underwent the Great Depression in the 1930s, the Soviet economy recovered rapidly in the

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1950s, and it proved that a planned system was useful. The planned economy was beneficial to the development of steel and power industries and other heavy industries. This system, however, did not work in the third industrial revolution

(IT revolution), and was detrimental to an economy on the basis of information. Since the information lifecycle was short and most information products could

only be active for one or two years, the market economy was able to respond quickly to this change. But based on the economic pattern of the Soviet Union, the information products would become obsolete long before being eliminated from the market.

In the 1980s, I have seen such a case during my investigation. In 1977, China

imported the production line of the minicomputer “SOLAR” from France with

the total investment of USD317 million (among which USD169.7 billion was foreign exchange), and the annual production capacity of the production line

was 400 units of minicomputers. Judging from the then-technical standard, the SOLAR minicomputer had comparatively high performance, complete software and hardware, and good usability. But under the bureaucratic decision-making system of the planned economy, this project spent four years in negotiation and

another three years in construction, and when the production line was finally put into operation in 1983, the SOLAR minicomputers became outdated and

were replaced by the minicomputers with higher performance and high-grade microcomputers due to the rapid advance of computer technologies. After three years of production, the SOLAR minicomputer manufacturer produced 208 units

of machines but only 100 were sold. Consequently, the factory had to negotiate with other countries in the hopes of upgrading the products by introducing new

technologies. The projects of floppy disks and high-speed printers imported from

France encountered similar experiences. This disclosed the fundamental weakness

of the rigid bureaucratic decision-making system under the planned economy in both the Soviet Union and China.

With the rapid development of science and technology after the 1970s, the third

industrial revolution, namely the revolution of information technology, appeared,

and people entered an era of high technology. The characteristic of this era was: Technologies advanced more and more quickly. At that time, the Western capitalist

countries mainly implemented a market economy and a private economy, and therefore driven by profits, private enterprises with a small size and a wide variety

not only could adapt to the changes of and support the development of high

technologies in a diversified and flexible way, but also owned a entrepreneurial system which could directly transfer the scientific results into products by taking

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advantage of market-orientated venture capital. The economic systems enable the Western countries to acclimatize themselves in the new situations of the high technology age. Under the conditions of more and more rapid technological advances, increasingly complex economic changes, constantly shorter production

cycles, and ever faster product upgrade, the production organization became increasingly diversified, the IT products and other industrial products could keep up with the technological development, the economic growth could comply with

the changing demand of the market by transforming from extensive to intensive

growth. This trend of technological development was incompatible with the planned economy on the basis of a state-owned economy and its rigid decision-

making system. In consideration of this, Richard Barbrook asserted that the Soviet

Union was incapable of leading the IT revolution. The political and economic systems of the Soviet Union were conservative, inflexible, slow in reacting, and lacking in sensitivity, which contradicted the flexibility and variability of the

information technology. The highly centralized plans and instructions of the Soviet

economy emphasized the rank and authority and did not allow a distributed

system like the Internet. The Internet which was non-central, interactive,

and equal, could only be the product of an open and free society. The highly-

centralized politics in the Soviet Union insisted on political unity and ideological indoctrination, and thus it was hard for the country to accept an unmonitored and free means of communication like the Internet. Barbrook wrote: “The socialism

under such a system could by no means represent the future of an information society, but symbolized the Fordist past of the industrial age. After the fall of the

Berlin Wall and the collapse of the Soviet Union, even the most fervent leftists lost hope in socialism under the Soviet system in the information era.”

Naturally, it was unnecessary to recount the political factors, such as the Cold

War and the two parallel world markets between the East and the West, the small

proportion of trade between the Soviet Union and Western countries, restrictions from the Coordinating Committee for Multilateral Export Controls (Cocom) in importing technologies, and the suppression of the use of information technologies

by the Soviet ideological policies (the use of photocopiers required a security permission, and long-distance telephone and telex were controlled by special programs).

Tao Wenzhao also mentioned two details in the Tragedy at the Dawn of the

Information Age: A Reflection on the Ending of the Soviet Union Model:

First, the comparatively closed Soviet mode stifled the exchange of

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information technology.

Under the theory of two parallel world markets, the external economic

activities of the Soviet Union were basically limited to the semi-closed

Council for Mutual Economic Assistance (Comecon), and became detached from the economic and technological development of the developed

Western World. Among the Soviet total foreign exports in the 1950s and 1960s, the trade with the Comecon members accounted for 55% while

that with capitalist countries only took up 15%. In the 1970s, the Soviet Union proposed to replace the Cold War with détente and developed the

economic cooperation with Western countries, and as a result, its trade

volume with the West was expanded. But when the Soviet Union invaded

Afghanistan in 1980, the socialist countries suffered economic sanctions from the Western countries led by the U.S. Until 1985, the value of trade

with Western countries reached approximately 27%. A small proportion of foreign trade with the West and the restrictions in technology import

from the Cocom made it hard for the Soviet Union to obtain the most

advanced technologies from the Western bloc powers. The relatively closed environment left limited opportunities for the Soviet Union to get in touch with international academia, and only a few scientists could have access to the Western world under supervision. These facts restricted scientific exchange, research information was subject to censorship, and scientific

communication was under control. In an age of globalization, such a closed

state and detachment from the world could only lead to backwardness.

For instance, the United States adopted the measurement of 1/10 inch chips which went to 2.254 cm in the metric system in chip production. For simplicity, the Soviet officers decided to implement its own “metric inch” in chip production. So the chips manufactured by the Soviet Union

looked like those made in the United States, but actually the chips could not be inserted in the socket. Consequently, the microelectronic products

manufactured in the Soviet Union could not be exported abroad due to the semiconductor industry being unable to produce the chips tallying with the requirement of Western countries.

Second, the Soviet Union’s ideological policies curbed the use of

information technology.

In the history of the Soviet Union, there was once the “Lysenko Affair”

in which politics intervened in scientific research. Although this mistake was corrected later on, the scientific and technological development,

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especially the innovations in information technology, continued to be subject to ideological and political suppression in the Soviet Union. The country inherited the practice of paper supply control from the October

Revolution as the basic approach to restrain information, and printing, copying, information processing, and communication equipment were all

under strict regulation. Using the photocopying machines, one needs to get a security license: Approval from two departments for Russian, while

agreements from three departments for non-Russian languages. To use

long-distance telephones and faxes in each department or company has to go through special procedures. In such a context, personal computers to be owned by everyone meant subversion to the Soviet bureaucratic

system, including the bureaucratic system of scientists, not to mention the non-centered, open, interactive Internet. Joel Mokyr pointed out: What

determines the technical conservatism seems to be the fears of rulers about the devastating effect of technological changes that would probably have

on the stability of a Society. Information technology has been called the technology of freedom, so it was understandable that the Soviet Union under a highly centralized system took a repressive policy.

Discussions on Human Capital and Investment in Human Capacity Guo Shuqing: The economic impact of improving the expenditure on human capacity and quality In recent years, the situations of China’s foreign trade surplus and the U.S. trade deficit, China’s high savings rate and the U.S. low savings rate, China’s insufficient consumption and the U.S.’s excessive consumption, and the imbalance of global

economy, aroused attention from academic circles. According to the traditional principles of economics, the USD700 billion–USD800 billion of trade deficits in the U.S. current account demanded the same amount of net capital inflow to

compensate. Based on this, some people predicted that the American economy

would be doomed to decline or collapse, but the prediction turned out to be wrong (the global financial crisis in 2008 was a result of subprime mortgage

and financial derivatives rather than the imbalance of international trade). Guo Shuqing explained his idea in an article in 2007 that the same type of imbalance

in the world economy did not start from today, but had already existed for half

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a century. Analyzing from the angle of economic globalization, he wrote that “a balanced picture of the inflow and outflow of commodities and capital with the U.S.

as a pole while a group of other countries as another pole has been formed; The

U.S. maintained a huge deficit in its current account while in its capital account there was a corresponding surplus; Overall, the U.S. balance of payments reached

total equilibrium.” He even believed that for years, the United States had always enjoyed the cheap goods and low-cost capital from less developed countries, and perhaps this was a reason for the unprecedented economic prosperity in the U.S.

But one unique contribution of Guo Shuqing was that he proposed the costs

of human resources development in the U.S. economic analysis, that is, to increase

the expenditure on technology and culture, especially that on human potential. In other words, to increase the impact of the investment in human capacity and quality on the U.S. economy.

Guo Shuqing thought that “what constitutes the magnetic attribute of the U.S.

economy is neither the general manufacturing industry, nor general services; what

occupies the commanding heights of the U.S. economy and the global economy as a whole was the advanced scientific research, IT, biological engineering, investment and network companies, universities, laboratories, hospitals, the mass

media, publishers, sports clubs, movies, TV shows, music, as well as the financial institutions in Wall Street, Chicago, the entire country, and even the whole world.

Depending on all those factors and facilities, the United States has become an unparalleled innovation center for knowledge and technology, and its economy has maintained the unique power and flexibility, and thus it is able to exert fundamental influence on all the global markets, including goods, technology, advanced labor, capital, foreign exchange, land, and real estate.”

He observed: In the United States, the expenditure on human potential (research

and development spending in the broad sense), such as that on education, training, internships, self-study, culture, technologies, sports, health care, and adventure

tourism, was far more than the investment in kind; even the developed countries like the European countries and Japan could hardly be on a par with the U.S., let alone China, India, Brazil, and other developing countries. Certainly, this could

deny neither the necessity of the investment in kind, nor the facts that huge waste

of resources and excessive material consumption existed in the country, and there was a possibility of a drastic adjustment caused by the current expenditure trend. If we compared the total number of both investments in kind and that in

human capacity and quality in each country, we may find that the comprehensive investment rate of the U.S. would exceed that of China.

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From this, Guo Shuqing presented the problem: “As long as we see the deep changes of modern economy, we will find new perspectives and approaches in observing, analyzing, and evaluating the so-called savings imbalance...According to the traditional economics, the importance of savings lies in the fact that it can generate capital which is used in the physical investment and thus maintaining or expanding the scale of economy. The sources of economic growth, however, are no longer limited to physical capital nowadays; instead, the economic growth is increasingly dependent on the technological advance and cultural development, namely the development of human resources. For centuries, economics, which boasted as being the most accurate of the social sciences, classified the spending on human resources (expenditure on technology and culture) as consumption rather than savings and investment.” The conclusion was obvious: “Under current economic conditions, the concept of savings and investment desperately needed an adjustment.”6

How to adjust the concept of savings and investment? The question faced by us now is how to redefine savings and investment. Understandably, it is technically impossible. If we categorize the expenditure on human resources development as savings and investment instead of consumption, for example, to divide investment into Investment I (physical investment, that is the total investment in fixed assets and current assets), Investment II (expenditures on human resources development, that is spending on technology and culture), Investment III (total investment, namely what Guo Shuqing called comprehensive investment) based on the money classification in the Western economics, we may form a clear concept of savings and investment and develop a new idea on the conversion of savings into investment and the following impact on the economy in the analysis of the influence of this classification on the economic development. According to China’s present strength, if the investment in human resources, namely in technology and culture is modestly increased, China is likely to experience major changes of a rapid increase in productivity as what Schultz had predicted would happen in Japan and Germany after World War II. In the end, this inevitably involves our question of how to rewrite “the economics boasting of the most precise social science.” This act will exercise immeasurable influence on elevating the role of human capital. First of all, in the process of industrialization in the West, modern productive force created great material civilization, and people were gradually obsessed with converting savings into capital and fell into what Marx called “Commodity

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fetishism.” Even “labor — the father of wealth” would become a vassal of capital.

Now we reiterate that the expenditure on human resources is the money invested to enhance human potential, and it will restore the decisive role of human in

material production. It further proves that humans, especially the high-quality talents with special knowledge and skills, are the real powers for accelerating economic growth.

Next, the concepts of consumption, savings and investment, and investment

should be adjusted. After the traditional economics separated consumption from

production, the production nature and economic significance of consumption was

nearly reduced to nothing. This idea, in turn, put some of the economic theories in a predicament. Now, to separate the expenditure on human potential from

consumption as an important investment will not only put consumption back into the process of production, but also bring about revolutionary changes in the capital

theory, growth theory, and income distribution theory, and help to solve some of the economic mysteries.

Certainly, this is just a digression. It will be an enormous research topic and

systematic project beyond the capacity of this book and the author.

At last, it should be mentioned that some scholars, taking the education and

health investment between 1978 and 1996 as the total investment in human capital,

found that every RMB100 million increase in the human capital investment would bring about approximately RMB600 million growth in GDP in the following year;

every RMB100 million increase in physical capital could only produce RMB200 million GDP increases. In China, the governments at all levels now invest 2.5% of

GNP in education while 30% in physical capital. The corresponding proportions

were respectively 5.4% and 17% in the U.S., and 3.6% and 30% in South Korea. The ratio of physical capital investment to the human capital investment was 12:1 in

China, 8:1 in South Korea, and 3:1 in the United States. The spending on human capital of China was far behind the world average (Yang Yiyong).

The laws of human capital movement at different development stages The movement of human capital follows certain laws. Judging from the

development history of different countries and cities, the composition and development of human capital was different at each development stage. Generally

speaking, the initial stage is based on low-end labor force and can also be called the primary stage. At this stage, the labor force only owns some basic capacity,

wisdom, and low level of education (or even illiteracy) without any ambitions. In

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the early years of the Reform and Opening Up in the 1970s when a large number of rural labor flooded in cities, China was at this stage. For cities at the primary stage, the principal pressure is how to provide job opportunities for human

capital under the conditions of low wages and strong competition. When the

economic development enters into the second stage, that is the intermediate stage,

the employment was on the verge of saturation and wages would considerably rise. At this stage, as more foreign capital has been attracted, some successful

technologies will also be brought along and domestic firms will introduce some advanced technologies from other countries and areas. Accordingly, enterprises

will have a higher demand for the quality of the labor force, the country will

significantly enhance the access to higher education, and individuals will receive a certain degree of education to improve their qualities. For China, after the mid1990s, the new generations of young migrant workers generally went to junior

middle schools and were capable of skillfully mastering and utilizing production techniques. The cities in the Pearl River Delta which recently proposed to undergo an economic transformation are basically at the intermediate stage. The third

stage is the advance stage when the industrial structure of cities tends to be more sophisticated, namely with higher value added, and enterprises are equipped with

higher research capacity and level of technology, which in turn demand a higher education level of human capital.

Cities require both high-end labor and low-end labor in order to develop. We

should follow the law of motion of human capital and cannot deal with the low-

end labor in an oversimplified and rude way. In the development of China, many cities claimed to take measures to introduce high-end talents while reducing the

low-end ones for the purpose of coping with the pressure from the continuously growing urban population. A great number of urban areas started to clean up and rectify vendors, restaurants, bath centers, beauty salons, grocery stores, and

small building material stores. Whenever large cities faced the pressure from the

population, there was always the warning about “driving low-end labor away.”

Guangzhou City once claimed that the local poor social security resulted from the large number of low-end laborers who should be transferred to other areas. Some members of Chinese People’s Political Consultative Conference (CPPCC)

once proposed to set a “threshold” in Beijing for migrant workers. A member of the Beijing Municipal People’s Congress said “the mobile population absorbed by

small enterprises and outlets was the low-end labor rather than Beijing residents, and these people occupied the increasingly scant public resources of Beijing.”

Others believed that low-end labor mostly engaged in labor-intensive works which

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were not decent and did not tally with the image and orientation of Beijing as an international metropolis.

A city is called a city because it is established on the basis of the concentration

of people at different levels, which is the embodiment of prosperity and vitality

of the city. The bigger a city is, the more diverse the labor is required by the city. The prosperity and opportunities of a metropolis cannot be separated from the collective efforts of the low-end labor including farmer-turned-workers and many indecent stores, and therefore not just high-end talents are entitled to share the

achievements. As a matter of fact, no city can do without low-end labor. Urban residents need couriers to deliver express mail, hourly workers to do cleaning, maintenance men to unclog drains, waiters to seal meals, and security to ensure

the safety of residences. You cannot ask those workers to serve you as soon as you

need the services while driving them out of cities when they finish their work. If an exit mechanism is enforced on the small enterprises which have attracted large mobile populations, the resulting consequence must be the inconvenience in life and soaring living costs faced by urban citizens.

Cities can give priority to the development of high technology and modern

service industries, but by no means assume that the general service sector, small enterprises, and small stores are not necessary. In fact, those industries are interdependent rather than mutually exclusive. To strip off the low-end labor does not mean that the corresponding demands also disappear, and the high-end labor will not fill the vacancy left over by the low-end labor.

The growth of cities has to cope with the problem of cities being overwhelmed

by a constantly increasing population. The reason behind this is the imbalanced

development between different regions, and people tend to flood into large cities

with better infrastructure and more opportunities, such as Beijing, Shanghai, and Guangzhou. So the key is to make great efforts to promote balanced regional

development. To frequently force low-end labor out of the cities through administrative means only discloses the simple mindedness and brutality of city administrators, and is not practical in reality.

In recent years, the Pearl River Delta proposed the upgrading of some cities,

such as Shenzhen and Dongguan, by “ridding the cage of old birds in favor of new ones.” On the one hand, labor-intensive foreign-funded companies would be transferred to surrounding areas or West China; on the other hand, the labor force

with high quality would be retained in the developed Pearl River Delta to realize the sustainable development of Guangdong Province. This conforms to the laws

of human capital development and also indicates that the cities in the Pearl River

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Delta are gradually entering the intermediate stage and advanced stage of human capital since they demand a high-quality labor force.

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Chapter

Capitalization and Corporate Equity and Debt Financing

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: The Earliest Stock, the Stock Market Boom in Shenzhen, Stock Warrants of RMB10 Billion, and Hong Miaozi Market Let us begin with the stories of the earliest stock and stock markets after the Reform and Opening Up in China.

In 1986, a New York Stock Exchange delegation visited Beijing for a Financial

Reform Seminar and hoped to exchange a gift for a Chinese share certificate.

Liu Hongru, who was then Vice President of The People’s Bank of China, found a share certificate of Beijing Tiaoqiao Shopping Mall. But the stock had a fixed

term and a fixed interest with dividends, and did not resemble a real stock. The gift problem was solved when the Vice President of the Shanghai branch of The

People’s Bank of China sent a share certificate of the Shanghai Feiyue Audio Equipment Company Ltd. On November 14, 1986 when Deng Xiaoping met John Phelan, the Chairman of the New York Stock Exchange delegation in the Great

Hall of the People, Phelan gave Deng Xiaoping a badge of the New York Stock

Exchange while Deng presented a share certificate of the Shanghai Feiyue Audio Equipment Company Ltd. in return.

The American took this thing very seriously. On November 16, 1986, Phelan

flew from Beijing to Shanghai to register the transfer of the share. This caused quite a stir in the international community. At that time, there was no Shanghai Stock Exchange, and the transaction had to be completed in the Jing’an District

Branch of the Shanghai Trust and Investment Company under the Industrial and

Commercial Bank of China. In the large office of the Jing’an District Branch, the

Chairman of the world’s largest stock market encouraged the pioneers of China’s

securities market by saying: “The first U.S. stock market rose under a buttonwood tree at the foot of Wall Street, and it was far worse than this room.”

After the American guest received the share certificate, the gift was exhibited

in the New York Stock Exchange. This was the first comparatively standard share certificate of China after the start of the Reform and Opening Up period.

Then, let us look at how the Shenzhen Stock Market started flourishing.

In 1987, the Shenzhen Development Bank (SDB) began to issue shares.

Originally, the SDB planned to release 7.95 billion in shares with each having a par value of RMB20. People held a wait-and-see attitude towards the stock issuance.

The offering plan only completed 49.9% of the target number, irrespective of

government leaders taking the lead to purchase shares. The purpose of the stock issuance was solely for fundraising, and buying shares was the same as a long-

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term investment. Since there was no place for stock trading, the purchased shares had to be kept in drawers. In April 1988, the SDB distributed a dividend of RMB2

per share, equivalent to 10% of the par value, and new shares would still be offered at the par value. But this offer was still not quite attractive, and a lot of existing

shareholders even renounced their allotment rights. At the end of the same year, China Vanke Co., Ltd. faced the same cold shoulder in stock issuance. Around this time, Shenzhen opened its first securities company where the stocks of SDB and Vanke were able to be transferred, but in the years of 1987 and 1988, the company was rarely visited.

Until March 1989, the SDB paid a cash dividend of RMB7 per share, gave

bonus shares at a proportion of 1:2 to existing shareholders, and sold new shares

at a price of RMB40 (the par value was RMB20). Then, the stock price rose to

RMB50. That is to say, the stocks of RMB20 face value purchased in 1987 doubled the investment in 1989. In this way, the SDB for the first time drew much attention for the public by virtue of stock appreciation. The stock price rose sharply and shot up to RMB120 per share in May. Although the price once dropped due to the June

Fourth Incident, it remained at RMB90 per share. Encouraged by the appreciation

of the SDB, Gintian Industry (Group) Co. Ltd. went public in 1989. It was the third company to be listed in the Shenzhen Stock Exchange. The company planned to

offer 452,000 shares (face value = RMB10 / share) at first, and an additional 248,000 shares were issued later to meet the excessive demand. And all the shares were sold out.

In March 1990, the SDB offered the third dividend payout and the placing

of new shares and this generated greater motivation for potential investors. In the same year, two more companies issued their shares — Shekou An Da

Transportation Co., Ltd. and Shenzhen Champaign Industrial Co., Ltd. This gave people false impressions that owning shares would definitely bring a profit and

that long-term investment did not necessarily need a long time to generate a return. Since then, the stock market boomed in Shenzhen.

The third story is about the stock warrants which have created RMB10 billion.

In April 1993, China, from the south to the north, practiced an unlimited

issuing of stock warrants but limited offering of shares through public lottery. The successfully purchased warrants earned more than RMB10 billion altogether.

For example, Shanghai sold 182 million in stock warrants (RMB5 for each)

in the first round, and 568 million in the second round at a price of RMB2.2 per warrant; the income from the two rounds totaled RMB2 billion. In Jiangsu, Kunshan Sanshan Industrial Company Ltd. and Wuxi Taiji Industry Co., Ltd.

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issued 3,315 shares at a per share price of RMB3, and thus cultivated nearly RMB1 million in total. In addition, as for the stock warrant sold at a price of RMB2 per

sheet, Tsingtao Brewery Co., Ltd. sold 287 million warrants with a total income of

RMB574 million; Hefei Meiling Co. Ltd. offered 119 million warrants and received RMB238 million; five enterprises in Guangzhou collected RMB256 million by

selling 128 million stock warrants; five Fujian companies raised RMB288 million by offering 144 warrants; other companies, such as Jiangxi Jiangling Motors Co., Ltd.,

Hunan Changsha Zhongyi Electrical Appliances Co., Ltd., and Wuhan Phoenix

Company Limited, all collected over RMB100 million through selling stock warrants. It was estimated that just the warrants of new shares had drawn around

RMB10 billion and according to the Securities Market Weekly, the exact figure was

RMB12.2 billion.

At last, we will talk about Hong Miaozi Market, an informal market for trading

the non-listed company shares.

After the Lunar New Year of 1993, around 40,000 people gathered in the Hong

Miaozi (literally, the red temple) Street in Chengdu, the capital city of Sichuan

Province. They were spontaneously engaged in the transaction of the non-listed

internal shares or share certificates. Investors set up the market and conducted transactions through private negotiation. Such a spontaneously organized market

has also been seen in some other provinces or cities, and it was referred to as the “Hong Miaozi Market phenomenon.”

But why did the Hong Miaozi Market become active? The immediate reason

for this was the Shanghai and Shenzhen stock markets were bullish, and there was also a rumor that some financially affluent investors had come from Shenzhen to acquire stocks of several going-to-be listed companies, including Leshan Electric

Power, which stimulated the internal transactions of other stocks. The underlying cause, however, was that the offering of internal shares had reached a level that the demand for stock trading was very intensive. The stock market boom in

Shenzhen in 1990 involved only five companies with a total face value of RMB230 million. The Shanghai stock market surge in 1991 engaged as many as seven listed companies and the aggregate par value was RMB76.62 million. Sichuan Province

initiated the pilot project of the shareholding system in 1983, and after several years of adjustment and the regulatory activities in 1992, there were 90 pilot joint-

stock companies, among which nearly 20% issued individual shares. In May 1993, I saw 64 kinds of internal shares or share certificates in the Hong Miaozi Market.

The total par value was more than RMB2 billion while the aggregate market value went above RMB10 million at the highest, outstripping the size of the early

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Shanghai and Shenzhen stock markets.

Another reason for the flourishing of the Hong Miaozi Market was that the

stock issuance happened before the stock regulation in China’s stock markets and private placement underwent a stricter approval procedure than public placement. Consequently, there were more than 2,000 companies which practiced non-

public offering of shares in the shareholding system pilot, and these companies

issued internal stock certificates worth RMB50 billion. The non-standard offering,

however, absorbed a large amount of social capital since many employee shares were issued beyond the scope of the issuing companies. This also led to confusion between private placement and public offering among the general public, and

stock certificates were traded together with shares in the Hong Miaozi Market. It can be said that this was a problem left over by the non-standard pilot project of the shareholding system.

Later on, the state government issued a document to prohibit internal stock

trading. Each province also stipulated that internal stocks or stock certificates had to be registered and managed by securities companies and could no longer be traded in the market. By then, private transactions had temporarily subsided.

I told the above stories to remind people of the distortions in the development

of stocks and stock markets. This will be helpful for us to form a correct understanding towards the following topics of equity and debt financing in the capital market.

Capitalization Can Create Capital Out of the Market One outstanding problem faced by New China during the planned economy

period was capital shortage. The Reform and Opening Up period which started in 1978 restructured the financial system and allowed banks to lend investment

loans on the basis of deposits. Since 1985 and during the entire 11th Five-Year

Plan period, the amount of bank loans used each year was one or two times larger than the national budget appropriation, and in this way, the idle social funds were fully utilized. The 30-year “large public finance and small banking system” was

gradually changed towards “relying on banks to support construction,” but this was just a small part of the achievements in the financial reform.

In the first 10 years of the Reform and Opening Up era, between 1979 and 1989,

despite the government’s efforts to attract foreign investment, the result was not

positive and China still suffered from a capital shortage. In 1990, China launched the pilot securities market which enabled the country to be able to develop capital

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from the market at once. In 2010, China’s securities market celebrated its 20th

anniversary. During the 20 years between 1990 and 2010, China’s securities market

completed the equity financing of RMB2.5 trillion for more than 2,000 listed

companies, realized the corporate bond financing of RMB2.9 trillion, and raised the investment funds of RMB2.51 trillion. The total market value of the Shanghai

and Shenzhen stock exchanges reached RMB26 trillion. It was the opening of the

securities market that gave birth to a mechanism to create capital. It did not have

the golden touch, but it was able to constantly develop massive capital out of the market.

Marx termed the formation of negotiable instruments as “capitalization” The prerequisite of capitalization is to open up securities markets. I would like to introduce some Marxist theories with respect to securities.

Marx called stocks, bonds, bank notes, national debt, and other negotiable

instruments “fictitious capital” and referred to the formation of fictitious capital as “capitalization.” There are five main features of capitalization: 1. By equating regular and repeatedly-earned income with interests, it regards income as the

returns provided by the capital lent out at a corresponding interest rate. So, all these negotiable instruments can be seen as ownership certificates for the surplus value of the expected return of certain capital. 2. These certificates of ownership evidence the claim to the future gains (interests, dividends, and bonuses). 3. The

prices of the negotiable securities will fluctuate along with the changes in interest

rates, expected production, as well as supply and demand. 4. The certificates meanwhile become the paper copies of real capital. They legally entitle the owners

to receive a portion of the profits generated by the capital. 5. It is precisely because of this that the value of fictitious capital is nothing less than a derivative of the future value created by real capital. Take stocks as an example. The value of a

company’s shares is the sum of the present value of all free cash flow generated

during the company’s duration. Understanding these basic theories is of great significance for us to research the capital market.

The planned economy denied capitalization, but the opening of the capital market enabled some companies to have the first try In the first 30 years of the planned economy after the founding of New China, the

government avoided saying “capital” for fear that the capital market would breed

speculation, so when the 1st Five-Year Plan of massive economic construction

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was initiated, China immediately closed down the Beijing and Tianjin stock

markets which had been established after the Chinese Civil War. For enterprises, all revenue and expenses were centralized in government finance, while all

credit was centralized in banks. Commercial credit and papers were not allowed

between enterprises, much less the issuance of stocks and bonds. At that time, China implemented ownership by the whole people, while lands, the means of production, banks, and financial institutions were owned by the state. All

resources, funds and products could only be mobilized by the state rather than

being traded. The fact that neither lands and mineral resources, nor companies’

assets including means of production, could be capitalized and China allowed no capital market, resulted in the lack of a mechanism for capitalization. Although

China owned lands, mineral resources, and the means of production, it was unable

to turn wealth into active capital. Back then, not only China, but also the entire Soviet Union and the socialist countries of East Europe, did not establish capital

markets or form mechanisms for capitalization, and they all suffered from acute capital shortage.

In the Reform and Opening Up period of 1978, China transformed its planned

economy towards a market-oriented system by starting commercial credit and bond issuance, opening the capital market, and allowing banks to moderately

enliven the financial market. It was not until 1990 when China opened its stock markets that raising capital through issuing shares was forbidden. Besides, the

long-time socialist education led to an untrustworthy inclination of the public

towards stocks and stock markets. The first mover was the SDB. Under the support of Shenzhen Municipal Party Committee, the bank made an attempt at public offering in 1987 in the hopes of raising RMB15.9 million, but it turned out

that no one would dare buy its shares. Later, although Li Hao, the CPC Municipal

Committee Secretary, took the lead to purchase the stocks, only less than half of the scheduled issuance amount was sold. Besides, the purchased shares, like savings, were unable to circulate, let alone appreciate.

In 1990, China opened Shanghai and Shenzhen stock exchanges. This, in

essence, allowed enterprises to circulate the assets with future earnings by way of

issuing securities, and thus formed a mechanism for capitalization which could exchange assets for capital and create capital out of the domestic capital market. This mechanism would also facilitate the socialist constriction of China.

An impressive example was Maanshan Iron and Steel Company Limited.

Maanshan Iron and Steel Company had a lot of trouble in borrowing several million renminbi from banks, but it easily raised several hundred million

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renminbi through public offering and equity financing. Later, the company was

listed overseas, and collected approximately RMB8 billion within just a few years in both domestic and foreign markets. Another breakthrough in this regard

was overseas listing and financing. Originally, China generally issued bonds in foreign markets to raise a maximum of several hundred million dollars. At that

time, there was a shortage of foreign exchange in China, and the foreign exchange reserve had only USD167 million in 1978. The number rose to USD5.6 billion dollars in 1989. In 1995, China’s foreign exchange reserve was still less than

USD73.6 billion. However, China Telecom (Hong Kong) which is now known

as China Mobile (Hong Kong), was listed overseas in 1997, and successfully leveraged USD4.22 billion from RMB19 billion of net assets. It displayed the

charm and power of capitalization. In the last 20 years, China’s stock markets

have grown prosperously, and Chinese enterprises could either get listed on the Shanghai and Shenzhen stock exchanges, or go public in Hong Kong, the U.S.,

and European markets. It can be said that the opening of the stock market has created a mechanism of capitalization in China.

The secret of capitalization is to turn the assets with future earnings into exchangeable capital What is capitalization? It is often said that the capital market is where assets are exchanged for capital. However, this view is incorrect. In fact, the value of

a corporation is not an asset, and not all assets can be traded for capital in the

market. The real value of a company depends on the assets’ capacity to create profits in the future, and it should be subject to the market, and ultimately decided by the mutual trading willingness of both buyers and sellers based on

the recognition of the value of two parties. That is because only the asset is able to create future profits and can be traded for capital in the capital market. On the contrary, the asset without future profitability cannot be exchanged for capital in

the market. And even though the asset can make profits in the future, there is still a development process before it becomes tradable in the market.

The real secret of capitalization lies in developing the assets with the future

income-earning capacity into exchangeable capital in the capital market. The so-called “development” is to make a company go through the process of “reorganization–corporate joint-stock reform–listing.” The purpose of this process

is to enable the company to own exchangeable and possessable stocks with clear

property rights, i.e. certificate of title, by restructuring the corporate assets and

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turning the company into a joint-stock one. This process, specifically, includes the following four aspects: First, corporate assets will be restructured to eliminate financial harm and improve the business; second, companies will undergo a

shareholding reform to become a joint-stock company; third, accounting judgments

will be made in relation to the property value and the income from the property;

fourth, a legal proof of property ownership is required; fifth, investment banks and investment bankers will evaluate, price, recommend, and guarantee the profit-

making ability of the assets and corresponding risks. Only through such massive efforts can assets be turned into the stocks which are able to be traded, circulated, and held, and eventually exchanged for capital after the company is listed.

Certainly, it is far from enough to just undergo the development process

and obtain recognition from investment banks; companies must also attract enterprising strategic investors, such as Warren Buffett and Li Ka-shing, who

will risk taking out money to hold shares. After knowing Buffett and Li Ka-shing

have invested in the companies, other social investors will follow suit, and until

then, the stock prices truly become the price in exchange for capital in the market.

Understandably, this becomes an indispensable process for pre-IPO companies

in the modern stock market that investment banks usually lead high-level management of the companies to hold roadshows, in the hopes of introducing the

managerial and operational skills of the companies’ management, namely profit-

making capacity, and pricing non-listed shares. Why did so many investment banks, including Morgan Stanley and Goldman Sachs, compete to go public since the 1990s? Why did private equity funds, such as Blackstone, suddenly get listed

after entering the 21st century? This was because they felt jealous when seeing that strategic investors would make a considerable fortune as soon as holding shares

of restructured and listed companies. Those investment banks and private equity funds planned to expand capital through listing and hoped that both the wealth

of companies and the human capital of investment bankers should be turned into

capital. By capitalizing their profit-making capacity, they expected to reap huge profits in assets restructuring and stock issuance.

Capitalization added huge capital for enterprises. In December 2010, there

were altogether 2,040 companies listed in the A-share markets in Shanghai and Shenzhen, which had issued 3.32 trillion shares with a cumulative market

capitalization of RMB26.54 trillion. If the market value of overseas listed companies (around RMB14 trillion based on the statistics of 2009) were also

included, capitalization through domestic and foreign stock markets contributed approximately RMB40 trillion capital to China’s economy.

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Circulation added wings to capitalization It should be particularly noted that circulation plays a special role in the capital formation mechanism, namely, the discovery of the value of companies’ capital

in the market. This function is called “value discovery” in economics. In a fullcirculation market, the reason why the stock prices of listed companies can rise above the net assets value is due to the value discovery function of the market. The

market finds in the circulation the value of the expected future earnings generated

by net assets. China implemented a planned economy for several decades, and it always viewed circulation as a great threat. First issued in 1980, the treasury bills were unable to be circulated in China until nine years later, and Chinese

residents had to privately cash in their treasury bills at a low price. Although stock

markets were opened in 1990, no state-owned shares were allowed to be traded.

In addition, 15-year equity division of tradable and non-tradable shares led to the difference in the prices of state-owned shares and tradable shares. Without circulation, the market will not discover the value of state-owned shares, and

these shares can only be sold in a transfer agreement by lowering the prices. The

equity division reform in 2005 realized full circulation of shares and since then,

all functions of the stock market have been restored. It can be said that blocked circulation is a painful lesson China has learned in the modern market economy.

To turn housing into an asset of households In the above, we talked about the capitalization of corporate wealth. Now, let us discuss the capitalization of family housing or in other words, how to make housing a household asset.

Prior to 1998, all the houses in China were owned by the state, and housing

was distributed as a welfare benefit for employees. For one thing, the government was burdened with providing countless overdue houses to employees; for another, the staff never bothered about applying for loans to buy houses, much less

imagined to make housing personal property. Naturally, the real estate industry could hardly become the pillar industry of China. Here, the turning point was the housing reform in 1998.

There was an interlude before the reform. In November 1997 when Zhu Rongji

made research in Shenzhen, he had an interesting conversation with Wang Shi,

Chairman of Vanke. At that time, the Southeast Asian financial crisis spread to

China, and China was about to implement economic policies to stimulate domestic demand. Many experts from the academic circle believed that as iron and steel

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and automobile industries were no longer working, the real estate industry should work as the mainstay industry to expand domestic demand. Premier Zhu wanted to hear about the opinions of Wang Shi, whose company is now the

largest residential real estate developer in China. Wang Shi, however, held the opposite view. He replied in a frank way: “I cannot project the housing industry

as a pillar industry of the national economy in the next two to three years.” An

important reason for his response was that although China’s housing reform had

been going on for nearly 20 years, the real estate market was not complete. In the structure of China’s residential housing system, only about 30% was commercial

residential houses, and more than 60% was the welfare housing provided by the

governments at all levels. This would be an obstacle in the development of the real

estate industry. Wang Shi’s answer surprised Zhu Rongji, and after a few moments of silence, the Premier asked: “If the welfare housing system is abolished, will the

real estate industry become a pillar industry?”1 Since the Reform and Opening Up,

China planned to develop the housing industry into the pillar industry, but this

wish was not realized due to the fact that welfare housing had not been made into products.

In 1998, the State Council issued a circular to reform the welfare housing

system, and not only was the welfare housing allotment in kind stopped, but

also the existing publicly-owned houses were allowed to be sold to employees

at a subsidized price based on the employees’ titles, length of service, and other factors. The housing-reform houses were priced below the construction cost, and also exempted from 70-year land use tax and deed tax. The circular also provided

that these houses after housing reform were allowed to enter the market after certain years. The market-orientated housing reform activated people’s investment

demand in houses, and drove the development of housing mortgage loans. Finally, China put an end to the nearly 50 years of welfare housing system and achieved a market-orientated residential housing system.

Housing mortgage loans realize the capitalization of residential houses Now, we will further clarify the relationship between market-orientated housing reform and capitalization.

To build a housing market will in the first place capitalize the land attached to

housing property. The land of China is owned by the country, and its ownership

cannot be transferred. What can be transferred is the 70 years of land use right. To

separate land use right from land in the circulation of the property rights of houses

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realizes the capitalization of land use rights. At this point, it is the same as the rural land use right transfers under the system of collective ownership. In this way, the capital value of land use rights will appreciate along with the differential benefits brought about by the supply and demand in the market and the agglomeration effect of the city, and go far beyond the non-transferable value of state-owned

lands. The huge difference in the prices between the public housing under the ownership of central government, schools, and military departments and

commercial residential buildings lies in the fact that the non-transferable value of the former causes the lack of recognition in the market. Ten years after the housing market reform, the residents who gained the property rights of houses in the welfare

housing reform benefited from the wealth effect resulting from the significant

appreciation of property rights and land use rights, and the government cultivated the economic growth by turning the real estate industry into a pillar industry, in

spite of the soaring housing prices being reproached by different parties, especially the people with no housing property. It is precisely because of this, that now

local governments are able to take advantage of land finance. Officials of local

governments can skillfully play the games of linking the increase in land used for urban construction with the decrease in land used for rural construction2 and turning land into capital, in the absence of economic knowledge.

Another important measure of the market-orientated reform is housing

mortgage loans. Housing can be the asset of an individual family, but to own such

a personal asset, one has to raise a considerable sum of money. What turns the private ownership of houses into a reality is the housing mortgage loans. Housing mortgage realizes the capitalization of residential houses. Of course, banks will issue housing mortgage loans to workers and residents against houses. But what

banks really value is the stable future income of borrowers. Housing mortgage

loans, in fact, capitalize the future income of an individual and a family in the form of loans, and turn the future earnings into capital.

It should be mentioned that the CCB had promoted housing loans at the

beginning of the 1980s, but the result was not satisfactory. Thanks to the policies of “welfare housing,” no one would borrow money to buy a house. Until the end of 1997, the balance of national housing mortgage only amounted to RMB19

billion, of which the CCB took the majority. In 1998, the termination of the welfare housing system spurred staff and workers to buy houses, which not only fueled the growth in the real estate market, but also promoted the housing mortgage loans. As a result, a capital formation mechanism which takes the property rights of houses (together with the occupied land) as collateral — or rather,

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takes the future earnings of house owners as financial guarantees — had been

established. Therefore, Chen Zhiwu commented on the housing reform in 1998 as “an epoch-making turning point,” and said that the reform opened a door for

the capitalization of lands, resources, and resident future labor income in China. After the housing reform in 1998, housing mortgage loans grew rapidly. Statistics showed that the balance of housing mortgage loans was RMB2.27 trillion in late

2006; RMB3.03 and RMB2.98 trillion by the end of 2007 and 2008; RMB4.76 trillion at the end of 2009; and the number reached RMB6.22 trillion in 2010. The housing

mortgage loans of more than RMB6 trillion signified the present value of the future income of multiple families, and the housing reform initiated the capitalization of the future labor income of residents. Through the financial tool of housing

mortgage loans, at least RMB6 trillion of financial capital was created. Statistics indicated that the percentage of housing loans to GNP was 15.3% in China in March 2010, while the percentage peaked at 79% in the U.S.

The origin of the term “housing mortgage loan” The term “housing mortgage loan” was borrowed from Hong Kong by the Shenzhen Branch of CCB in the early 1990s.

In the past, banks only made loans to property developers and the loans had

to be repaid when the buildings were erected and sold. At that time, Shenzhen

allowed individuals to buy houses, but the house purchasers were able to pay off

the total house payment at once, and had to resort to banks for loans. To meet such

a demand, the CCB Shenzhen Branch introduced housing mortgage loans from Hong Kong. Property owners applied for housing mortgage loans from banks to

pay for their houses, and developers used the money paid by the house owners to repay the construction loans to banks. In such a way, this economic circle was completed.

Capitalization has a broad prospect in China At present, the capitalization rate is still very low in China. The market capitalization of the U.S. stock market, bond market, and housing mortgage loans

accounts for 156%, 210%, and 90% of the country’s GDP. In 2010, the market value

of China’s stock market, bond market, and housing mortgage loans were RMB26.5 trillion, RMB20.4 trillion, and RMB6.22 trillion, and their respective proportions

to GDP were 66.6% and 51.2% and 15.6%. Therefore, China still has large room for

capitalization and it will be the source of continuously providing huge financial

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capital to the economic growth of China.

Capitalization can not only turn corporate assets into the capital of joint-stock

companies to be traded in the market and constantly develop the potential of the capital (known as the growth of capital in the capital market), but also transform

lands and other natural resources and the future earnings of workers into financial

capital through financial means in order to augment the financial capital of China. This embodies the advanced management and operation methods in accordance

with the laws of modern socialized production. It is an achievement of civilization

created by both capitalism and human society. China is a developing country, and

still in the primary stage of socialism. Every year, massive expected future income

streams from corporate assets or employees’ labor can be used in direct financing to expand the core capital of enterprises and the personal wealth of employees. To

build Socialism with Chinese characteristics, China has to maximize the socialized and market-oriented production and master the skills of managing capital and developing assets into capital.

Hernando de Soto: The mystery of capitalization lies in the property system which enables assets to be converted into capital Around 2005 Xia Xiaojun recommended a book to me: The Mystery of Capital:

Why Capitalism Triumphs in the West and Fails Everywhere Else3 by Hernando de

Soto. The author raised certain questions: What is capital? How is it produced?

Why has capitalism attained extraordinary achievements in the Western world — specifically the United States, Europe, and Japan — but stagnated elsewhere?

Why is it that most citizens still cannot use the law to convert their savings into

capital? The writer believed that capital was not achieved by accumulation and assets were not capital at birth. To make assets become capital, there must be a conversion process, that is, a suitable ownership mechanism. This mechanism is

able to bring out the potential of assets and convert them into something real for

the convenience of people to understand and use. Hernando de Soto grasped “the secret of the hen that lays the golden eggs” as it was called by Marx. His answer was: Western capitalism is prosperous because the capitalist countries in the West know the secret of capital, and form a mechanism of ownership which extracts capital from assets.

Hernando de Soto described six effects of the property system in the book:

1. Fixing the economic potential of assets. Formal property representation

functions as the means to secure the interests of other parties, and to create

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accountability by providing all the information, references, rules and enforcement mechanisms required to do so.4

2. Integrating dispersed information into one system. The reason why

capitalism has triumphed in the West and sputtered in the rest of the world is because most of the assets in Western nations have been integrated into one formal representational system.

3. Making people accountable. In advanced countries, the formal property

system transforms people with real property into accountable individuals, and thus brings them into a more integrated legal system.

4. Making assets fungible. In the West, one of the most important things

a formal property system does is [to] transform assets from a less accessible condition to a more accessible condition. Under a formal property system, each asset is like a block of ice, and the property system enables people to melt the ice

into water, or process the ice into water vapor, in order to rotate the blades of a turbine engine or power a steamboat, but the nature of the ice as water has been unchanged.

5. Networking people. A legal property system is the first real network in

the West. It is a living entity, and grows with each transaction, and is thus able

to recognize new economic potential and additional roles from the constantly developing property representation.

6. Protecting transactions. The Western formal property system works like

a network. All the property records (titles, deeds, securities, and contracts that describe the economically significant aspects of assets) are continually tracked and protected as they travel through time and space

Hernando de Soto repeatedly pointed out that the population migration

to cities had rapidly divided labor and spawned in poorer countries a huge

industrial-commercial revolution. If there is so much dead capital in the world,

and in the hands of so many poor people, why have not governments tried to tap into this potential wealth? Why is it that most citizens still cannot use the law

to convert their savings into capital? Hernando de Soto unveiled the secret: It is essential to create an appropriate property system under the context of the law.

He warned government authorities to respect the institutional innovation of

the property system. But through which means can we reach the opposite shore, since a formal property system has a number of benefits? According to Hernando de Soto, the most effective way is to respect the existing institutional innovations

outlawed by authorities, and integrate the effective “illegal regulations” into the formal legal system before widely promoting these regulations.

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Now that the existing property system has many benefits, why is it seen by the

authorities as “illegal institutional innovations”?

When looking back upon China’s Reform and Opening Up, I cannot help but

think of the closure of Chengdu Hong Miaozi Market for the exchange of private

company shares in 1994, the shutting down of Zibo Equity Exchange in 1998,

and the discontinuing of the trading of legal person shares through STAQ and NET systems in the same year. Despite an open and protective attitude towards the property system and multiple reasons for the closure of those markets, those

events represented twists and turns in China’s development. The 20-year arduous development and splendid achievements of the Shanghai and Shenzhen stock

markets were credited to Deng Xiaoping, who said the following words in his tour to South China in 1992: “We allow people to reserve their judgment, but we

must try these things out. If, after one or two years of experimentation, they prove feasible, we can expand them. Otherwise, we can put a stop to them and be done with it. We can stop them all at once or gradually, totally, or partially. What is there

to be afraid of? So long as we keep this attitude, everything will be all right, and we shall not make any major mistakes.”

Hernando de Soto is President of the Institute for Liberty and Democracy (ILD),

located in Lima, Peru. He is mainly engaged in formulating schemes of property system reform for more than 20 countries in Asia, Latin America, and the Middle

East together with the ILD. He was listed as “one of the most influential reformists in the world” by Time magazine and Forbes magazine.

While reading the book of Hernando de Soto, I reflected on the process of

China’s Socialist construction and the Reform and Opening Up period’s advances. During the first 30 years of the planned economy, Chinese people undertook large-

scale economic construction, but still could not transform the accumulated huge

assets into capital. During the more than 30 years of the Reform and Opening Up era — especially the 20 years when the securities markets had opened up

— the total market capitalization amounted to RMB26 trillion, the government debt reached RMB14.77 trillion (among which the debt owed by the Central Government was RMB6.27 trillion), and the corporate bond outstanding totaled

RMB1.1 trillion (the annual equity and debt financing of 2009 exceeded RMB900 billion). China’s stock market was ranked second in the world. Those experiences have shown that China has preliminarily established a mechanism which is able to transform assets into capital.

Reviewed today, Deng Xiaoping’s words on constructing socialist political

civilization are still pertinent to the development of the capital market. He said:

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“If socialism wants to gain advantages comparable to capitalism, it must boldly absorb and draw upon all achievements of civilization created by human society,

absorb and learn from the nations around the world, including the developed

capitalist countries, all the advanced mode of operation and management methods that reflect the laws governing modern socialist production.”

Chen Zhiwu: The secret of capitalization is to convert dead wealth into active capital In recent years, Professor Chen Zhiwu at the Yale School of Management wrote

two articles discussing the subject of capitalization. One article was called “If Dead Wealth Becomes Active Capital”;5 and the other was “The Mystery

of Capitalization.”6 I think those two works thoroughly reveal the essence of capitalization and the capital operation of investment banks.

As I said earlier, it is necessary to have a development process for converting

dead capital into active capital, and this process is capitalization. Chen Zhiwu

generalized this process of capitalization in two steps: first, to clarify the scale and

ownership of property rights and provide a supporting institutional framework to protect property rights; and second, to circulate the clearly established property

rights and turn them into transferable financial contracts that can be widely traded. Chen Zhiwu said: “It is in this way that the originally dead and immobile wealth will be converted into the capital which can produce more value and become active capital. Active capital is able to better generate money.”

He uncovered the secret of capital: We must distinguish among what is

money, what is wealth, and what is capital. He expounded on the relationship of the three. He said that from the perspective of Contract Theory, wealth is usually

commodities or goods, money is the carrier of value after goods are sold; and capital is more like the title deeds of goods. It is the money in a broad sense and the property rights in contrast to concrete wealth (goods).

He described the process of capitalization and concluded that wealth was not

necessarily converted into money at a stroke. The future income of individuals is

wealth, but if there is no financial instrument to cash in the future income through

bills and securities, the income is at most the wealth, which can only be felt but cannot be spent, rather than capital. If parts of future earnings are circulated in the form of title deeds (pledges), the future income stream can also be transformed

into capital. The “title deeds,” as termed by Chen Zhiwu, play an extremely important role in the process of capitalization.

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Wealth is larger than capital and capital is larger than money in scale. The

capacity of a country to capitalize wealth (goods) and the future income stream

— namely the systems of market, contract, and property rights — decide the distance between the above three. Fundamentally speaking, money is what is left

after wealth is sold, capital is the outcome of capitalizing wealth through property rights contracts, accommodation bills, and securities, and it represents the title

deeds of assets and future income stream. It is only through those title deeds that the originally existing but dead wealth (goods) and future income stream come alive and become active capital.

Chen Zhiwu divided the Reform and Opening Up era of China into two

phases. The first phase was between 1978 and 1990 when a planned economy was

replaced by a market economy, and the core of this period was the market-oriented reform. After 1978, almost all stuff was able to be traded in the market, including

all types of agricultural products, manufactured goods, the labor force, and real estate. The flexibility of market transactions increased year by year.

The second phase began in the 1990s, especially after 1998, and this stage

can be summarized as the period of capitalization. The market-oriented reform

just shortened the distance between wealth and money, while the reform of capitalization transferred the following four kinds of wealth into capital: 1. land

and natural resources; 2. business property and future income stream; 3. future labor income of individuals and families; and 4. future government revenue. These

four kinds of wealth are the core sources of capital for any country, but not all countries are able to convert these forms of capital and future income into capital. The prerequisite for this is the clearly defined property rights of these capital

sources, which allow the wealth to be circulated, or better still freely traded in the form of property right contracts. The reform of capitalization aimed to convert business assets (including physical assets and the future revenue stream), lands

and all kinds of natural resources, and future income stream of workers, into transferable financial capital by turning them into property rights, securities, and accommodation bills in order to augment the financial capital of China.

Chen Zhiwu further explained: “In the past, we focused more on the impact

of the industrial revolution, which happened 200 years ago, on human society,

but ignored the financial revolution which occurred 150 years ago. In the absence of the knowledge of this financial revolution, we can hardly find out the secret

of capital, let alone deeply understand the nature of the U.S. economy and the undergoing economic and social changes in China.”

Of course, Marx talked about the subject of capital more than 100 years

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ago. But the capital market had not yet been developed at that time, nor had it experienced the economic and financial globalization of today, so people did not

form profound knowledge of capital. It will be of a great help for us to understand

and utilize the capital formation mechanism in order to expand the capital for China’s economic growth, if we can clarify the relationships among money, wealth,

and capital, understand how to turn dead wealth into active capital, and establish a sound property system which converts assets into capital while taking into account the changes in today’s international financial market and the theories of Hernando de Soto and Chen Zhiwu.

Securities Markets Own the New Mechanism to Rapidly Expand Business and Capital This title is very catching. People cannot help but ask: Can securities markets

really raise capital for enterprises directly? As has already been said in the above, there were some remarkable numbers in China’s securities market: The market

has completed the equity financing of RMB2.5 trillion for listed companies, raised RMB2.9 trillion of debt financing, accumulated investment funds of RMB2.51

trillion 20 years after the opening of the market. The total market capitalization of the Shanghai and Shenzhen stock exchanges reached RMB26 trillion. Then, how did the securities market achieve direct financing?

As noted previously, under the market economy, the formation of business

capital mainly relies on the accumulation of capital or bank credit. Bank credit

is indirect financing, because banks will first absorb customers’ deposits before

granting loans to enterprises. Could there be a place where people in possession of surplus money directly trade with those in want of money? This led to the direct financing in the capital market, and a capital culture was derived from the capital market, including the listing of companies, securities financing, asset

reorganization, mergers and acquisitions, and so on. In particular, the securities

market has established a mechanism of capitalization, which can develop new capital out of the market. It manifests the great vitality of direct financing.

Enterprises are able to bypass banks as intermediaries and directly collect ready capital in society through issuing securities (stocks or bonds) in the capital market

in order to rapidly expand the scale of business and capital by annexing existing

businesses, completing business and asset reorganization, and forming enterprise groups.

In this section, I would like to focus on the question: What is the capital

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market, and how did it innovate the capital formation mechanism?

First, what is the capital market? To put it simply, a capital market is the

market where assets with future earnings can be converted into cash through

securities, namely where capital can be directly traded. In economic life, the capital market is usually the general name for all kinds of markets mainly dealing with securities transactions, including stock markets, government bond markets,

bond markets, investment fund markets, and the financial derivatives market, and it is often called the securities market. Capital markets in a broad sense refer to the markets for debt instruments with maturities greater than one year. These

markets also involve long-term bank loans and syndicated loans, as distinguished from short-term money markets for assets with maturity periods of one year

or less. In addition, the capital input mentioned in the previous capital mainly concerns the capital which has been invested in the real economy and formed certain productive power. In this chapter, we will expand our topic to the fictitious

economy and securities markets, that is to say, to include not only additional capital injection in the real economy, but also the transfer, circulation, and trade of

capital deposit of the society in the form of securities in the securities market, and the capital investment through asset-backed securities and financial derivatives in the financial field.

The capital market is the innovation of the capital formation mechanism on

the basis of social credit, shareholding system, and securities transactions. The innovation manifests itself in the following aspects:

1. The capital market is different from the indirect financing of banks, it

comprises direct dealings between capital users who establish enterprises by

absorbing capital and investment as assets and investors who own a significant

amount of surplus money, so it is direct financing. It allows enterprises to have a new mechanism of directly attracting capital beyond banks.

2. The securities market provides enterprises with a new mechanism to realize

the capitalization of assets. Truly, the assets of any business have already been fixed in production and circulation, and it is impossible to take physical assets (plants

and equipment) to the market displayed to investors or bargained for capital. The assets can only be traded with investors in the forms of negotiable instruments

evidencing ownership of equity (stocks) or debt obligations (bonds) with expected profitability under an intermediary’s recommendation or guarantee. That is why Marx called securities trading “transactions of fictitious capital.”

3. The securities market owns a sound mechanism of enlarging core social

capital. Businesses can absorb capital from society to directly expand their core

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capital through initial public offering (IPO) or secondary equity offering and let investors directly bear risks and corresponding benefits from investment. They can also choose to issue bonds. It realizes financing through borrowed capital as well, and debtors can collect money from creditors directly rather than through banks as

intermediaries. As opposed to bank loans, it is a type of quasi-core capital that has a corresponding time-limit and risks in the balance sheet.

4. The securities market displays three characteristics in aggregating capital:

First, it provides a comparatively stable investment place for all kinds of capital with no specific purpose (especially, different funds); second, it transfers a variety of sporadic capital into huge concentrated capital; and third, through the transfer of long-term securities between different investors, it turns short-term capital into long-term capital.

5. The securities market allows investors to directly put money to enterprises

(capital users) in the principle of risks corresponding to benefits. Different from the risks of loans which are overly centralized in banks, it disperses investment risks among investors. For example, stock investors will not only receive dividends

and earnings from premiums when stock prices rise, but also assume risks when the invested companies operate at a loss and their stock prices fall. As another

example, bond investors will be paid periodic interest at a high coupon rate and get back the principal at maturity, while in times of poor business management, it

is also possible to withstand default risks in the case where the principal may not be returned or repaid at discount.

6. The securities market not only directly increases capital input in real

economy and innovates the capital formation mechanism through issuing

securities (stocks and bonds) in the primary market, but also realizes the transfer, circulation, and trading of capital deposit-backed securities in the secondary

market. It promotes business mergers and acquisitions and assets restructuring

and achieves industrial structure adjustment by taking advantage of the market’s functions of value discovery and optimization of resource allocation.

7. The capital market offers a place for all investors to gain property income.

Investors can choose all kinds of financial products, such as stocks, bonds, and

investment funds to gain investment income as they deposit savings in banks in exchange for interest.

8. The transactions of equity financing and debt financing in the capital market

is not the simple trading between capital and assets. The capital market reflects a series of complex capital activities including capital financing, property rights flow,

corporate restructuring, debt restructuring, industrial expansion, as well as asset

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management. It is precisely because of this that the capital market not only allows the flow of securities, i.e. fictitious capital, but also enables the circulation of real

capital through business mergers and reorganizations. It manifests the market’s capacities in promoting industrial structural transformation and optimizing resource allocation.

9. Bonus shares and allotment of shares to existing shareholders of joint-

stock companies were other innovations of capitalization in the capital formation mechanism.

People tend to think that the profits of an enterprise should be distributed

to its shareholders as bonuses in addition to dividends. Western shareholding companies followed this principle to give out all the profits at the very start.

However, with the development of production, the joint-stock companies thought

their hands were tied by this practice and gradually knew to put aside a portion of profits as accumulation funds for expanded reproduction. Since the reserves were

used by companies’ assets and unable to be distributed in cash, this part of the profits was dispensed in the form of bonus shares. Over time, this practice evolved into the current popular bonus issue. Profits are distributed in stocks rather than

cash, and all after-tax profits are used for capitalization. This approach was widely

applied to the joint-stock companies in Shanghai and Tianjin, and Jiangsu, and Zhejiang provinces, before the birth of New China. The bonus issue capitalizes profits for enterprises in a mandatory way, and enlarges the capital necessary for

production. It also allows shareholders to cash in their bonus shares in the stock

market at any time since what they have received are stocks rather than cash. In the market economy, many listed companies will also launch new shares at a

price lower than the market price while distributing bonus shares. This is another innovation which has enlivened joint-stock companies. It gives an incentive to the existing shareholders who will be willing to take out money to increase investment and expand shares. Of course, shareholders can also transfer their warrants, which,

in fact, is the capitalization of stock options. The bonus issue and allotment of new

shares innovated the method of capitalization and capital formation mechanism.

They not only added new content to the stock market but also endowed joint-

stock companies with the vitality to truly realize self-accumulation and selfdevelopment, thus adding charm to stock transactions. In the pilot projects of

shareholding reform, the dividend payout in cash by Shenzhen Development Bank

(SDB) in 1988 aroused little sensation and people equated it with bond interest. But the bonus issue and allotment in 1989 and 1990 by the bank drew people’s

attention to the mystery of stock appreciation, and therefore stirred up the stock

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market boom in Shenzhen.

It needs to be noted that financing is just one purpose of developing the capital

market. The capital market is an open market on the basis of joint-stock companies. Once a joint-stock company goes public, it will become a public company with its shareholders from across society. The main aim of the capital market is to boost the construction of the corporate system, promote the diversification of property rights, and improve corporate governance structure with the help of financing. This should become the basic policy orientation for capital market construction.

Whether an enterprise should choose secondary equity offering or debt

financing when raising money in the capital market? This requires a cautious decision.

Seasoned equity offering is a double-edged sword. Although it means wealth

maximization of enterprises, when seasoned equity offering projects cultivate profits, the return to pre-existing shareholders will be diluted due to the expansion

of the companies’ shares. Logically, in a mature stock market, when a project’s profitability prospects are very prominent, existing shareholders do not welcome equity financing. In general, listed companies will first consider debt financing

and maximize the interest of existing shareholders by borrowing capital. In fact, to

simply pursue rapid growth and commit to enlarging a company’s size rather than

strength will not make any sense. Not only will the company’s earnings per share

not increase, but they may be diluted, and it is likely to raise the risk of bankruptcy. So some people suggest that if the financed project is not very profitable, it would be better to give the money to shareholders.

Listed companies, however, will choose a seasoned equity offering in the

interest of the management instead of shareholders. Because if an enterprise grows larger, it means that its market share will increase and the remuneration and

rights of the management will expand correspondingly. So when an enterprise faces an opportunity of rapid growth, it will be hard for management to resist the temptation. At this time, seasoned equity offering will expose the contradiction in interests between the management and shareholders in a listed company.

In foreign countries, enterprises do not completely rely on seasoned equity

offerings to realize expansion. There are mainly four funding sources for an enterprise to undertake expansion. The company can either collect money from

undistributed profits and depreciation within the company or resort to borrowing and issuing additional shares to raise funds outside the company. It is said that

the U.S. companies wait an average of 20 years to undertake a seasoned offering.

Companies mainly count on undistributed profits, depreciation, and loans to

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increase their scale and strength. The management of foreign listed companies

does not easily decide to issue additional shares, because this financing method contains uncertainty. For example, a project is estimated to need RMB2 billion, but

the company would probably just raise RMB1 billion to RMB1.2 billion in actual

financing, and it will impede the implementation of the project and make the project get caught in an awkward situation. Besides, the market will also make a rational response to the blind secondary offering of listed companies. On the one hand, with the growth of institutional investors, such as funds, they could choose

to directly participate in the company’s affairs or nominate their own directors and

dismiss the existing management. On the other hand, if the management performs

poorly, the stock price will go down and this will provide the competitors with acquisition opportunities. Only the companies which can withstand the test of the market will survive.

The economy of a country must establish a mechanism which can effectively

accumulate and concentrate capital and rationally reorganize capital on the basis of the market in order to utilize all capital (including idle funds, temporarily

idle funds, incremental capital, and stock capital) of the society more fully and

efficiently. This is the premise to ensure constant optimization and reorganization of social resources.

The Replacement of Banks by Direct Financing The largest contribution of the capital market is to bypass banks as intermediaries to allow direct financing between capital users and investors. It opens up a new

world for economic operation by substituting for the indirect financing of banks.

The further development of the capital market is to generate a variety of asset-

backed securities and investment funds, and build various kinds of derivatives

markets, and thus a large fictitious economy has been formed in addition to the real economy.

During the second half of the 20th century, the biggest change in the financial

area was the development of capital markets and direct financing causing the

contraction of the indirect financing of banks. Early statistics said that the balance

of loans in the U.S. commercial banks was approximately USD4 trillion in 2002 while the total market capitalization of the U.S. stock markets and bond markets amounted to USD21 trillion and USD22 trillion, respectively, in 2003. This group

of figures indicated that the function of long-term financing was mainly assumed by capital markets in the international financial market. In 2003, the proportion

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of financing through capital markets by U.S. enterprises accounted for 80%. Bank credit focused on working capital loans and consumer loans, and medium- and long-term loans occupied a very small proportion, usually lasting less than five

years. A more significant achievement of replacing banks with direct financing is to realize financial disintermediation by removing banks as intermediaries.

To balance investment return and risk by investors themselves becomes another important innovation in the capital formation mechanism. Banks have to break themselves free from indirect financing to directly engage in the transactions of various capital and assets in order to get rid of the long-term loans but short-

term deposits. This forced Western countries to break through the rigid separation

between commercial banking and securities businesses implemented ever since the Great Depression in the 1930s and move towards a mixed banking operation. The

over-development of various kinds of financial derivatives led to the latest global financial crisis.

China has implemented a policy which emphasized indirect financing since the

start of the Reform and Opening Up era, and evaluating the annual credit growth target of banks is expected. The Central Bank of China proposed “expanding the scale of direct finance” as early as 1996, but the laggard development of the capital market made it difficult to enlarge the scale of direct financing. Between

2001 and 2008, bank loans accounted for around 80% of the total financing of the non-financial sector while stocks and corporate bonds only took up 20% (19.5%

in 2009). It was reported in 2010 that the latter proportion may exceed 30%. The problem is that, on the one hand, the real economy overly relies on banks, and

despite the advocacy of the policy of “managing the supply of money and credit,” lots of loans are issued every year. On the other hand, the Central Bank has been

focused on the balance sheets of commercial banks and only takes into account the item of new renminbi-denominated loans, which cannot accurately reflect the total financing volume of the real economy. In fact, with the development of

the financial market and the active financial innovations, commercial banks are

constantly tempted to circumvent the control over credit scale. The innovations of various kinds of financial instruments, such as entrust loans, off-balance sheet business, and structured products, sped up the financial disintermediation in

China. But the financial statistics of the Central Bank overlook the data in this regard. The most recent dramatic change is that the Central Bank, after collecting various data (entrusted loans, off-balance sheet business, structured products,

assets, and debts) disclosed a figure: The ratio between bank credit and non-credit

financing has already reached 56:44 in 2010. Therefore, the working conference

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of China’s Central Bank in 2011 for the first time did not propose a new target

of annual credit growth but instead it suggested maintaining a reasonable social

financial scale. In the Report on the Work of the Government delivered by China’s Premier Wen Jiabo in March 2011, it was clearly stated: “We will keep financing

from all sources at an appropriate level ... We will increase the proportion of direct financing.”

Pilot Scheme in China’s Stock Market and Detours in Equity Division Reform Under a planned economic system, China had no capital market in the past, and

both the government and enterprises lacked experience in utilizing domestic

and foreign capital markets. For a very long period of time, China’s Socialist construction was often harnessed with the raising of capital. Initially, domestic

construction only knew asking for financial appropriation. It was 30 years later

when domestic construction sought out bank loans. The major channels to utilize foreign capital were usually limited to attracting foreign investment, hosting

international fairs for trade and investment, forming joint ventures with foreign partners, finding loans from foreign banks, and issuing bonds in overseas markets. Until 1990, China started the Shanghai and Shenzhen stock markets as a pilot

project. At first, the government only dared allow small enterprises instead of large ones to go public. In the early years of the stock market pilot project, the size of

listed companies was too small, and there were a considerable number of poorly performing stocks which posed a negative impact on the healthy operation of the stock markets.

Capital markets are at the top of the modern market economy. The construction

of the capital market must have a correct design at the very beginning. Under such

a design, the market should be strictly regulated to meet the international standard and gain continuous vitality and motivation for development, self-discipline, and

innovation. China’s capital market deviated from the proper course in its initial phase, and thus had to pay a heavy price for the next 10 years. What were the detours taken by China’s capital market?

First, in the pilot project of the Shenzhen and Shanghai stock markets, there

was a narrow-minded market concept as held by smallholders who cultivated test plots under the small-farm economy. When Shanghai and Shenzhen stock markets started in 1990, the Shanghai Stock Exchange only had seven stocks and Shenzhen

had five. At that time, China lacked the financial experience of developed capitalist

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economies, and believed that the stock markets could be gradually expanded after they were stabilized by ensuring the successful transactions of dozens of

stocks. However, China did not expect that the modern financial market would be the one which spanned across regional boundaries. Once stocks are listed,

they will be subject to not only the performance of these listed companies, but also huge finances and capital beyond geographical boundaries and the interests of possibly millions of shareholders. Take the seven stocks listed in the Shanghai Stock Exchange as an example. The total market capitalization of these stocks was

less than RMB4 billion, but they generated billions in capital. This would definitely

result in a surge in stock prices. Besides, the government authorities stuck to the pilot project of merely nine companies, and did not prepare a batch of follow-up companies to be listed in the market, create enough financial products to meet the overwhelming needs of investors, or have large enterprises like Shougang

Group and First and Second automotive group corporations with strong assets

and reputations to occupy and stabilize the market. Under the law of supply and demand, it was inevitable that stock prices were bid up and fluctuated suddenly.

Second, the shareholding system reform ought to start with large business,

but there was a historical limitation in the understanding and real practice in 1990. At the time, state-owned enterprises had gone through contract responsibility

reform, and dare not risk being labeled as capitalist economies by rashly echoing

the shareholding pilot reform. The decision-makers were both afraid of and unwilling to get large enterprises involved in the pilot project of shareholding

reform, because they thought that this reform would entail huge risks and large enterprises had a more significant bearing on the national economy and the

people’s livelihood than small enterprises. In addition, local government-owned

enterprises, village and township enterprises, and joint ventures had been under

partnership or collective ownership, and what they were in want of was capital, therefore, they had motivation to participate in the pilot reform. Consequently, in the early stage of the shareholding reform, there were large numbers of small-scale companies and 120 pilot companies left problematic stocks for the stock market.

Third, there was strong administrative intervention in the procedure of listing.

At the beginning, local governments had the rights to assign listing quotas, and

then they were in charge of recommending qualified candidates to be listed in the

market after the securities regulatory authority had determined the total number of listed companies for a certain period. As a result, the listing of companies which ought to be a market activity was manipulated by non-market behaviors of governments and showed a number of disadvantages. For example, the local

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governments used listing to support the poor companies and intended to encircle more money through the bundled listing of several companies as a group.

Fourth, China could hardly get rid of ideological constraints. Since the

government was afraid that stock flows may cause the loss of state-owned assets, it only allowed circulation of additional issuance of new shares to the public and secondary offering of state-owned shares could merely be transferred via

negotiation. This led to the long-term equity division and the difference in the

prices between tradable shares and non-tradable shares. On the one hand, stateowned shares were transferred at the price of net assets for a long time and never

sold at the market price since they could not circulate in the market. On the other hand, the market discovered the growth potential of enterprises, namely the expected earnings growth created by net assets, in the circulation of tradable

shares. Meanwhile, the market also found the value of tradable shares resulted from the short supply under the law of supply and demand, as most non-tradable shares were not allowed to circulate. Consequently, this gave rise to the abnormal

price growth of tradable shares. During the 15 years (1990–2005) of stock market development, more and more non-tradable state-owned shares were accumulated in the market. It caused equity division, a chronic disease which successive economic supervisors would hardly risk to treat.

However, a modern society is an open society. In particular, Hong Kong

became a special area for financial practice and effective communication of

financial knowledge between China and foreign countries. What truly made

China understand the financing in the capital market was the successful practice of overseas listed H-shares, N-shares, and red chips, including the back-door

listing of CITIC Pacific and Shougang Group, and the reverse IPO of SeaRainbow Holding Corp. Additionally, a number of showcase companies in some cities also realized reverse takeovers by creating shell companies. For example, China

Strategic Holdings acquired interests in the manufacturers of beer and tires

and was successfully listed in the overseas market; and Shanghai Industrial

Holding Limited stirred a boom in red chips when it went public in Hong Kong in 1996. These experiences taught the country about the allotment of shares,

capital injection, and corporate spin-offs. The stock market was continuously standardized and developed, some large enterprises went public, and a number of enterprises succeeded in increasing assets while reducing debts and restructuring through mergers and acquisitions. Consequently, project construction was able to

raise capital through corporate listing and trade the equity of assets for capital in addition to inviting investment.

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More importantly, the state-owned enterprises were in desperate need of

money to get rid of troubles then, and the stock market became the only way for state-owned enterprises to raise capital through the joint-stock reform and

corporate listing. This practice was quite controversial in the theoretical circle,

because some believed it brought about severe distortion in the capital market under the market economy, and created a way for administrative powerdominated resource allocation. It, however, opened up a new path for state-owned enterprises to undertake reform and overcome difficulties by providing a new capital formation mechanism.

The long-term equity division in China’s stock market resulted in the different

prices between tradable shares and non-tradable shares. During the 15 years

(1990–2005) of equity division, China adopted “conservatism” in the first 10 years. There was no loss of state-owned shares since they were forbidden to be circulated, but they also gave away the value-added opportunities. In 2001, China shifted

to “adventurism,” and came up with the measure of unloading state-owned shares at the market price in the hope of replenishing the national social security fund, but this led to the stock market plunge. Following that, the government implemented “flightism” by stopping the previous measure of trading state-

owned shares, but this halt of the practice was too late to reverse the situation. A bear market followed in the next five years and the Shanghai and Shenzhen stock markets were on the verge of collapse. The equity division reform of 2005 brought about the full circulation of shares. The market suddenly discovered the value of

enterprises’ growth, and the special role of China’s stock market as an emerging market. It pushed up the stock index of 2006 and 2007. The decrease in the holding

of the former non-tradable shares and the emergence of global financial tsunami

stemming from the U.S. subprime mortgage crisis, led to more than one year of the

market crash in 2008. The equity division and the corresponding reform in China’s

stock market can serve as a typical case for proving the special role of circulation in the capital formation mechanism in the history of the global securities market.

The circulation of state-owned shares was forbidden for 10 years. This, on

the one hand, prevented the value of these shares being found; and on the other

hand, these shares appreciated by being hoarded as non-tradable shares. After the

shares were allowed to be traded at the market price, the panic selling of tradable shares by social investors led to the collapse of the stock market. As a result, in the

equity division reform, the government had to carry out the measures of value

consideration, reverse share split, and bonus shares as compensations for the full circulation of state-owned shares. It was a great irony to the people who were

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strictly against the circulation of state-owned shares for fear of the drainage of state assets.

A stock market with full circulation displayed the contribution of asset

securitization in the capital expansion of direct financing to the capital formation mechanism. The significance of this reform is to have enlarged the core capital

of enterprises in the first place. Take the stock market of 2006 as an example. The market raised RMB559.4 billion in that year through stock issuance and allotment, and the assets or equity of listed companies were increased by RMB535 billion owing to the issuance of new shares, which correspondingly augmented

the market capitalization by RMB5,360.1 billion. Under the condition of a full circulation market, if shareholders of a listed company think it is necessary, they can trade a certain portion of the RMB535 billion shares in the market in exchange for cash based on the market price, and use this money to expand the core capital

of any new project they would like to invest in. Next, the equity division reform has promoted the appreciation of state-owned assets. Around May30, 2007 when the Shanghai Stock Exchange Composite Index was near 3,000 points, Liu Jipeng

made a calculation: In June 2005 when the equity division reform had just been started, the market value of tradable shares was roughly RMB1.4 trillion while that

of non-tradable shares was RMB2.8 trillion; two years after the reform (namely in May 2007), the market capitalization of tradable shares reached RMB6 trillion while

that of non-tradable shares amounted to RMB12 trillion. The market value of nontradable shares rose by RMB9.2 trillion compared to the figure before the reform.

Discounting the appreciation of general legal person shares by RMB1 trillion, the

increase in the value of state-owned shares and legal person shares in 852 stateowned or state-controlled listed companies rose up to a daunting RMB8.2 trillion. What did the appreciation of RMB8.2 trillion mean? First, it was 2.2 times more than the net assets of 157 enterprises owned by the Central Government at the end of 2006; second, calculated according to the budget standard of the Ministry of

Finance, the state-owned net operating assets added up to RMB8 trillion since the

establishment of New China 58 years ago, equal to the appreciation of state-owned shares within just two years of the equity division reform. The achievement of full circulation was a slap in the face of the people who argued that stock flows may

lead to the loss of state-owned assets. On the contrary, full circulation of stocks not only caused no loss of state-owned assets, but realized the growth in the value of state assets under the market function of value discovery.

By the end of 2008, there were altogether 1,710 companies listed on the

Shanghai and Shenzhen stock exchanges with a total stock issuance of 1,876.7

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billion shares. The stock index plunged in that year and Shanghai Stock Exchange Composite Index tumbled to 1,820 points at the end of 2008 from 5,261 in late 2007.

The total market capitalization of Shanghai and Shenzhen stock markets was only RMB12.13 trillion by the end of 2008, two-thirds less than that of 2007 which was

RMB32.71 trillion. The market value shrank more than RMB20 trillion within just one year. The number of investors, however, increased by a large margin. In 2007,

there were 60.57 million new accounts of investors, 11 times that of 2006 (5.38 million). The effective security accounts totaled 92 million and the proportion of institutional buyers accounted for 46%. It basically changed the long established

investors’ structure dominated by individual investors. The new accounts opened in 2008 were only 16.64 million, though significantly lower than that of 2007, three

times higher than the number of 2006. Furthermore, statistics showed that the number of A-share holding accounts remained above 47 billion, around 40% of the total accounts, which indicated that the existing buyers became more and more

mature in investment. Stimulated by the measures to expand domestic need and a loose monetary policy, the Shanghai Stock Exchange Composite Index climbed to 3,200 points by the end of 2009 from 1,820 points early that year, and the total market capitalization increased to RMB24 trillion.

In 2010, China’s securities market saw its 20th anniversary. The total number

of listed companies in the Shanghai and Shenzhen stock exchanges exceeded 2,000 with a total market capitalization of RMB26 trillion, ranking the second in

the world. It basically was on par with China’s economic status. In those 20 years, China’s capital market accumulated RMB2.5 trillion in capital for enterprises

through equity financing and RMB2.9 trillion through bond financing, vigorously supporting the fast and sound development of the real economy.

In a stock market with full circulation, the role of direct financing had been

markedly enhanced. In 2007, the stock markets raised RMB779.1 billion (including

secondary offering), breaking through the long-term financing limit of RMB100 billion per year. Despite a stock market downturn in 2008, the financed amount still

reached RMB333.6 billion. In 2009, RMB512 billion was collected through the stock markets, among which RMB202.2 billion was obtained through IPO and RMB309.8 billion was from secondary offering. This fully shows the financing function of the

stock market. Although bear and bull markets emerged alternately in those years, the equity division reform realized full circulation of stocks, increased the market’s

acceptance of large blue chips, and significantly improved the asset evaluation function and resource allocation efficiency of the market. This will lay a solid foundation for the comprehensive development of the capital market.

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The Development of the Bond Market In the development of the capital market, the bond market took a longer detour than the stock market.

National bonds Let us begin with national bonds. In the early days of New China, the governments

issued public debts. From 1950 to 1958, the country released six kinds of public

debts with a total of RMB3.84 billion, and distributed interest of RMB0.98 billion.

During this period, if there had been any innovation, it was the issuance of

commodity-based bonds in the early 1950s. This was because New China had just been established, and the inflation left over from the Second Chinese Civil War

could not be easily wiped out at that time. To convert money into commodities to maintain the value of currency was the last resort in the period of financial

difficulties. In the mid-1950s, the financial and economic situation had been basically stabilized and the government gradually felt that there was no need to

continue debt release. In 1958, the Ministry of Finance reviewed the past work

and concluded that the issuance of new debts according to budget was constantly

used to repay the old debts and thus could hardly attain financial balance. So it proposed to no longer release new debts and public debts would not be used

anymore as a tool to balance budgets. Until the end of 1968, a total of RMB4.82 billion in public debts and interest was repaid in full. Assistance loans of SUR71.41

billion sent from the Soviet Union in the early period of New China, especially during the Great Movement to Resist America and Assist Korea, were paid off

ahead of time in 1965. Under the extremely leftist thinking impacted by the 10 years of the Cultural Revolution, the Ministry of Finance published an article

signed by Cai Zheng in the People’s Daily to celebrate China becoming a debt-free — both domestically and externally — Socialist country.

After the policy of Reform and Opening Up was announced in 1978, the

power decentralization and profit sharing to local government and enterprises

lowered the proportion of financial income in national revenue. Therefore, it was difficult to maintain a balanced budget because construction expenditure was

very large. There were deficits of RMB17 billion and RMB12.75 billion in 1979 and

1980, respectively. Accordingly, starting from 1980, national debts were resumed but with a new name: government bonds. The government, however, continued

the inflexible practice of the planned economy and did not allow the transfer and circulation of government bonds. At that time, the financial authorities clung to a

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conservative understanding, and believed that if residents purchased government bonds, this represented the promise to support national construction financially. To

transfer the bonds, they would break the promise. Here, the financial authorities overlooked the factor that bond-holders may be forced to transfer their bonds out of special needs, not to mention the market needs of evading risks, making

profits, and speculating under market-oriented interest rates. Government bonds without circulation were lifeless and could hardly continue after several years.

The key construction bonds released in 1988 were planned to raise RMB3.5 billion, but until June 1989 only RMB1.25 billion were purchased, less than half of the expected amount. The issued bonds, on the other hand, became disposed goods

privately traded at a reduced price. The treasury bonds in Western countries were considered as gilt-edged bonds while the non-tradable government bonds

in China were deemed as discounted goods. This was a pity for the conservative authorities under the planned economy who knew little about market and circulation. In consideration of this, in 1988, the government had to launch a

pilot project in several cities to allow the circulation of government bonds, which

opened a way for the development of the bond market. Taking this chance, some well-informed people pocketed the price differences by purchasing government

bonds at discounts in small towns before selling them in large cities. This created a lot of rich people, including the famous millionaire Yang Huaiding, and helped the speculators of that age to realize the primitive accumulation of capital.

The innovation in China’s government bonds, if any, was the release of three-

year inflation-linked bonds in 1992. The nominal interest rate was scheduled to be

9.5% per year along with an inflation-linked subsidy. This innovation, however, caused great trouble. The problem stemmed from the pilot transactions of treasury

bonds and futures, and following the three-year-term government bonds, the government created the treasury bond futures contracts coded 327. Treasury bond futures aimed to hedge or to speculate on the price movement of bonds. Originally,

the market value of fixed-rate bonds was susceptible to only one variable: the

fluctuations in interest rates. But since these government bonds would also be

influenced by the rate of inflation-indexed subsidy, they increased the temptation

to excessive speculation. One year later, the Central Bank raised the interest rate of three-year deposits to 12.24% in July 1993, and created a two-year interest

margin. Whether those bonds would compensate for the difference in interest rates at the maturity date became another unknown mystery. Within more than one

year from July 1993 to February 1995, the Ministry of Finance did not give a clear

decision and various guesses were made in the market. Behind these rumors, there

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were the bets worth millions of renminbi. Eventually, the bets resulted in a huge gamble of billions in February 1995. Until February 24, 1995, when new treasury bonds were scheduled to be launched, the government authorities announced compensation to the bond holders. In this way, the treasury bond futures which

contained three variables — interest rates in the market, inflation-linked subsidy ratios, and compensation to the interest rates difference — brewed the famous

“327 bond incident.” This brought about tremendous pain to the financial circle

and to this day many people still hold a negative attitude towards treasury bond futures. (Please refer to Chapter 15 for more information on the “327 bond futures scandal.”)

The size of government debts and the risk of loans to local government financing vehicles At the end of 2010, the government debts of China amounted to RMB6.75 trillion, accounting for 16.96% of that year’s GDP (RMB39.79 trillion). According to the

report released by the National Audit Office, the outstanding debts owed by the

local governments at the provincial, municipal, and county levels added up to RMB10.71 trillion, 26.91% of the GDP. If the local treasury bonds of RMB200 billion issued by the Central Government on the behalf of local governments every year

from 2009 to 2010, and the implicit liability of the public sector were also counted, the proportion of outstanding debts of the public sector to GDP was around

50%, within the warning line of 60%. So, when Jia Kang, Director of the Research

Institution for Fiscal Science under the Ministry of Finance, was interviewed by China Economic Times, he said: “The audit results help us to form a basic judgment that the total debts of the public sector are generally within the safe area calculated based on the key indicator of debt-to-GDP ratio.... The debt volume has no problem and is still in the “green-light zone.”

The cause of the problem was that since 2008, the loans to local government

financing vehicles grew too fast, and the different standards and calculations

from the Central Bank, China Banking Regulatory Commission (CBRC), and National Audit Office gave rise to various interpretations of this phenomenon.

In addition, the hasty embarkation of some projects aroused all kinds of doubts

towards local government debts, such as low efficiency resulting from executiveled operation, insufficient cash flow to cover principal and interests, and repayment risk for banks. Besides, since 2009, the CBRC frequently prompted and demanded in its documents that it control the risks of the loans to those vehicles.

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Local governments and commercial banks, on the other hand, thought the risks

were controllable, and within the capacity of cash flow, therefore they did not worry about non-performing loans. In April 2011, the CBRC released a document

which required the effective risk regulation of borrowing by local government-

backed investment units. It emphasized the control over newly-increased loans and the mitigation of the risks of existing loans. In particular, the loans which were transferred into corporate loans under the endorsement of the CBRC and

the related banks and governments would continue to enjoy support based on business principles, while those loans to government-backed financing vehicles

would not be aided, if their cash flow was below standard and the capital funds

and collateral were not sufficient. The financial media reported that the CBRC laid

a heavy hand on local government-backed investment units by allowing no loans to new projects, no extended terms, and no borrowing for repaying. But, to make remedies was undoubtedly necessary and correct.

I believe that we must hold a correct understanding towards the risks in

relation to local government debts and search for a permanent solution to improve the system.

First of all, local government-backed investment units were born as a result of

the RMB4 trillion stimulus package launched by the Chinese government against the global financial crisis. And there was an inborn defect in the system. Among the

stimulus package of RMB4 trillion, the Central Government would be responsible for RMB1.2 trillion and the rest would be the burden of local governments and

enterprises. However, in fear for excessive investment made by local governments, the country emphasized the balance of local finance all along and forbade the

issuance of bonds by local governments in law. Consequently, local authorities

set up financing vehicles to raise funds for various projects and leveraged bank loans. Among these projects, some may not be very effective and the cash flow

may hardly cover both the principal and interests. But the debts of China’s local governments were distinct from the public debt crisis in Greece and other

countries. Greece released government bonds to pay the operating expenditures of

the government, while the loans to local government-backed financing vehicles in China were mainly devoted to public works and infrastructure construction, and

the debt increase would at the same time bring about the growth in government assets. Even if the cash flow of some projects cannot pay the principal and interests, the gap should be filled by the budget instead of being considered as

bad debts completely shouldered by banks. The government officials should not

easily get rid of those debts, which may cause public dispute. The results of the

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audit indicated that among RMB10.71 trillion of local government debts, the local

governments had repayment liability for RMB6.71 trillion, accounting for 62.62%;

warranty liability for RMB2.33 trillion, representing 21.8%; and rescue liability for RMB1.66 trillion, constituting 15.58%. There were, of course, some structural risks caused by excessive and uneven debts and close repayment dates of the public

sector, but the debt size and risks of the entire local government financing vehicles were lower than market expectations and less serious than some people had thought.

Second, the tax system should be further reformed. The direction of the tax-

sharing reform in 1994 was correct. It greatly motivated local governments,

especially governments at municipal and county levels, and in fact became the largest power for China’s rise. After 1994, however, as the urbanization of

China sped up, the public expenditure borne by local governments increased

dramatically, beyond the revenue received by the governments under the existing

tax-sharing system. Local governments had to rely on land-sourced fiscal revenue and bank loans to compensate for the gap. The reform of the tax system, therefore,

should at least modestly adjust the proportion of revenue to local governments and enable the governments to have enough financial capacity to fund public expenditure under the support of the tax system. This is of great importance.

Third, local governments should be allowed to issue bonds. At the same time,

local budget management should be further improved in terms of standard level

and transparency and citizens and the market should be effectively motivated to supervise and oversee government borrowing. If we want to minimize the financing risks of banks and local government-backed investment units, the risks of public expenditure and commercial loans must be strictly separated, and the

financing structure dominated by bank loans in funding public works should also be changed. After all, under the instruction of “controlling the risks of new loans

while reducing those of existing loans, and undertaking risk reevaluation” by the CBRC, there will always be some projects whose risks will be shouldered by

governments rather than banks. The Central Government ought to create financing channels for local governments to pay for those expenditures in tax system and municipal bond system.

Fourth, loans to local government financing vehicles should follow the laws

of construction projects. Medium- and long-term contracts will be signed based

on project duration, and payment plan will be in accordance with construction progress. The so-called “no new loans, no extended terms, no borrowing for

repaying” should refer to no more loans to new projects. We should not force

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commercial banks to sign contracts with existing projects once a year, and cut off loans easily, lest the projects will be suspended waiting for money or stopped halfway. This is the biggest fear in financial management.

The negotiable instrument law turned corporate bills into bankers’ acceptances and directed all corporate financing risks to banks The development of the corporate bond market was more complicated than that of the treasury bond market.

The order of economic development should be bill market before corporate

bond market and bond market before stock market. China, however, adopted an extremely utilitarian attitude. It started from satisfying the capital financing needs

and placed the stock market in the first place. China had three misunderstandings of the bill market: 1. Commercial bills will attack financial order and thus companies are not allowed to issue promissory notes. The financial authorities

believed that only banks have the right to issue currency. Moreover, there was

a rigid understanding that socialism was against business credit because all bills would disturb the finance. Accordingly, enterprises were prohibited from

launching promissory notes and all credit was centralized in banks. Even the meal vouchers of government departments and enterprises should be printed “no circulation.” 2. After the Reform and Opening Up era began, the Law of the People’s

Republic of China on Negotiable Instruments turned corporate bills into banker’s acceptances and banks bore all risks of corporate financing. This actually reflects the rigid theory of “all credit being centralized in banks.” The provision not only

forbade the financing through commercial papers, but also tied bank credit closely

with commercial credit. It became an obstacle in expanding business financing and adjusting the proportion between direct and indirect finance. 3. The government later stipulated that commercial papers should be based on real economic

behaviors, and would not be issued to increase the liquidity of enterprises. From

here, we can see that financial authorities stuck to the rigid theory and could hardly get rid of the overly cautious attitude.

The release of enterprise bonds with purchase rights From the 1980s, China began to allow some institutions affiliated to Central

Government departments and state-owned enterprises to raise money for construction projects through the issuing of bonds. At the beginning, the bond

credit was not high which made the bonds different to sell. Later, a new kind of

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bond — enterprise bonds with purchase rights — was launched. Around 1983, I

worked for the China Construction Bank. I remembered that representatives from China National Machinery Industry Corporation sought us out to discuss raising

money from the market for the automobile construction of the 6th Five-Year Plan. The development of the automobile industry during the 6th Five-Year Plan

required approximately RMB13 billion. At first, they thought of issuing stocks. Then, I suggested that the company had to be changed from a state-owned system

into a joint venture, and that the company had to admit the ownership of assets by shareholders, and a shareholder meeting should be convened regularly to disclose

company accounts. They felt that it was very difficult to change the system, so they considered enterprise bonds, but were still afraid that no one would purchase

them. Cars were considered scarce resources then. At last, they decided to issue a kind of enterprise bond which contained the purchase rights to automobiles. In other words, a certain amount of enterprise bonds will entitle the owner to

purchase several cars in the future. In this way, the bonds were easily sold. As far as I can recall, the factories of many scarce resources, such as steel and cement,

launched similar enterprise bonds, and it became a unique feature of China’s bond financing in the early stages of Reform and Opening Up.

Overlapping management slowed down the development of the enterprise bond market For a long time, enterprise bonds developed slowly in China. This had a direct relation to multi-end management. This implies a distortion in ideology and system. The bond issuance ought to be within the business scope of the financial

field, and have nothing to do with the State Planning Commission (later known as the National Development and Reform Commission). And under the planned

economy, China usually assigned the State Planning Commission to take control of the enterprise capital construction and funding sources. To prevent excessive

investment, the State Planning Committee also held the approval right of new

project bonds in its hand. From then on, the issuance of bonds was totally

controlled by a non-financial institution in China. The State Planning Commission determined the size of bond issuance each year and was responsible for granting issuance permission. It emphasized the connection between bonds and

construction projects, and thus made bonds the dedicated financing instrument for projects. In addition, the interest rate of bonds would be set by the Central Bank and transactions would be regulated by the China Securities Regulatory

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Commission (CSRC). Overlapping management is precisely an important factor

hindering the development of China’s bond market. Meanwhile, China has strict requirements as to the issuers, asset scale, and funding purposes of enterprise

bonds. This limits the qualified issuers mainly to state-owned enterprises and key

enterprises, and non-state-owned enterprises are largely excluded. The market capitalization of foreign bond markets was generally equal to around 100% of their

GDP (the United States 143%, Japan 136%; and 15 European countries 92%). In 2007 and 2008, the total value of outstanding bonds in China’s market were RMB12.32

trillion and RMB15.10 trillion, representing 47.9% and 50% of the respective years’ GDP. Among them, the market value of enterprise bonds was only RMB680.3 billion, accounting for 2% of GDP. Statistics showed that the financing amount

of corporate bonds was 10 times that of equity financing in the U.S. In 2007 and 2008, China had issued enterprise bonds of RMB183.2 and RMB265.5 billion,

respectively, equal to 23.5% and 79.5% of the corresponding years’ stock financing. It can be seen that it is of great urgency to change the overlapping management of

enterprise bonds and implement unified planning, examination, and management by financial department.

Another systematic barrier in the development of the bond market is the

man-made division. Before 1997, there was only one market for the trading of

bonds, namely the exchange-traded market. In 1997, there was an illegal treasury bonds repurchase in the exchange market, which caused systematic risks. So the

higher financial officials decided to keep banks away from the stock market. To

prevent capital illegally flowing into the stock market, the State Council called

for all commercial banks to step out of the bond market and the subsequent establishment of an interbank market (over-the-counter market). Since then, the

bond market has been divided into the interbank market and the exchange market, and the transactions, registration, and custody of bonds in the two markets are

under separate management of China Central Depository & Clearing Co., Ltd.

(CCDC) and China Securities Depository and Clearing Company Limited (CSDCC). The State Council stipulated that treasury bonds should be registered with and in the custody of CCDC and issued and traded in the interbank market. After 2002,

the Ministry of Finance allowed the issuance of treasury bonds in both markets.

Enterprise bonds can be released in the interbank market and may be transferred to the exchange market later. Convertible bonds and bonds with attached warrants would be launched and traded in the exchange market. In fact, the distinction between the two markets was blurred.

Fundamentally speaking, in the development of the bond market, China has

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to overcome the two obstacles of overlapping management in bond issuance and

man-made separation in the bond market. Only when the relations of production are straightened out, can we boost the development of productive forces. This Marxist theory is frequently repeated by us, but in practice, profits cloud the minds of government officials. Divorcing theory from practice becomes the stumbling block in the development of productive forces.

Short-term financing bills, medium-term notes, and corporate bonds At the dawn of the new century, the financial sector worked hard to promote a variety of direct financing options and tried to carry out major reforms in bill

financing. Such measures were in an attempt to break through the dilemma of

the National Development and Reform Commission (NDRC), which controlled the issuing of enterprise bonds, having accomplished nothing in the face of the financing difficulties of companies.

In May 2005, the monetary authorities engaged in notes financing by bypassing

the examination of the NDRC on enterprise bonds in order to lower bank financing risks and expand enterprise direct financing. They allowed large enterprises to

issue one-year bills, called “short-term financing bills,” as an alternative to oneyear loans. This was the first breakthrough in corporate financing.

Then, the second breakthrough was made when the CSRC promulgated the

Experimental Measures of Corporate Bond Issuance in July 2007. These measures bypassed the control of the NDRC over enterprise bonds and rightfully carried out a pilot scheme starting from the corporate bonds of listed companies.

The third breakthrough was a larger reform initiated by the Central Bank. In

2008, the Central Bank allowed non-financing enterprises (including non-listed

companies) with legal personality to release liabilities of three to five years, known as “medium-term notes,” as a substitute for medium-term loans below five years.

It should be said that short-term financing bills and medium-term notes

were two innovations of China’s financing instruments. Those two innovations overcame the obstacles created by China’s Law on Negotiable Instruments, which

only allowed enterprises to issue bankers’ acceptances instead of promissory notes

and endowed the NDRC with the approval right of enterprise bond issuance. So enterprises have gained two bond financing tools which will remit principal

and interest in a given period and the bond market has injected new vitality

with two new kinds of bonds. Under the circumstance of the non-financial sector with no intention to forgo the control over enterprise bonds, the creation of these

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innovations is truly an alternative way to save the market.

During the pilot project of short-term financing bills in 2005, the offering size

of the bills exceeded RMB100 billion. Impacted by the “Shanghai pension scandal”

in July 2006,8 the issuance of short-term bills slowed down but still outnumbered RMB290 billion in 2006. Up to the end of November 2007, there were more than

565 short-term financing bills with a total value of over RMB750 billion, far larger

than other corporate debts. In 2008, the short-term financing bills were estimated to be RMB433 billion. Then, in 2008, 41 middle-term notes were launched and

they totally raised RMB173 billion. In the pilot project of corporate bonds of listed companies, the bond issuance collected RMB11.2 billion in 2007 and RMB22.8 billion

in the following year. Those three innovations of direct financing broke through

the barrier of non-financial sector approving bonds, greatly eased the financing pressure of companies, and indirectly dispersed the risks of bank loans.

In addition, the corporate bond market removed bank guarantees in 2007.

Bonds were issued under the system of verification rather than examination and

approval and middle-term notes were issued under the registration system. In this

way, enterprises released debts by relying on their credibility. It drove forward the development of the bond market, especially the corporate bond market which turned a historic page.

New changes in China’s enterprise bond market With the economic and financial advances in China, the bond market grew rapidly.

During the financial turbulence triggered by the U.S. subprime mortgage crisis, the

prosperity in China’s corporate bond market constituted a special kind of Chinese characteristic of the international capital market.

The outstanding changes in China’s bond market since 2008 were as follows:

1. By the end of 2008, the total trading volume of the bond market including

repurchasing and transactions in cash surpassed RMB10 billion, and developed from RMB404.7 billion in 1999 to RMB100.8 trillion. Among these transactions, cash transactions increased from RMB9.8 billion to RMB40.8 trillion, and repurchases grew from RMB394.9 billion to RMB60 trillion with both realizing a historic leap.9

2. The enterprise bonds for the first time broke through RMB400 billion to

reach RMB421.43 billion in 2009. The enterprise bonds outstanding was RMB1.1

trillion, exceeding RMB1 trillion for the first time. It was a milestone in the history of China’s capital market.

3. In 2009, China totally released medium-term notes of RMB695.89 billion,

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short-term financing bills of RMB447.91 billion, and corporate bonds of listed companies of RMB71.29 billion. Together with enterprise bonds, the total volume

of direct debt financing of the non-financial sector for the first time outnumbered

RMB1.5 trillion. In 2009, financing through IPO reached RMB202.20 billion, money raised through seasoned equity amounted to RMB309.81 billion, and the volume of direct equity and debt financing exceeded RMB2 trillion. The rapid growth of direct financing was another milestone in China’s capital market.

4. Five-year term enterprise bonds became the mainstream varieties in the

enterprise bond market, and middle-term bonds became more and more popular. Among the enterprise bonds issued in 2009, five-year bonds accounted for 33.62%, 13.26 percentage points higher than the proportion of the previous year.

5. When issuing bonds, companies rely more on credit themselves and third

party guarantees, and the dominance of banks dominating the guarantee system

has been changed. In 2009, the third party guarantee mechanism became the most frequently chosen method in enterprise bond issuing, followed by accounts

receivable pledging agreement. Other guarantee means including land use right

mortgage, pledge of stock rights, and sinking funds were also applied in actual practice. In addition, more and more companies with high credit ratings launched debenture bonds, which also won recognition from the market.

6. The total volume of corporate bonds, enterprise bonds, medium-term notes

and short-term financing bills amounted to RMB1.67 trillion in 2010, roughly on the same level with the amount issued in 2009 (RMB1.66 trillion). Compared to

the money raised in the stock market, which was RMB1.26 trillion, funds collected through bonds were 31.4% higher in 2010. It was evident that the bond market had made considerable progress.

Radical reform is necessary for big developments in the bond market A major event in the bond market in 2010 was the joint release of Notice on the Pilot Participation of Listed Commercial Banks in Bond Trading on Stock Exchanges by the CSRC, The People’s Bank of China, and the China Banking Regulatory

Commission (CBRC). Since then, listed commercial banks were allowed to enter stock exchanges. Caijing Magazine called this notice the foundation for the interconnection between commercial banks and stock exchanges after 13 years of separation and seven years of negotiation among relevant government

departments. However, this reunion was not easy. Although stock exchanges

were positive towards this new policy and the CSRC was also considering the

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bond issuance of large enterprises, this policy as pointed out by some bankers

“has greater symbolic sense than practical meaning” and can hardly reverse the “declining tendency” of bond transactions if analyzed deeply. Therefore, Caijing Magazine predicted that the bond market structure collectively dominated by

Central Bank bills, financial bonds, and government debts will continue to exist in the short run, and the split pattern of the bond market will not be fundamentally changed during the 12th Five-Year Guideline.

Statistics from the bond market indicated that the turnover of bonds decreased

year by year ever since the launch of corporate bonds in 2007. From the beginning

of 2010 to November 4, the cumulative turnover of bonds of the exchange bond market amounted to RMB5.22 trillion, representing 4.02% of the total bond market turnover. The interbank market turnover totaled RMB129.71 trillion, accounting

for 95.98% of the overall gross turnover in the bond market. Why has there been a downward trend in the exchange bond turnover? It clearly related to the poor liquidity of the exchange bond market, the lack of institutional investors, low

approval efficiency of corporate bond issuance, and the inherent weakness of the high issuance costs of bonds. The advantages and weaknesses of the two bond

markets were explicit when compared from issuance efficiency and investment sources.

First of all, the interbank market practices a registration system and its funding

mainly comes from commercial banks, insurance companies, and other large financial institutions; whereas the exchange bond market lacks large institutional investors, and the main investors for corporate bonds are fund companies,

securities firms, and small- and medium-sized investors. So, the exchange bond market has limited market capacity and poor market acceptance.

Second, it generally takes approximately three months for the bond issuance

in the interbank market but at least six months in the exchange bond market. Therefore, since 2008 when the interbank market launched medium-term notes,

many good-quality listed companies would choose to raise money by releasing middle-term notes in the interbank market.

Finally, a more important fact is that when stock markets suffer a decline in

mobility, the CSRC will tighten the approval process of corporate bond issuance.

This is also the reason why so many listed companies are not willing to launch corporate bonds in the exchange bond market. It is said that China Telecom planned to undertake corporate bonds in 2008, but since the issuing volume was

large, there was not a sufficient number of investors despite the Shanghai Stock Exchange’s efforts to promote market subscription, so those bonds were transferred

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into middle-term notes to be issued in the interbank market. Companies generally

believe that the interbank market is preferred in terms of issuing efficiency and financing costs.

In order to promote the development of the bond market, securities

supervisory authorities are considering a timely reform in the issuance method. The NDRC is brewing a simplified issuing approval procedure, and plans to try out the issuance policy of “issuing first and registering later” of the bonds targeted at institutional investors. In other words, issuers, investors, and intermediaries

can collectively discuss the details of bond issuance, and relevant issuance

materials will be delivered to the competent authorities for recording after the

bonds are released. This mode will be able to take full advantage of the strong risk identification ability of institutional investors. If a violation or fraud occurs, a warning will be given for the first time, and a suspension of bond issuing will be ordered for the second time.

In comparison to the NDRC, the interbank market is faster in financial product

innovation. It was reported that the National Association of Financial Market

Institutional Investors was considering the private placement of debt financing instruments for non-financial enterprises in the interbank bond market, namely

“private placement bonds.” The proposal has been approved by its own Council

and will soon be launched. This issuing method will bypass the debt ceiling of 40% (the ratio of accumulated outstanding bonds to net assets), and the bond issuance goes first before registration. Some insiders commented that the innovation of

private placement was of essentially the same importance as the release of middle-

term notes. Besides, I remembered that in the early years of Reform and Opening

Up, when we discussed the bond issuance with representatives from the Japanese

financial circle, they talked first about the methods of private placement. It seemed that China CITI Bank started from private placement when releasing debts in Japan.

Relatively speaking, corporate bonds were issued intermittently, which

received much reproach from the market. Stock exchanges have proposed the issuing before registering of corporate bonds, but the CSRC took a prudent attitude to avert risks.

In October 2010, the Fifth Plenum of the 17th Central Committee of the

Communist Party of China (CPC) passed the Proposal of the CPC Central

Committee for Formulating the Twelfth Five-Year Plan for National Economic and Social

Development. In the tenth section of “Speeding up reforms and improving the socialist market economy,” it clearly stated the need “to actively develop the bond

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market.” Now, authorities of relevant departments are committed to simplifying the approval procedure of securities issuance, and enlarging and strengthening

the markets under their respective control. However, if the authorities continue to act in their own ways in terms of regulatory standards, the larger the future market size, the higher the difficulty in regulatory coordination. The fundamental solution is to change overlapping management and market segmentation, reshape the pattern of interests of each government department, and push forward the

unification of markets for the long-term development of the bond market. I think that if the bond market wants to develop to a large extent, large-scale and radical reform will be indispensable.

The Development of a Multi-Level Capital Market Is Inevitable The finance of enterprises should be divided into capital financing and short-

term borrowed capital financing. The two are different in financing channels and

approaches. Business capital financing, including venture capital financing and capital expansion, is a long-term demand for funds. It has higher costs, and higher risks and returns than loans, but does not need to be repaid in the short term. This kind of funds can only be raised through the direct financing in the capital market,

sometimes through equity participation of joint stock companies, venture capital firms, and investment funds, over-the-counter (OCT) dealing, and company

listings and share capital expansion in local equity exchanges and securities markets. This is an inherent part of capital formation mechanism and cannot be replaced by bank loans or main-board market.

In the development of China’s capital market, the government has only

focused on open stock markets but overlooked the importance of OCT markets, local equity exchange markets for middle- and small-sized enterprises, growth enterprise markets (GEMs), and other kinds of markets. Figuratively speaking, it is

“the blossoming of a single flower.” In fact, the market economy always develops spontaneously at first and will experience a gradual process. In the Shanghai and Shenzhen stock markets, the stocks of Shanghai Feiyue Audio Equipment,

Shanghai Vacuum Electron Devices Co., Ltd., and SDB, emerged spontaneously for the purpose of raising venture capital or expanding capital. Without any loan sources, those companies had the need to collect money through issuing stocks

and trading their shares. Then, along with the pilot project of the Shanghai and Shenzhen stock exchanges, the government opened STAQ and NET markets for

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the exchange of legal person shares, and many local equity markets for non-listed

companies, such as Zibo Equity Exchange. It should be said that those markets

appeared in response to the financing or expansion needs of large- and mediumsized companies, and played an important role in raising money for companies. The financial authorities, however, worried that those markets, large or small, would disrupt financial order and fuel speculation. As a result, Chengdu “Hong

Miaozi Market” was closed down in 1994, Zibo Equity Exchange was shut down

in 1998, and STAQ and NET markets also came to an end later. Finally, there were only two open markets left: the Shanghai and Shenzhen stock exchanges. In 2000, the government planned to open a GEM in the Shenzhen Stock Exchange. But

affected by the U.S. tech-stock bubble, the GEM was further postponed and the

Shenzhen Stock Exchange was practically “laid off” since IPOs and new stock

issuings were stopped for the preparation of the second-board market. Since

then, the open stock market is like a peony with all green leaves being cut off. The problem is that as the economy develops, enterprises will definitely have the need for raising money and expanding capital, but the bans on irregular fundraising

and stock issuing without government permission have shut all the doors for equity financing and directed all capital financing demands to banks. As for banks,

the credit market has already been saturated, and capital financing is too risky to be attractive to banks. As a result, the economic sector accused banks of being

unwilling to make loans; on the other hand, the gap between deposits and loans in

banks grew larger and larger. The problem of financing difficulties faced by small-

and medium-sized enterprises, which plagued the financial community for the last 10 years, in fact stemmed from the confusion between business capital financing

and short-term financing. The government only knew to urge banks to provide loans for medium- and small-sized enterprises instead of developing a capital

market system of multiple levels. The lack of a multi-level capital market, however, is a major factor that has long been ignored.

During the economic transition of China, there were two major types of

enterprises that had the demand for capital financing. The first was state-owned enterprises. The replacement of appropriation by loans in investment caused a shortage of own capital and over-indebtedness. The second type was the private

companies which did not have sufficient money for starting or expanding a business. These two kinds of enterprises needed to build up own capital under

the help of a joint-stock system and multi-level capital market. The conflict was not noticeable when Hong Miaozi Market and Zibo Equity Exchange were

forced to close, because at that time, the state-owned enterprises could still

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manage to borrow money from state-owned commercial banks and the number of private enterprises was not very large. But the situation has changed with the development of China’s economy. For one thing, although some over-indebted state-owned enterprises have obtained equity through the debt-for-equity swap in 1999, there are still a considerable number of state-owned enterprises with

excessive debts which have not benefited from the debt-for-equity swap and are

deprived of the opportunities to raise capital in the capital markets other than the open stock markets. For another, under the policy of “unwaveringly encourage,

support, and guide the development of [the] non-public economy,” the largescale development of private enterprises requires a large amount of capital. The

key to fulfill this need is to admit non-government credit and open a multi-level market. The OTC markets of both delisted stocks and non-listed stocks should

be initiated at the same time. Meanwhile, China is a large country with so many listed companies, thus companies of different sizes shall not be indiscriminately

concentrated in national stock exchanges. Markets for trading the shares of small enterprises may be set up in several medium-sized cities when it is necessary.

After the equity division reform, China’s stock markets are capable of

establishing a multi-level market system. In response to the appeals from all sides,

the financial authorities are seizing the opportunity to promote the building of a multi-level capital market, optimize the structure of the capital market, and increase the proportion of direct financing through multiple channels.

In a multi-level capital market system, the main-board market is at the core

and responsible for nurturing blue chips. The equity division reform officially initiated in April 2005 was undoubtedly a monumental event in the history of China’s securities market. From then on, China’s securities market entered an age

of full circulation. This marked a new chapter in the history of China’s securities market. The equity division reform wiped off the institutional obstacles hindering

the growth of the securities market, constantly optimized the structure of listed companies, and fully improved the investment value of the securities market.

Meanwhile, the reform in stock issuing and listing system gradually set up

verification and sponsor systems, greatly increasing the degree of marketization. A large number of large-cap blue chips, such as Industrial and Commercial Bank of

China (ICBC), China Construction Bank (CCB), China Shenhua Energy Company

Limited (CSEC), and China National Petroleum Corporation (CNPC), and China Life Insurance Company, have successively landed in the A-share market. It has

upgraded the overall quality of China’s listed companies from the source, and dramatically expanded the content and coverage of the securities market. At

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present, the Chinese government should not only rely on high-quality and large-

scale state-owned enterprises to develop blue chips, but also vigorously promote asset restructuring and business acquisition in hopes of creating blue chips by

taking full advantage of the benefits from equity division reform. In such a way, companies listed in China’s main-board market will be equipped with better

competitiveness in overseas markets. At the same time, the government should also attract high-quality foreign listed companies to issue shares in China’s market.

The opening of the securities market should be a two-way process, which is an internal requirement for the healthy and sustainable development of the securities market. At present, the capital market in Mainland China is gradually equipped

with the conditions for overseas listed companies to go public in China. In addition

to the great improvement in the function, structure, standard, and transparency of

China’s capital market, gradual development of dual-listed A+H shares mode and the accumulation of listing experiences in both Mainland and Hong Kong markets

will pave the way for overseas listed companies to be listed in the main-board market of Mainland China.

In the past 20 years, the construction of China’s multi-level capital market

continuously made new and major achievements. In May 2005, Shenzhen Stock

Exchange initiated a small and medium-sized enterprises board. After many years

of preparation, GEM finally came out in Shenzhen on October 30, 2009. This will,

to a large extent, mitigate the financing difficulties of small- and medium-sized enterprises, and at the same time further improve the structure and functions

of the capital market. The industries of venture capital and private equity for supporting early start-up businesses will rise accordingly, and venture capital

will gain a channel to withdraw its funds. The opening of GEM will not only create a financing channel of low listing requirements for the potential small-sized enterprises which have been founded just for a short time and are still at the startup and expansion stages, but also create an environment for nurturing or attracting

early institutional investors, venture capitalists, investors of private equity, and other kinds of institutional investors to the market. The interaction between listed

enterprises and investors will further push forward the improvement of the basics and conditions of GEM.

China Financial Futures Exchange (CFFEX) was established in September 2006,

and stock index futures also started smoothly in April 2010. The agency share transfer system of Zhongguancun was set up to supplement the exit mechanism

of the main-board market. The system is now striving to develop new functions,

such as to introduce the “market maker rule,” allow qualified individual investors

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to participate in transactions, establish a board transfer mechanism, and expand its target enterprises to include qualified non-listed high-tech enterprises in other

national high technology industrial development zones. This provides a platform for the share transfer of non-listed companies, and is the basis of a multi-level market.

In short, only with a multi-level market can various capital financing demands

of companies be satisfied and can the capital market develop in a healthy manner.

Speed Up the Development of the Capital Market and Virtual Economy In 2002, the 16th National Congress of the CPC clearly put forward the idea that “going ahead with reform, opening up, stability, and development of the capital

market” are the major ways to “give a fuller play to the basic role of the market

in the allocation of resources” in order to “build up a unified, open, competitive, and orderly modern market system.” However, China’s economy has long stayed

at the stage of extensive growth, and the real cause is insufficient marketization, especially the laggard development of the capital market and the virtual economy and the underdeveloped modern financial services industry.

The Chinese government must keep pace with the times in order to speed

up the development of the capital market and virtual economy. Here, we have to clarify several questions.

The role and functions of banks: Banks cannot always dominate everything During the long-term construction of a socialist country, China always had a lopsided attitude towards banks — either too little attention or too much attention. In the first 30 years after the founding of New China, all newly

increased fixed input of production, including initial working capital, depended on fiscal appropriations, and only the demands for seasonal working capital

were satisfied by bank loans. Although China used to overly rely on state finance to fund economic construction but restrict the functions of banks (the so called

“large public finance and small banking system”), 30-year “centralizing all credit in banks” and the discontinuing of sales on credit and payment in advance of

business credit made banks dominate the credit market. The Reform and Opening Up in 1978 resumed commercial credit and encouraged lateral connection of

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funds. The financing structure thus was changed. The involvement of bank credit

in investment, the reliance of economic construction on banks, and the indirect financing-based financial policies dominated the economic life of China for more than 20 years. Since then, non-performing assets grew in number and banks

became cautious and even fearful for credit loans, which created barriers to the

conversion of savings into investment. The opening of the capital market, the hot sales of treasury bonds, and “China’s stock mania” exposed the defects of financial

products. Against such a background, it was inevitable that surplus funds would swamp the capital markets, and this was a natural response when the economic

and financial development reached a certain level. In this case, the function of banks should not be overestimated. A more proper choice was to further develop the capital market and virtual economy by making the most of the situation.

For a long period of time, the development of China’s capital market lagged

behind. A realistic reason was the government worried that the development of the

capital market would generate new financial risks. There are two inborn features

about the capital market and virtual economy: First, the value discovery function

of the market will definitely give birth to all kinds of speculation; and second, constant financial innovations are bound to compete with banks for money, which often causes huge capital to fall off the chain of production and circulation. These

two features are intertwined with each other and usually go against traditional

financial orders. So the activities in the capital market and virtual economy were often forbidden or rectified under the reason of violating financial orders, and sometimes, the related higher financial officers were also punished. For many

years, the financial authorities have always said to divert bank deposits to other

investment instruments, but they still feel doubts about the capital market and virtual economy. As a result, corresponding actions were constantly postponed.

Fundamentally speaking, what they fear is that the capital market will take out capital from the hands of banks and a huge amount of money will flow out of the controllable pond of banks but jump into the unruly ocean of direct financing.

The cleaning up of irregular funds frequently aroused stock turmoil, which

forced people to ask: During the economic development of China, how should the government accurately determine the roles and functions of banks?

Banks and the stock market are not separated. It is often a matter that people

tend to overestimate the role of banks based on certain inertial thinking, and it

seems that banks should dominate everything. Moreover, since there is inherent dread and exclusion for speculation, people usually hold a low expectation for the role and functions of the capital market. Moreover, the separate management of

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banks and the securities market gives rise to the contest between the two parties

for money in reality. In the 1990s, the reason why the monetary authorities had repeatedly requested bank credit to stay away from the stock market was mainly

to isolate risks in the market and ensure a normal and healthy turnover of bank

capital in social reproduction. There is also a general impression that the circulation of funds between banks and the stock market must have some legitimate channels, and certain rules cannot be violated in the circulation. Banks and enterprises were

asked to obey some rigid rules, such as negotiable instruments should not be discounted to exchange for money; banks cannot issue loans without indicated purposes to individuals; stock collateral loans were not allowed to be issued to

enterprises and individuals by banks; and even the securities investment trust was

almost deemed a violation. These contradictory rules led banks to an inextricably awkward situation. In July 2001, the Central Bank released a China Monetary Policy Report. It mentioned that “currently, the phenomenon of enterprises diverting loans

to the stock market is quite common, but the regulatory department lacks effective

control measures.” Then, the Central Bank set a difficult task for commercial banks by “asking them to strengthen risk management, track the actual use of loans, enhance loan review, and prevent credit funds from flowing into the stock

market.” Of course, with financial statements, we can track the performance of

loans, but the question is how to prevent risk? There are some ambiguous facts

that need further clarification. The first one is that the era of the planned economy has gone away. Every fund of enterprises, including own capital and credit capital, should be used under central coordination and circulated at a fast speed, but not

necessarily saved under different special accounts for individual supervision

of banks. Truly, enterprises should focus on the development of main business, strengthen core competitiveness, and increase market shares to be industry leaders. Putting away the main business and participating in the purchase of new shares in the primary market by enterprises is not encouraged; nor do we approve of enterprises specializing in securities investment, including trust financing in

the market, without taking account of their main businesses. However, since 1999 when enterprises were allowed by law to enter the stock market, the capital

exchange between the stock market and banks became more complex: First, enterprises could act as strategic investors to participate in new shares offerings;

second, enterprises were able to merge and acquire listed companies based on the rules of the market, such as the banner acquisition of Founder Technology Group

by Beijing Yuxing Machinery Electronics Research Institute; and third, enterprises were allowed to use temporarily idle funds to take up trust financing and other

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securities investment. At this time, strategic investment, and shareholding through acquisitions and trust financing, could not be easily discriminated from

general securities investment. In fact, it is also hard to tell which is own capital and which is credit capital when the money is invested in the securities market.

In particular, as soon as enterprises are involved in the market-oriented mergers and acquisitions (M&A), the boundary between M&A deals and general securities investment is blurred. Besides, things will change from time to time. Take stock collateral loans as an example. China has long forbidden the issuing of stock

collateral loans, but since the government has decided to encourage the marketoriented M&A, if bridging loans with the pledge of stock rights are not allowed,

business restructuring, M&A, and management buy-outs (MBOs) can hardly develop. Then, what role should banks play in the market-oriented reform in

order to support enterprise M&A? And how should they compete with foreign enterprises and banks (including investment banks) in the market?

There is a view that listed companies can only invest in securities based on

own capital and that they must not purchase stocks by loans. This is an ostrich policy. It may well be asked if an enterprise devotes own capital to strategic investment, M&A, and trust financing while applying loans to the main business, does it comply with the rules of the game? Conversely, to allow own capital to hold shares in strategic investment may also be a “violation” and “misappropriation” from the perspective of the capital owners.

The socialist market economy has merged credit capital with own capital, and

it is useless and unnecessary to refine the nature of both funds. To separate own capital from credit capital cannot truly isolate the risks from the securities market.

How to deal with competition between the capital market and banks? During the development of China’s capital market, the news of “bank credit illegally flowing into the stock market” and “banks cleaning up irregular funds”

was frequently heard. This was not accidental. It was a reflection of the long-term capital competition between the capital market and banks during the process of

financial disintermediation. In essence, the capital market used direct financing as

a substitute for the indirect financing of banks to a certain degree. From the first

day of China’s capital market, it fought with banks for capital in order to realize development. The capital movement between the capital market and banks was mainly manifested in competition.

In China, this competition was fundamentally changed since the mid-1990s.

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Before that time, the money diverted to the capital market from banks was mainly engaged in the real economy. For example, in the 1980s, there were more than 100

trust companies which diverted bank deposits to extra-budgetary construction projects; in the mid-1980s, the local government and enterprise bonds craze

attracted money to investment projects instead of being saved in banks; in the late 1980s, approximately 300 trust companies used call loans to make long-term investment; and in the early 1990s, local governments forced banks to support

local projects by lending out long-term loans with short-term funds or issuing loans above the credit ceiling. All these investments were devoted to projects of the real economy. However, after the mid-1990s, the capital market gradually turned to develop the virtual economy, including the securities market, by using

the capital it had won in the contest with banks. This change was closely related

to the reduction of investment opportunities in the real economy and relative surplus of capital. The development of the securities market and direct financing,

nevertheless, have pushed China’s economic and financial reform and growth to a new level.

In the long run, with the expansion of financial disintermediation, the

competition between the capital market and banks will last for quite a long time.

This is particularly because the capital market has developed from nothing, and

therefore it has to contend with banks for capital in order to survive and develop. In this campaign, the capital market will always be in an offensive position,

and scramble for capital in the form of financial innovation. However, financial

innovation is a challenge to the existing financial management system, and breakthroughs are usually made by exploiting policy loopholes. In fact, there is but one step from innovation to violation. If such a breakthrough is approved by the

monetary authorities, it will be an innovation and an effective way to reduce bank

deposits; otherwise, it will become a violation which can entail risks. On account of people’ fear against financial risks and speculations, Banks usually disseminate the ideas of “orthodox” economics as a counterattack against the capital market,

and sometimes this action may inflict huge damage on the capital market. For

example, the two overly rigid “prohibitions” (i.e., the flow of bank funds into the stock market against regulations is prohibited; and the investment in the stocks by

state-owned enterprises and listed companies is prohibited) announced in 1997, and the large-scale cleaning up of irregularly used funds in 2001 brought about a huge impact on the stock market.

In order to realize financial reform and development, the development of the

capital market and virtual economy, the growth of the securities market, and the

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expansion of financial disintermediation by diverting bank capital to stocks, bonds,

and investment funds are inevitable. Financial authorities must make careful, objective, and comprehensive analyses and judgments in financial supervision and regulation. It is necessary to not only strengthen financial monitoring and guard

against financial risks, but also seize opportunities to develop the capital market and virtual economy by making the best use of the situation. More importantly,

there is no reward without risk, and regulators should not throw out the baby with the bath water.

In the new century, especially since 2005, the contest between the capital market

and banks for capital showed new features. On the one hand, the capital market

undertook short-term financing bills, medium-term financing notes, and corporate bonds of listed companies, which grabbed a huge amount of savings from banks (RMB1.6 trillion between 2009 and 2010); on the other hand, commercial banks fought back against the capital market through off-balance sheet businesses of

“shadow banking” to bypass the credit ceiling. To be more specific, the off-balance

sheet activities that banks engaged in mainly included entrust loans (RMB1.13 trillion in 2010), off-balance sheet business based on bank credit, such as banker’s

acceptances (RMB2.33 trillion in 2010), and the constantly emerging new financial instruments including off-balance sheet derivatives and structured products.

Rediscover capital surplus It is inevitable that surplus funds will flow towards the capital markets. This is a

natural response when the economic and financial development reaches a certain degree.

Under the planned economy, it was the common practice that we directly

increased the investment in the industries with insufficient capacity while reducing

the money put in the industries with excess capacity. So, when there was an acute shortage of consumer goods, Premier Zhou Enlai had to personally interfere

in the problem as to how to secure several tons of steel and aluminum from

capital construction for the purposes of increasing the production of household hardware and other metal goods used in daily life. Unfortunately, however clever

the director of the Economic Planning Committee may be, he cannot predict the

supply and demand of thousands of products. More often than not, the results of direct investment will be that long-term investments cannot receive immediate

returns, whereas short-term ones are unlikely to make substantial profits; and the high cost of regulation only results in little success.

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Under the market economy, China can not only rely on price mechanisms to

balance supply and demand in the commodity market, but also attract physical capital and optimize the allocation of resources by regulating asset prices in the capital market in order to redistribute industrial production capability and

promote the adjustment and optimization of production structure. That is why in

the modern market economy, the adjustment of production structure will always be accompanied by financial restructuring. There is information saying that the

ratio between bank financing and direct financing of the capital market in foreign

countries are as follows: 1:1 in the U.S., U.K., Canada, and Australia; 1.7:1 in Japan;

1.6:1 in South Korea; and 1.4:1 in Thailand. The ratio of China, in contrast, is 4:1. It indicates that with the economic and financial restructuring, the capital markets of foreign countries have absorbed a large amount of excess liquidity, and it also implies that the development of China’s capital market is far from adequate

and there is still large space for more capital to be invested in the market. Sheng

Songcheng, Director of the Financial Survey and Statistics Department of the People’s Bank of China, said in his article published on the website of the Central

Bank that the ratio of bank credit to non-credit financing in China has already reached 56:44 in 2010.

It should be said that the formation of huge liquidity in foreign countries in

modern times is totally different from the capital surplus under the traditional

economy. In the first place, financial computerization has sped up the circulation of capital in the real economy, and capital can be used in a more sufficient and

effective way. At the same time, the huge liquidity may also result from less

investment opportunities caused by excess capacity and finished goods, a saturated market, and lower average rate of profits in some industries. In the

next place, the large amount of liquid assets also reflects an increase in people’s

wealth and savings, as well as the growth of insurance funds, reserve funds, and various other funds. Take China’s national social security fund as an example. As

of the end of 2009, the national social security fund reached RMB776.6 billion, and if the investment return of RMB244.8 trillion was also counted in, the total size

outnumbered RMB1 trillion. By the end of 2010, the assets under the management

of the national social security fund totaled RMB856.69 billion, and according to the estimate of Dai Xianglong, the figure may well amount to RMB1.5 trillion by the end of 2015.

Foreign experiences have also proven that a large number of liquid assets

are always a kind of surplus which should be solved through searching for new investment areas and opportunities. When the real economy is on the verge of

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saturation, the need for the step-by-step development of the fictitious economy is again revealed. The emergence of large liquidity has brought about the following results.

First, it gave birth to new investment and financial planning industries in the

financial field. The reason was very simple: If there is more and more capital in the market, there is a need for money management; if some people are engaged

in wealth management, new markets and industries related to new investment

opportunities will be discovered. Here, a key issue is to give special incentives to financial managers in the profit distribution mechanism, namely the so-called

“high reward will lure talents.” Thus, it is not hard to understand the reason why the modern investment banking industry (including asset management companies

and investment and financing consultancy industry) rose in Western countries in the past 20 years. The surplus capital and the development of direct investment in the capital market attracted a group of financial elites to constantly create new

financial instruments, products, and investment methods, and explore new markets for investment opportunities through financial innovations. This also explains why Western investment bankers, namely the financial elites, usually set up investment

banks in the form of partnerships and became financially affluent above the majority in society by relying on special distribution and incentive mechanisms.

Second, it promoted innovations in asset-backed securities and securitization.

Equity, debts, and some futures which have already turned in assets and

will produce future income, are packaged into securities to be traded in the market. This not only revitalizes illiquid assets but also creates new investment opportunities for huge liquid assets around the world.

Third, asset securitization gave full play to the unique functions of value

discovery and optimized resources allocation of the securities and futures markets. It has not only attracted a huge amount of money and stimulated financial

prosperity and development, but also promoted the adjustment of industrial structure, and the redistribution of resources.

Fourth, asset securitization has greatly developed the trading market of virtual

capital, and as a result, a many times larger fictitious economy has been formed

in addition to the real economy. In 1997, the total volume of the global fictitious economy was estimated to be USD140 trillion, five times that of the real economy. In 2006 right before the U.S. sub-prime mortgage crisis, the number of global

stocks and financial derivative products totaled USD536.5 trillion, 10 times larger than the world’s GNP of USD48.2 trillion. Between 2007 and 2010, the nominal

value of global financial derivatives outstanding surpassed USD620 trillion, and in

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2008, the number was as large as USD743.5 trillion, 10.1 to 12.57 times that of that year’s GDP. This huge fictitious economy is both a result of the accumulation of virtual capital and a reflection of the financialization of the global real economy.

Undeniably, the development of the capital market and fictitious economy

was a double-edged sword. The development not only strengthened financial globalization and attracted a large amount of capital, but also in turn aggravated

capital surplus. The new situation is that some USD1 trillion of hot money

is wandering around the world in search of new investment and business

opportunities and a higher investment return than the average rate of return. Understandably, while promoting the advance of the real economy, the huge liquidity may also generate the risk of excessive speculation which will magnify economic bubbles. Besides, the volatile flow of huge liquid assets will probably

foster a new regional economic crisis. The financial crisis in Southeast Asia in 1997 and the global financial crisis triggered by the U.S. subprime mortgage crisis in 2007 are the best examples.

Financial risks There is a fear that since the saturation of bank credit and the real estate market

bubble already existed, would the development of the capital market and fictitious economy, and the initiating of corporate bond markets, GEMs, and stock futures, increase financial risks? When considering financial risks, we should not only

focus on the debt assets in banks, but realize that the underdevelopment of the capital market make risks overly concentrated in banks. This is a greater risk and

cannot be easily solved. It is also the lesson we have learned from the financial crisis in Southeast Asia in 1997.

The biggest difference of a socialist market economy from a planned economy

is that markets are more diversified, funds and wealth are more decentralized, and risks are more dispersed. Therefore, when dissolving and controlling financial

risks, we have to apply a market-oriented approach: Wealth should be distributed among investors, so should risks.

In the management of financial risks, we should follow a Chinese saying —

“Do not put all your eggs in one basket.” Banks should update their ideas by establishing a concept of “broad-sense finance and risk.”

Privately offered funds and financial innovations In 2001, some people equated privately offered funds with illegal funds, and

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believed that privately offered funds were neither standard nor regular. This view seems to be a paradox. China has not publicly launched a regulation on privately offered funds for a long period of time. The so-called “privately offered fund”

in fact exists in the form of a contract and for the purpose of managing wealth for others, so Wang Guogang also called the fund “privately contracted capital.”

We admitted that some privately offered funds may be operated improperly and against regulations or established for the purpose of market manipulation. But we still have to form an unbiased understanding towards the privately offered fund.

In 2001, I said that the emergence of privately offered funds is an important

financial innovation in an article called “Sober Reflection on the Cleaning Up of the Funds Used Against regulations in the Stock Market” published in the Securities Investment Weekly.

Why is it that the privately offered fund is a financial innovation? Does

this idea confuse right with wrong? First of all, the management has appealed loudly for the creative development of institutional investors and investment funds. After several years of appeal, only a dozen fund

companies were established which have launched less than 40 funds with

no more than RMB60 billion. The privately offered fund, which existed in the form of entrusted wealth management or joint venture, however, promoted the establishment of several thousand companies operating

a huge amount of money. The total wealth under the management of

these companies reached RMB700 billion, or even RMB800 billion– RMB900 billion, according to the respective estimates of Xia Bin and

Wang Guogang. This number cannot be easily achieved under intended

development. In the second place, although the Central Bank repeatedly banned the flow of credit funds in the stock market against regulations

and fundraising without the permission of relevant authorities through irregular ways, the privately offered funds successfully collected hundreds

of billions by exploiting policy loopholes under the banner of entrusted money management. Is it not a creation?

The emergence of a large amount of privately offered funds is not a

mere coincidence and it reflects the objective needs in the economic and

financial area. Certainly, there may be the problems of raising or operating funds in violation of regulations, but we should first understand that those problems arose from objective needs.

What are the needs? First, the appearance of privately offered funds

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discloses a lack of investment opportunities in the existing production areas, and therefore, enterprises feel the need to invest their money into

the financial area or other industries other than existing production and circulation channels in order to look for new investment opportunities.

Second, it signifies the awakening of financial awareness of

companies, and the companies become active in maximizing profits by using temporarily idle funds. Third, it reflects a need for new investment

industries. Such a huge amount of money is not entrusted to trust companies, securities companies, or fund companies, but to investment

consulting firms. Surprisingly, the internal operation of some privately offered funds are more equal, strict, and closer to the international standard than those of close-end investment funds having developed for several years in China. This is embarrassing for the existing fund

companies and fund managers. Fourth, it represents a need for new

investment instruments and financial products. The fact that a large number of privately offered funds have emerged indicates that companies are not content with bank loans, government bonds, and stocks, but search for more investment instruments and financial products, as well as new investment channels and markets.

Accordingly, China has to draw on the experience of Western

developed economies, and extensively develop the capital market and the fictitious economy. The market functions of value discovery and resource

optimization should be given full play, and new financial instruments, institutions, markets, industries, and systems should be created to dredge the existing financing channels and offer new investment opportunities for surplus capital.

Admittedly, the over concentration of privately offered funds on

investment in securities will easily cause market manipulation and excessive speculation. This shows, on the one hand, the control over

IPOs and secondary offerings is too loose. In the future, it is necessary to strengthen the supervision towards seasoned equity offerings and explore

new financial channels from corporate bonds. On the other hand, it also implies the importance of setting up venture capital funds and GEMs

in order to create conditions for the transfer of surplus capital to new industries. Besides, the solutions to the problems of non-standard practices of privately offered funds and the resulting potential legal disputes are the tasks for the administrative department in legal construction.

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What Have We Lost With an Underdeveloped Capital Market and Virtual Economy? The laggard development of the capital market in China, especially the restricted

circulation of state-owned shares due to the long-term equity division, is the major obstacle to the innovation of capital formation mechanism. In particular,

since the start of the Reform and Opening Up era, China has developed a special preference for bank financing, and thus the country has long implemented an unbalanced financial system in favor of indirect financing. When developing the

capital market and virtual economy, the government was always worried about

excessive speculation and anarchy in the market, and thus hesitated to take further steps. It seemed that for the government, bank deposits and loans were easier to control. Consequently, it resulted in a deformed pattern of “excessive large banks but an extremely small capital market.” However, nothing is given without a disadvantage in it. It is necessary to take consideration of opportunity costs.

What have we lost with an underdeveloped capital market and virtual

economy? Before the equity division reform, the losses were as follows.

1. Property rights were prohibited from being circulated under the rigid

system for decades. When several trillion in remnant assets were finally traded

through listing, these funds were frozen again under the equity division system and lost the opportunity to be optimized. Take the stock market before the equity division reform of 2005 as an example. There were more than 1,360 listed

companies which issued 170 billion of new shares at the expense of freezing 400 billion of pre-existing shares. The release of RMB1 new shares will generate RMB2.4 frozen pre-existing shares on average. The market value of 170 billion

new shares amounted to RMB1.1 trillion, whereas the value of pre-existing shares, which occupied 2/3 of the market, still lingered around the net asset value of up

to RMB800 billion. Besides, in order to develop the market for tradable shares, all OTC dealings were blocked. Sun Zhifang, China’s famous economist, criticized the State Planning Committee and the Ministry of Finance for devoting all the money

to capital construction and new projects, but made hundreds of thousands of longestablished enterprises live off their past gains or use the equipment to the utmost

capacity. Now, the capital market is used to help the state-owned enterprises out by raising several trillions in capital through new shares issuing. But those

several trillions of assets with future income are unable to circulate due to the equity division; therefore, their value cannot be discovered or increased through

circulation. No matter how many reasons there were, judging from the overall

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economy, China suffered a big loss only for a little gain. 2. The fact that China’s stock market is lifeless has forced some large- and medium-sized enterprises to be listed overseas. In 2005, the market value of negotiable shares in the Shanghai and Shenzhen stock markets was no more than RMB1.1 trillion while the negotiable market capitalization of Chinese companies listed overseas was as large as RMB2.2 trillion. This indicated that China has lost the negotiable market capitalization equivalent to that of two stock markets, which in turn caused the losses in the business volume of investment banks, the employment in current securities companies as well as the intermediary service and other related services. 3. The continuously delayed opening of GEMs and privately offered funds and the lack of financing sources and exit channels of venture capital left the independent innovation of high-tech industry without support. 4. The proportion of bank deposits and loans is too large, and among them, a large number are bad assets. Consequently, financial risks are overly concentrated in banks. When banks went public, people argued that the stocks of banks were priced below the actual value. Actually, in a market economy, you get what you pay for. If a good asset is always placed together with a bad asset, the good asset cannot be sold at a high price. This is the opportunity cost that must be paid by banks in a system where risks are mainly concentrated in banks. 5. The capital market in China is not developed, and the proportion of business direct financing accounts for less than 15%. Chinese enterprises can neither issue promissory notes, nor corporate bonds, let alone privately raise investment funds. All funds should rely on bank loans. Companies, thus, have lost the opportunities to expand capital through establishing various forms of capital formation mechanisms without banks acting as intermediaries. It should be noted that the capital market and virtual economy are at the top of the market economy. The stagnant development of China’s capital market is also an important factor which has prolonged the transition from a planned economy to a market economy, continued the government-led investment, prevented the market economy from being fully developed, and forbade the market from playing a basic role in resources allocation.

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Chapter

Creative Destruction: Mergers and Acquisitions

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: Microsoft’s Attempted Acquisition of Yahoo Let us begin with the acquisition proposal from Microsoft for Yahoo and their subsequent business relationship.

On February 1, 2008, Microsoft Corporation offered to buy Yahoo! Inc. for

USD44.6 billion in cash and stocks, or USD31 per share. After several months of

dialogue, and even though Microsoft had raised its bid to USD47.5 billion (USD33

per share), Yahoo still insisted on a USD53 billion price (USD37 per share, the highest stock price Yahoo had ever attained). On June 12, 2008, Yahoo ended all

talks with Microsoft after several rounds of back-and-forth bargaining and then

Yahoo inked a non-exclusive search advertising alliance with Google. With such

a move, Yahoo hastily outsourced its paid search service to Google. As a result,

Microsoft withdrew its offer for Yahoo. So Yahoo declared victory in this acquisition. Why did Microsoft want to buy Yahoo? According to analysts, the online

advertising market was expected to grow from over USD40 billion in 2008 to

nearly USD75 billion to USD80 billion by 2011. Google took up nearly 75% of the U.S. Internet advertising market, far ahead of all other rivals. Yahoo, although

ranking second, only occupied 9% of the market. Microsoft attempted to reverse

the continuous loss-making situation in its online service unit and catch up with

market leader Google. In fact, the real intention of Microsoft was to contain the power of Google through the acquisition of Yahoo, but unfortunately, this act only paved the way for Google to grab more market share.

Yahoo CEO Jerry Yang argued that through cooperation with Google, Yahoo

could better seize the opportunities in the fast growing online advertising market. Yahoo wished that by teaming up with Google on search advertising, Yahoo would

gain USD250 million to USD450 million in operating cash flow in the first year. After 12 months of implementation, Yahoo could expect an USD800 million annual revenue opportunity without incurring any additional cost.

However, things went contrary to Yahoo’s wishes. The U.S. Department of

Justice stifled this cooperation out of antitrust concerns. On October 2008, Google abandoned its search partnership with Yahoo. In the latter half of October, the

third quarter financial statement of Yahoo recorded a 64% net profit loss. Yahoo suffered a major blow and Jerry Yang went back to Microsoft, asking whether Microsoft would reconsider the takeover. On November 6, Microsoft CEO Steve

Ballmer responded rapidly and explicitly rejected renewing its bid. He said that no acquisition was currently under consideration, but a search deal with Yahoo would

be better if done sooner rather than later. On November 18, Jerry Yang announced

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his departure as CEO of Yahoo. Analysts from the Bank of America perceived this move as paving the way for Yahoo’s multiple choices in the future.

At the end of May 2009, Microsoft launched Bing, its new search engine. By

the end of July, Microsoft and Yahoo announced a 10-year search deal where Microsoft would power Yahoo’s searches while Yahoo would become the exclusive sales force for both companies’ premium search advertisers. According to the

details disclosed by both parties, Microsoft will hand Yahoo all user data collected through the agreement on Yahoo sites. For the first five years, Yahoo will take 88%

of the revenue from all search ad sales. Yahoo Chief Executive Carol Bartz said that retaining user data would be an important part of any search advertising

partnership for Yahoo, which aims to use it in helping to tailor the graphical display advertising.

Analysts pointed out that the deal between Yahoo and Microsoft came about

two months after the launch of Microsoft’s search engine Bing, which had already been taking a share of the market from Yahoo and Google in the search engine

market. Yahoo has a larger network of search advertisers than Microsoft, and this partnership will give Microsoft the chance to integrate Yahoo’s search engine

technologies into Bing. Bing-powered U.S. searches will rise to over a 30% share of

the market and Bing will become the second most popular search engine in the U.S., thus presenting a challenge to Google. Statistics showed that Google commanded

a 65% share in the U.S. search engine market while Yahoo handled 20% of searches and Microsoft accounted for just under 10%.

Analysts also pointed out that this deal would save Yahoo from investing

money and time in a search engine. However, Yahoo had to give up its own search

engine, which may mean the end of Yahoo as an independent company. Jim McGregor, an analyst at In-Stat in Scottsdale, Arizona, suggested that Yahoo will

likely merge with Microsoft before the close of the contract period. “Once you give up a key part of your business, it’s hard to regenerate that,” McGregor said.

Certainly, the losses and gains of mergers are closely related to the interests

of participants. Outsiders always hold different views and hardly come to a consensus, but their analyses somewhat reflect the difference in acquisition strategies.

Creative Destruction: Mergers Promote Industrial Restructuring and Resource Optimization The corporate merger and acquisition (M&A) is a multi-functional economic

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activity. In the market economy, enterprises will sooner or later need to optimize the allocation of asset stocks. The corporate M&A is an important way to achieve

the optimized allocation. In countries with a developed market economy, M&A is always a hot choice in the capital market and also an indispensable way for listed companies to expand themselves in both scale and strength. It has changed the past situation where enterprises can only rely on self-investment and self-

accumulation to achieve industrial growth and capital expansion. Enterprises now

are able to choose among many other options including purchases and M&As in the capital market to realize rapid growth and economies of scale. This change also brings about the dramatic expansion of industries and facilitates industrial

consolidation, which thereby provides an effective means for the modern economy

to upgrade industries and innovate technologies. It is said that M&A activities in the capital market are the key to ignite the engine which will drive the radical development of listed companies. This statement is no exaggeration.

The market-based M&A transforms the capital formation mechanism in the

optimization of asset allocation, but its function is far beyond just that. The modern M&A takes advantage of a great variety of financial innovations and it also

represents an innovation in the capital formation mechanism in terms of capital expansion and industrial integration. For one thing, it promotes the rational flow and optimized configuration of asset stocks and facilitates the adjustment of the

industrial structure by developing mergers between companies to those between

business groups. For another, through reorganization, enterprises can complement

each other. This will result in corporate synergy and raise the overall value of capital. Corporate M&As will facilitate the accumulation and concentration of capital, effectively consolidate the resources of different companies, and enhance

enterprise competitiveness. More importantly, these activities will also accelerate industrial restructuring, increase industrial concentration, and add new vitality

and power to economic growth. Therefore, the impact of corporate M&As on the capital formation mechanism, as Joseph Schumpeter has put it, is a kind of “creative destruction.”

Since the 1980s, the enthusiasm towards market-oriented M&As in the Western

countries fluctuated along with the economic development. There were five stages

of M&As, basically from horizontal mergers, vertical mergers, conglomerate mergers, leveraged buyout (LBO), to cross-border mergers.

The earliest mergers occurred in the late 19th and early 20th centuries and

were mainly reflected in the form of horizontal mergers. Several small firms

offering similar products in the same industry combined into one large company

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in the form of cartels, trusts, or associates. Horizontal integration aimed to expand

market shares and reduce operation costs. This merger trend affected nearly all industrial sectors and the big businesses which were formed through M&As

controlled more than 50% of the market in iron and steel, tobacco, oil, and other

industries. Some large companies, such as DuPont, Exxon Mobil Corporation, the United States Steel Corporation, the American Tobacco Company, the United States

Sugar Corporation, and the United States Rubber Company, were built up during this period. Lenin also wrote some comments on, and predicted, this kind of

corporate merger which happens in Western countries in his 1916 book Imperialism, the Highest Stage of Capitalism.

The second merger wave happened between the 1920s and 1930s, and

the forms of mergers tended to be more diversified. Although there were still

horizontal mergers between banks or retailers, vertical integration conducted by industrial manufacturers towards the upstream suppliers and the downstream buyers became prevalent. The purpose of this kind of merger was to lower transaction costs by converting market transactions into internal transactions of a

company. A number of important industries, such as automobile, oil, iron and steel, and food industries, realized capital concentration in this upsurge of mergers.

The third stage was the conglomerate mergers developed between the 1950s

and 1960s. This kind of merger focused on the amalgamation of a large number of large companies or manufacturers of unrelated products. As a result, many giant companies involved in different industries came into being. Conglomerate mergers

can serve the purposes of diversifying business and evading the risks caused by a single industry or market. Of course, some firms also merge to realize reasonable tax avoidance or expand financial and capital cooperation.

The fourth merger wave occurred between 1975 and 1991. The capital

market was highly developed after the Second World War, and the integration among several listed companies took place. As the corporate merger involves

two parties, it may encounter objections from either side. This gives rise to the separation between friendly mergers and hostile mergers and the emergence of a reverse takeover. The most significant feature of this merger boom was the

introduction of planning and intelligence services of investment banks. Since then, corporate M&As became a special business of investment banks. Starting from

the 1980s, almost all company mergers involved the planning, organization, and implementation by investment banks. The mergers and anti-takeover measures

made the originally unpeaceful capital market become even more restless. In 1990, I visited the United States and Canada for an investigation of takeover activities

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of Western countries. At that time, investment banks integrated the planning and

organization of corporate mergers with capital operation. They created many financial innovations, especially the LBO in which the control of a corporation is

acquired through borrowed money. These innovations pushed corporate M&As to

a new stage and added new content into the capital formation mechanism. One of the most important financial innovations was in the wide use of bridge loans and subprime bonds in corporate mergers. It bypassed banks as intermediaries and

created conditions for the rapid transfer of social capital surplus into core capital. When I investigated company mergers in the United States in 1990, investment

banks told me that in 1980, the total value of M&As nationwide was USD44.3

billion. The figure stayed above USD100 billion ever since 1984 and surpassed USD200 billion in 1989.

After the 1990s, with the intensification of economic globalization and

international competition, business takeovers evolved into alliances between giants in the same industry and a large number of cross-border M&As. This was

the fifth merger wave. Cross-border mergers were intended to distribute resources

in a global context, create economies of scale, increase competitiveness, and capture global market shares. In the late 1990s, the mergers by large enterprises

and banks worldwide happened frequently. On December 15, 1996, Boeing, the world’s largest aerospace company, announced the acquisition of McDonnell

Douglas, the world’s third largest aerospace manufacturer. In 1997, the new Boeing company was expected to generate earnings of USD48 billion, becoming

the largest civilian and military aerospace manufacturer around the world. Other

examples included the USD50 billion merger of Bell Atlantic Mobile and GTE

Wireless and the USD20 billion takeover of MCI by British Telecommunications. In

April 1998, three large takeovers in the U.S. financial industry manifested the fierce competition in the global financial market. First, Citigroup was formed, following

the merger of Citicorp and Travelers Group to create the world’s largest financial services organization with total assets of USD700 billion. Then, the largest bank

in the U.S., NationsBank, declared the acquisition of Bank of America for a deal worth USD61.6 billion at the same time as Chicago NBD announced a USD29.6

billion merger with Bank One Corporation. From those examples of business integration through M&A, it is clear that to increase international competitiveness is the fundamental purpose of industrial consolidation. In the two merger waves

which happened in the late 20th century, investment banks became more skillful in

capital operation, and takeovers worth tens of billions of dollars were frequently

seen. Corporate mergers not only activated the stock market, but also gave full

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play to the market’s functions of value discovery and resource optimization.

After entering the new century, M&A activities became more and more active,

and each year, the total value involved was above USD1 trillion. According to the

data from financial information provider Thomson Financial, the value of M&A deals worldwide hit a new record high of USD4.38 trillion, 21% higher than that of 2006. Despite an impact from the subprime crisis, the total value in the U.S.

was still as high as USD1.57 trillion with an increase of 5.5%. European firms outperformed their U.S. peers for the first time in five years, with M&A activity amounting to USD1.78 trillion. The subprime mortgage crisis was a dividing line for 2007, global takeover activities in the second half fell by 27% compared with the

figure of the first half, and the decline was even larger in the U.S. where it reached 46%. With the expansion of the global financial crisis in 2008, Thomson Reuters lowered the total value of global buyouts to USD2.89 trillion, and the figure further

went down to USD1.96 billion in 2009, the lowest level since 2004. Global M&A deals rebounded following the economic recovery in 2010, with the total value rising to USD2.4 trillion, 22.9% higher than the number in the same period in 2009. It was the highest value since the financial crisis in 2008.

The following are the largest takeover cases which happened in the last

few years. In 2007, Texas utility (TXU) was made private in a USD45 billion

cash-and-debt buyout and First Data Corporation (FDC) entered into a merger

agreement for the price of USD27 trillion. In 2008, InBev, the brewery based in

Belgium, completed a USD52 billion hostile bid to take over the U.S. AnheuserBusch Companies, which topped the list for takeover price. In 2009, ExxonMobil

purchased XTO Energy for USD41 billion. In 2010, acquisitions above USD20

billion included: the takeover by America Movil of Carso Global Telecom at a price

of USD27 billion, the purchase of Britain’s International Power by French GDF

SUEZ for USD25 billion, the USD22.1 billion acquisition by the fixed-line operator CenturyTel of Qwest Communications International, and the merger deal valued

at USD20.6 billion between the Russian telecommunications operator VimpelCom and Weather Investments.

It is worth mentioning that the global financial crisis brought a winter season

to the merger activities in different regions, and takeover deals fell 38% in the U.S.,

29% in European countries, and 12% in the Asia-Pacific market, compared to the figures in the first half of 2008, but China and Brazil saw an increase of 25% and

93%, respectively, in their domestic company acquisitions. The new feature in 2008 was that the total volume of canceled M&As due to the financial crisis reached 1,100,

with the value amounting to approximately USD800 billion, an all-time high. In

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2009, the value of European and American M&A deals decreased 44% and 24% while the emerging market accounted for a record 24% of global buyout value.

In 2010, the U.S. still topped the list of global M&A activities in volume terms, followed by China. In the same year, the merger deals in the capital markets of

emerging economies amounted to USD806.3 billion, over one third larger than the worldwide merger value and an astonishing increase of 76% compared to the same period in 2009.

Leveraged Buyouts and the Junk Bond King Mike Milken Now, I would like to turn to the subject of innovations of subprime bonds and leveraged buyouts in the capital formation mechanism.

What are subprime bonds? In the U.S. bond market, the risk level of bond

investment is determined by the debt-servicing capacity of bond issuers. There are two bond rating agencies in the U.S. — Moody’s Investors Service and Standard & Poor’s, which assess the debt repayment capacity and creditworthiness of debtors.

Higher ratings of bonds mean lower risks and financing costs (interest rates). On the contrary, if a bond has a low rating and is considered below investment credit level, the bond issuer has to pay a higher founding cost or interest rate to attract

investors. Among more than 20,000 American enterprises, only 800 are entitled to

issue investment-grade bonds, and others can only offer low-grade bonds, namely,

subprime bonds. Even though some small- and medium-sized enterprises promise high interest rates, many underwriters are still unwilling to purchase the bonds for

fear of ruining their reputations. Consequently, people also called subprime bonds “junk bonds.”

Junk bonds typically carry a rating of “BB” or lower and offer interest rates

four percentage points higher than those on safer government issues. The two major U.S. bond rating agencies believe that junk bonds are probably issued by

the companies which have a high likelihood of default, and thus easily incur principal losses and high risks. That is why the traditional Wall Street investors

often focused on blue chip companies and overlooked the low-return bonds with huge potentials. However, junk bonds usually offer higher interest rates than

investment-grade bonds, longer bond terms than bank loans, lower returns to

shareholders than equity financing, and are less restrictive than loan financings, and thereby are a better financial channel for small- and medium–sized enterprises.

The difficulties in selling did not hinder those companies’ enthusiasm for high-

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yield bonds.

The upsurge of junk bonds was attributed to an American financier named

Mike Milken. Mike Milken was praised by The Wall Street Journal as “the greatest

financial thinker” in the U.S., and he was also said to have more influence than

any other financier since J. P. Morgan in the American financial world. Although Milken was “cast out” by Wall Street, it was he who discovered the value of the junk bond market and opened a new world of this financial tool of junk bonds.

Milken possessed an extraordinary talent for finance. When he studied at the

University of California, Berkeley, he, at 19 years old, came up with the formula: P = EFT (DHC+ESC+ERA), which means prosperity is the sum of financial technology times the sum of human capital plus social capital plus real assets.

Milken long believed that people’s repulsion for junk bonds was a kind

of prejudice. While he was in school, he got the opportunity to learn that the

default rate of a corporate bond with a low rating was far lower than the market expectation. In other words, the bond risk was not as high as the market had

predicted. Since the earning of this kind of junk bond was higher than the risk, junk bonds were better investment choices than investment-grade bonds. In 1974, as the inflation rate and unemployment rate increased in the U.S., credit became extremely tight and the funds with high returns in many fund companies were

downgraded to junk bonds by bond rating agencies. Fund companies were eager to sell those low-grade bonds for fear of impairing quality and the image of their funds. Milken, however, saw the opportunities. He thought that the only obstacle before low-grade bonds was poor liquidity, and those bonds could not easily be

sold in the market. After the 1970s, Milken had set up a department especially for

the trading of high-yield bonds in Drexel Burnham Lambert where he worked.

From then on, he pursued his career in junk bond investment. While lobbying

for the purchase of junk bonds, he also made intensive research on the low-grade issuers in search of profit prospects. Due to his regular analysis of the financial situations of small- and medium-sized companies which issued subprime bonds,

the annual rate of return of the subprime bonds handled by him could reach 50%. Milken had an amazing memory and he always knew who had what kind of

bonds, what was the price, and how much was the yield to maturity. Accordingly, his clients readily followed his advice, and their junk bonds brought through

the department of Milken all earned high profits. Many risk-taking investment

institutions, including insurance companies and pension management companies

became his loyal clients. On Milken’s advice, First Investors Funds firmly held junk bonds, and they turned out to be the best-performing funds in the U.S. for

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three consecutive years from 1974 to 1976. The sales of First Investors dramatically

increased. In this way, the bond department headed by Milken became a trading market of junk bonds. It raised money especially for emerging companies and

high-risk companies, and thus created liquidity for low-grade bonds. Following Milken’s lead, junk bonds gradually became the investment tools which were fanatically pursued by investors. By the year of 1977, the market share of Milken’s

business accounted for 25% of the high-yield bond market. Since those bonds with high returns became very popular investment products, other investment banks

also stepped into the junk bond market. The name of subprime bonds also evolved from junk bonds to high-yield debts.

In the early 1980s, Milken went one step further in his business. He not only

sold junk bonds, but also issued and underwrote subprime bonds, which he called “high-yield financing,” for small- and medium-sized enterprises, emerging companies, and even high-risk companies, which had sound financial standing

and sufficient cash flow. The most famous case was that Milken underwrote USD2

billion subprime bond issues for MCI Communications. This successfully helped the company break up the monopoly by American Telephone and Telegraph Company.

However, what made junk bonds extremely popular were leveraged buyouts.

At first, the most difficult part of corporate acquisitions was capital financing,

and to use borrowed money to meet the cost of acquisitions sounds absurd. To buy a company is not like buying an ordinary commodity, and it needs several hundreds of billions in capital. So, how to raise such a large amount of money?

Commercial banks make loans only on the basis of pledged assets, and investment banks only underwrite investment-grade bonds issued by companies with high

credit ratings. Who dares to lend you a huge amount of money to acquire a company? At this moment, someone thought of leveraged buyouts. Leveraged

buyouts were initially linked to management buyouts (MBO). The leveraged buyout first appeared in the U.S. in the late 1960s among some small non-

listed joint-stock companies. Those companies were on the verge of bankruptcy due to poor management, and the acquirers were mostly the managers or the

management of the acquired companies. The buyers had no sufficient capital to

acquire enough equity, and therefore had to use debt to finance the purchase. The acquiring company put up a very small amount of equity through the leverage effect to close the deal, as well as a very large amount of debt. So the leveraged

buyout in the 1960s usually relied on bank loans for funds under strict conditions

and high interest rates. The purchasing prices were often the discounted book

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value of target firms and most acquirers could not afford to pay a premium over the book value. In the late 1960s, some large insurance companies and property

funds also participated in leveraged buyouts as subordinate debts. With more

acquisition capital, the acquiring companies were able to pay the premium or undertake a larger transaction. But subordinated creditors demanded not only high

earnings but also equity participation as a compensation for high risks. Although it was difficult for leveraged buyouts to raise money, the return on investment was

generous. Starting from the 1970s, investment banks got involved in leveraged buyouts. Companies specializing in leveraged buyouts emerged as a result, but

the financing process was still not easy. Between 1979 and 1980, the first leveraged buyout boom appeared, and the composition of purchasing funds was 60% to

70% from bank loans, 20% from privately raised subordinate bonds, and 10% from equity. At that time, the United States experienced an economic recession, and the interest rate was constantly at a high level (the prime rate was as high as 20% in 1981). Banks set strict conditions for loans, and a very long time was needed for

the negotiation with all borrowers and creditors in an acquisition transaction. As a large number of people were getting involved, it was very hard to simultaneously reach a consensus in so many different aspects, so there was great uncertainty

during the process. It generally took three to six months for an acquiring company

to complete a leveraged buyout, but only with a rather low success rate, therefore this activity could hardly become popular.

When corporate mergers developed vigorously, the demand for financing

increased dramatically. In 1981, the United States Congress passed the law to provide a tax shelter for Individual Retirement Accounts (IRA). The sudden increase in the pension fund offered substantial capital resources for the financing market. Investment bankers and Milken saw opportunities in this change and intended to turn junk bonds into a financing channel for corporate mergers. Some investment banks which engaged in leveraged buyouts found that many companies had a good cash flow, so they discussed with Milken to acquire those

financially affluent companies by issuing junk bonds. They started to turn “buying assets with borrowed money” into a reality. The actual practice was Drexel

Burnham Lambert would issue a “highly confident letter,” in which the company

promised to get necessary capital for a takeover. It meant that Drexel Burnham Lambert was responsible for underwriting the junk bonds offered for the purpose of corporate acquisition. This solved the largest difficulty in company mergers and

restructuring and made financing very easy. As a result, even small- and medium-

sized firms were able to take over large ones through leveraged buyouts. It was

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rumored in the stock market that as long as Milken sent a highly confident letter to

a client, not a single listed company could get away with being merged. Therefore, a group of private equity funds swarmed in the M&A market and acquired many enterprises with excellent cash flow on the basis of junk bonds and leveraged

buyouts. Consequently, the acquisition through debts ignited the merger boom in

the 1980s. At the end of 1988, Henry Kravis paid USD25 billion to purchase R.J. Reynolds Tobacco Company, but among the total acquisition price, he only took

out USD15 million and the remaining 99.94% of capital was financed through Milken’s junk bonds. Because of Milken, Drexel Burnham Lambert became a

professional underwriter for junk bonds and also a financial pillar to support the

growth and development of small- and medium-sized companies. In the 1980s, the financing for the high-risk technology firms such as CNN, Time Warner, and

MCI Communications, was largely attributed to Milken. Milken became the angel

for small companies while he was hated by inactive large companies. Milken and Drexel Burnham Lambert built up a great reputation through underwriting junk bonds and supporting leveraged buyouts.

It should be said that the contribution made by Milken in the 1970s and 1980s

to the rise of the U.S. emerging industries, especially to the development of the optical fiber industry and mobile communications industry, is undeniable. Some

people even credited the advance of the high technology industry in the U.S. after

the 1980s to Milken’s efforts in solving the financing problems of high technology firms in the capital market.

In the mid-1980s, corporate mergers surged massively and the junk bond

market reached a climax after dramatic expansion. Throughout the 1980s, the U.S. companies issued USD170 billion of junk bonds. Among this number, Drexel

Burnham Lambert contributed USD80 billion, accounting for 47%. Within just four

years from 1983 to 1987, Drexel Burnham Lambert quadrupled its income from USD1 billion to more than USD4 billion, and became the most profitable company on Wall Street. Milken was also nicknamed the “junk bond king.” In 1986, Milken

earned USD550 million through the commissions from selling junk bonds. The

typical leveraged buyout case in 1989 was the purchase of RJR Nabisco by Kohlberg Kravis Roberts & Co. L. P. (KKR). The bid price was USD31 billion, but the KKR

only paid USD1.5 billion while the rest was financed by bond issuance through

Drexel Burnham Lambert, where Milken worked, and several other investment banks. Drexel Burnham Lambert got USD200 million commission in this deal.

After the 1980s, leveraged buyouts gradually matured. The usual practice

typically involved three steps: 1. Investment banks will lend the acquirer a bridge

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loan (a short-term loan) for less than six months. A bridge loan is interim financing to provide buffer time for the acquiring company to issue subprime bonds. 2.

Subprime bonds will be issued. 3. The investment banks will arrange for bank loans.

Certainly, the junk bond is only a prerequisite for the leveraged buyout. Then,

how can management buy a company through borrowed money? How to ensure

that the debt and interest will be repaid? It has to date back to the situation of the

U.S. companies in the 1960s and 1970s. At that time, the U.S. enterprise groups indulged themselves in overly diversified operations. They set up excessive

departments overstaffed with non-productive personnel and implemented an unwieldy system with low efficiency in disregard of conservation effect. Some

companies had very good cash flow and thus were able to afford more debts. But the management worried that debts would bring about trouble and insolvency risk, so they would rather maintain a minimum level of debt than take on more

liabilities, even though they knew that issuing debts would increase the return on equity. When investment banks helped the management complete a leveraged

buyout through offering junk bonds, managers were transformed from the employed to owners. They were greatly motivated to engineer asset stripping

and restructuring plans and reduce agency cost in order to fully tap the potential and growth of the acquired enterprises. Leveraged buyouts have provided a new

mechanism which can cut down the agency cost of managers and at the same time maximize shareholders’ interests. The conversion of the role of the management

is the real driving force to the success of leveraged buyouts. The stripping and reorganization of assets are two essential means to ensure a successful leveraged buyout.

From here, it is clear that subprime bonds serve as a lever in innovating

the capital formation mechanism by leveraged buyouts. The innovations of the leveraged buyout are manifested in the following aspects.

First of all, it converts ambitious managers of a company from employees to

owners by virtue of subprime bonds and enables the managers to realize their own value as human capital, which in turn greatly increases the value of management.

Second, as managers are transformed into owners, asset stripping and

restructuring are turned into a reality. As a result, the allocation of resources will

be optimized and agency costs will be reduced, which will further enhance the growth of the company and capital.

It is because of the creative transformation of the role of managers that a

series of new incentive mechanisms, such as management stock ownership and

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employee stock ownership, was gradually formed. Managers are extricated from an employment relationship, and the value of management and human capital are greatly improved. The company takes on a completely new outlook.

During the development of leveraged buyouts, some investment banks and

private equity funds are activated to make huge profits. They specialize in hunting

some companies with an adequate cash flow and make a profit by acquiring companies through issuing junk bonds and undertaking leveraged buyouts. But,

if the management cannot be motivated, how can investors expect a spectacular performance?

The unchecked growth of junk bonds and leveraged buyouts eventually

evolved into a real disaster. In the late 1980s, the financial competition was fierce in the U.S. and many village and township banks (namely, the ordinary savings and loan institutions) ran into a dilemma due to the market saturation. Milken took the

opportunity by introducing junk bonds to those distressed banks. As a result, small banks at the village and town level got involved in high-yield bonds in a large scale in the hopes of improving their profitability. During an economic boom, the

high profits of junk bonds will easily make people forget about the low quality of these bonds; but once the economy slows down, the default rate will rise sharply and the returns will drop dramatically. At the time, the small village and township

banks were content with the interest margin between the high yield of junk bonds and low interest rates of savings and took no consideration of the risks of junk

bonds. The excessive issuance of junk bonds accumulated a lot of problems, which

eventually became one of the causes of the stock crash in 1987. At the end of the 1980s, the junk bond bubble induced a crisis. Many small and medium-sized banks

went bankrupt and became victims of this junk bond disaster. Subsequently, the U.S. government worked to clean up the savings and loan crisis, but it was not

until October 1989 when George H.W. Bush signed the Financial Institutions Reform,

Recovery and Enforcement Act that the savings and loan institutions were completely restructured. The U.S. government paid USD166 billion in bailout money, more

than 1,800 savings and loan institutions became insolvent, and several hundreds

of people were imprisoned. The years between 1981 and 1990 in the U.S. were described as “a decade of greed.”

Junk bonds triggered the stock market crash in 1987. Drexel Burnham Lambert

and Milken were sued for the firm’s alleged involvement in economic crimes in March 1989. Drexel Burnham Lambert was fined USD650 million and the firm went bankrupt in 1990. In April 1990, Michael Milken was sentenced to 10 years in prison for six felonies including concealing the ownership of securities, assisting

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in tax evasion, and filing false account statements, and also fined USD1.1 billion which was the largest monetary penalty ever imposed on an individual. He was

permanently barred from Wall Street and the securities industry. In 1989, when Milken was still on trial and under judicial examination, the Wall Street Journal

reported him to be “the greatest financial thinker,” and Life magazine listed him as “one of the five men who have changed the 1980s.” The once crowned “junk bond king” had confirmed his status in the financial history of the U.S.

Unfortunately, history always repeats its mistakes. In 2006 and 2007, leveraged

buyouts resurged again. In 2006, the total money raised through this activity

exceeded USD220 billion, double that of 2005. By comparison, the leveraged buyout boom in the 1980s was less significant. Moreover, the KKR set a new record by cooperating with the leading global private investment firm, Texas Pacific Group (TPG) Capital, to acquire TXU Corporation in a transaction valued

at USD45 billion, far beyond the purchasing price of RJR Nabisco. Even Milken was astounded to hear such an unreasonable deal. He said, when attending an investment meeting in Hong Kong in 2008, “a leverage ratio of 30 to 1 was not a normal business, and it has never been or will ever be one!”

Since his release from prison, Milken has devoted himself to public services by

funding education and medical research. In 1996, Milken worked with his family and friends to form an educational service company called Knowledge Universe.

Through a series of acquisitions, the annual revenue of the company grew rapidly from USD17 million to over USD1 billion. At the beginning of 2005, Milken’s

company purchased KinderCare Learning Centers with USD1 billion to turn Knowledge Universe into the largest private provider of daycare services in the U.S.

It owns more than 2,000 centers with approximately 5 billion licensed caregivers and can accommodate 268,000 children around the U.S. Milken also established the Prostate Cancer Foundation (PCF). By 2003, the foundation had financed USD210 million and become the world’s largest privately founded prostate cancer research

institution. By using his commercial awareness, Milken created the Milken model

in medical research investment. The Milken model, in a nutshell, is to stimulate research by drastically cutting the waiting time for grant money, to flood the field

with fast cash, to fund therapy-driven ideas rather than basic science, to hold the

researchers that he funds accountable for results, and to demand collaboration across disciplines and among institutions, private industry, and academia. Milken changed the culture of medical research and created a sense of urgency that focused on results and shortened the timeline. Andrew von Eschenbach, director

of the National Cancer Institute commented on the contributions made by Milken

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by stating: “It took a business mindset to shake things up. What he’s done is now the model.”1

M&As of China’s Enterprises: Government-Led Activities During the first 30 years after the founding of New China, property rights and stock assets were not allowed to be transferred As a result, the mismatch between supply and demand could not be easily solved and the market’s competition

mechanism could hardly work under China’s traditional economic system. The industrial restructuring, had to rely on the increase in investment and government invention, which suppressed the market’s demand for resource optimization. Certainly, under the rigid system of a planned economy, market-oriented M&As and investment in the banking industry had no prospect.

After the start of the Reform and Opening Up era, the planned economy was

transformed into Socialist market economy. At the same time, corporate M&As gradually developed, basically from government-led mergers to market-oriented mergers.

Here, it is necessary to talk about the roles and functions played by

governments, especially local governments in China’s economic transition.

There was a role shift in the process. The government ought to play the role

of a manager and coordinator of different interest groups and their economic behaviors (including corporate takeovers). But during the economic transition,

China’s government also served as investors, major shareholders, as well as decision-makers in business acquisitions. The government had to make a series of decisions, such as how to adjust the strategic layout of the state-owned economy

and undertake strategic reorganization of state-owned enterprises through corporate M&As; how to coordinate the mergers of companies or business groups from different regions, industries, and countries or under different systems of

ownership; and how to manage the acquisition by an advantageous company

to realize assets increase and debt reduction. In a Socialist market economy, the

two kinds of roles played by the government were incompatible. The coexistence

would inevitably cause bias and impair the fairness in the government’s management. The reform of governments should be directed towards the separation between government functions and enterprise management. The tasks faced by the governments are to gradually divide the roles as investors, large

shareholders, and decision-makers from the role of administration, and become a

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real regulator and coordinator in economic activities. As China is heading towards a market economy, this change is of particular importance to local governments. In 1995, the pilot project of optimizing urban capital structure started. It was predicted that with the economic transformation towards a Socialist market economy, it was necessary to promote the rational flow and optimization of stock assets, which would in turn constitute enormous potential needs for investment banking services. Later, in order to bail out state-owned enterprises, the Chinese government implemented many measures by boldly learning from the market economy, such as enterprise mergers and bankruptcies, suspension of interest repayment of overdue loans, write-off of bad debts, discount government loans for enterprises’ technical transformation, and debt-for-equity swap. Those measures indeed made considerable achievements. However, investment banks have not been properly developed. Unexpectedly, the government was unwilling to give up the role in resources allocation concerning the vital question of who has the final say in industrial consolidation, corporate mergers, and asset restructuring. Therefore, government departments took over the basic role of the market in the allocation of resources. For example, the decisions in relation to suspension of companies’ debts and interests and debt-for-equity swaps were made by the Economy and Trade Committee rather than banks; mergers, reorganizations, and equity flows of enterprises and business groups were largely manifested in administrative reorganization and the transfer of state-owned assets led by the government sector; acquisitions in the stock market were also conducted in the form of governmentled utilization of “shell companies;” and the so-called “substantial reorganization” of listed companies were often reduced to asset swaps or complete swaps as a substitute for market-oriented mergers and business restructuring. These government-dominated behaviors not only curbed the development of investment banking, but also were subject to the segregation among different administrative organs and government departments. There were also many man-made factors, such as rent seeking, careless mismatches, and arbitrary arrangements. This practice failed to realize advantageous complementarities between enterprises and was harmful to the rational flow and optimized reorganization of stock assets. There were generally three kinds of enterprise M&As in China according to the previous experience.

Government-led debt-ridden mergers between state-owned enterprises and non-listed companies In the early stage of reform, government appropriations were replaced by bank

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loans and many state-owned enterprises entered had excessive debts. In the 18 pilot cities of optimizing capital structure to bail out state-owned enterprises,

many companies went bankrupt to avoid debts. Therefore, the administrative

department proposed the principle of “more mergers, less bankruptcies,” and regulated insolvency and acquisition procedures. At first, the most widely applied

measure was the debt-laden merger of disadvantageous companies. It enjoyed

plenty of preferential policies, such as the overdue interest owed by the acquired companies could be reduced or exempted, and loan repayment could be postponed for five to seven years. As the loan interest relief will reduce banks’ allowance for

doubtful accounts and is also subject to the write-down quota, debt-laden mergers must ask for approval from competent authorities and the head office of creditor banks.

This kind of merger has motivated advantageous companies to realize

business expansion through acquisitions by the offering of preferential policies.

This practice not only eases the social unrest caused by bankruptcy cases and

increases in unemployment, but also reduces related bank losses. However, this type of debt-ridden merger has two defects. First, when the acquiring company lacks sufficient capital for a takeover and the government is also unable to give financial support, such a merger will bring out a large amount of debt, which may

exert a negative or devastative impact on the originally advantageous company.

Second, specific plans of mergers including interest deduction, exemption amount, and grace period ought to be determined by creditor banks, but in practice, government departments take the place of creditor banks and investment banks to have the final say.

Of course, there is also a great deal of alliance between large companies. It

was said earlier that at the eve of the 15th National Congress of the Communist

Party of China in 1997, the State Council decided to form a business conglomerate

of four leaders in the petrochemical industry as an example for other industries. The four enterprises — Yangzi Petrochemical Company, Yizheng Chemical Fibre

Company, Jinling Petrochemical Corporation, and Nanjing Chemical Plant — were

under different administrations of China Petrochemical Corporation, Ministry of Chemical Industry, Ministry of Textile Industry, and the local government of

Nanjing before the merger. The conglomerate made the first move in industrial consolidation through an alliance among industrial giants. Under the condition of

divided administration, this initiative broke through institutional and management barriers in business organization.

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From the listing-oriented acquisition mode to bundle listings of unprofitable firms This story has a direct bearing on me. Liaoning Province founded the Jinzhou

Chemical Fertilizer Plant with all equipment introduced from overseas. The plant produced 300,000 tonnes of synthesis ammonia and 520,000 tonnes of urea annually. With over RMB2 billion outstanding liabilities at home and abroad, its debt to asset ratio was as high as 97.5%. The factory was completed and put into operation in 1992. However, due to over-indebtedness, lack of funds, and

temporary losses in trial production, the plant found itself in a predicament. Neither bankruptcy nor debt to equity swap was a choice for the plant. At

this time, the nearby Liaohe Chemical Fertilizer Plant planned to go public in Shenzhen. Liaohe Chemical Fertilizer Plant was established by introducing large equipment in the 1970s, with an annual production capacity of 300,000 tonnes

of synthesis ammonia and 480,000 tonnes of urea. After the discussion among

Liaoning Provincial Government, Ministry of Chemical Industry, Economy and Trade Committee, and China Securities Regulatory Commission (CSRC), the Liaohe Chemical Fertilizer Plant was allowed to be listed by issuing 130 million

shares to the public. Among the total raised capital, RMB690 million would be

used to acquire Jinzhou Chemical Fertilizer Plant. After this takeover, a large chemical fertilizer group would be formed with an annual output of 600,000 tonnes of synthesis ammonia and 1 million tonnes of urea. The combination of listing and acquisition has achieved multiple goals, including industrial consolidation,

building business conglomerates, enterprise restructuring and listings, easing excessive debts, and supporting state-owned enterprises to increase assets and reduce debts in the capital market without building redundant construction.

Shortly after the takeover by Liaohe Chemical Fertilizer Plant, I published an

article named “Put Resources to Best Use: On the Model of Liaohe Chemical Fertilizer Plant” in Beijing Economic Daily on February 2, 1997 as a recommendation to this model. In my article, I expressed it in this way:

China’s state-owned enterprise reform is at a critical period. How will the modern corporate system be promoted among China’s stateowned enterprises in 1997 and years to come? How to alleviate the overindebtedness of enterprises? How to build large business groups with

international competitiveness through industrial consolidation? And how to make the capital market serve the state-owned enterprises reform

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with no repetitive and blind construction? These questions are the major concerns of the nation. The special report made by this newspaper today

on the takeover of Jinzhou Chemical Fertilizer Plant by Shenzhen Liaohe Tongda Chemicals Company Limited (name used in the listing by Liaohe Chemical Fertilizer Plant) by raising capital through listing introduces a successful model to the economic circle.

It seems that it was a coincidence. Jinzhou Chemical Fertilizer Plant

had a debt to asset ratio of 97% and found itself in significant debts of

RMB2 billion. Liaohe fertilizer plant planned to build a mechanism of self-

management and self-development through stock issuance. Meanwhile, the Ministry of Chemical Industry also wanted to undertake industrial integration by forming joint-stock companies. A few things happened simultaneously. The ministry contributed a quota of company listings, and made Shenzhen Tongda Chemicals Corporation join Liaohe fertilizer

plant to form a listed company, which gave Liaohe fertilizer a chance

to implement a shareholding reform. Then, the listed company raised RMB690 million through issuing shares to complete the takeover of Jinzhou fertilizer factory. This move not only eased the over-indebtedness

of the acquired factory, but also created a blue chip stock with an expected

return of RMB0.58 per share for the stock market. At last, Liaohe fertilizer

plant developed into a large corporate group with its annual output growing from 300,000 tonnes of synthesis ammonia and 480,000 tonnes of urea to 600,000 tonnes of synthesis ammonia and 1 million tonnes of urea. China had made its first step of industrial integration.

It has not been anticipated that the IPO of Liaohe Tongda company

would have accomplished a number of things in one act — shareholding reform, flotation of shares, debt restructuring, industrial consolidation, and the forming of a large business group.

It has put forward many questions worth thinking about.

As the capital raised through listing is a scarce resource, how should

we use it properly? To devote this resource in problematic stocks left over by history or to invest in small companies without economies of scale in different provinces? To encourage the producers of televisions, refrigerators, and clothing whose production capacity is saturated, to expand their production and participate in unpromising business competition, or to concentrate the resource in some large projects?

What are enterprise groups with international competitiveness? Can

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the small- and medium-sized enterprises connected together by provincial

or municipal governments for the propose of integrated management be called enterprise groups? How could these miniature groups compete with massive business conglomerates, let alone in the international market?

How to implement industrial consolidation? Is it a close-door merger

administered by government departments, or a market-oriented operation

like the takeover by Liaohe Tongda company? Of course, support and guidance from competent departments are welcomed. The successful listing of Liaohe fertilizer plant was inseparable from the assistance from the Ministry of Chemical Industry, Liaoning Provincial Government, and CSRC.

How to ease over-indebtedness of enterprises? The fundamental

solution is to increase capital. Without capital increase, how could we

reduce the debts of enterprises? If neither the Central Government nor

local governments contribute money but ask enterprises to expand capital through self-accumulation, how could the over-indebted enterprises refill

their own capital since they are unable to repay either debts or interest?

Can we open a new way by making financially affluent companies acquire insolvent companies through listing?

What is called a modern enterprise system? To build enterprises solely

funded by the state is one model while to establish state-controlled jointstock companies belongs to another. I am not in favor of accelerating the

shareholding reform as long as the government advocates “invigorating

large enterprises while relaxing control over small ones.” The enterprise

reform will not be accomplished solely by issuing shares. However, it is

true that the shareholding system offers a good model for the modern enterprise system. In particular, by expanding capital based on the need of economics of scale, we will build a capital formation mechanism by

accumulating and concentrating capital both within the enterprise and from the society. This is not comparable to other models.

How to organize corporate mergers and debt restructuring?

Investment banking industry should have done more. At present, many securities firms which are engaged in the listing of joint-stock companies are content with acting as ordinary underwriters and show indifference to business mergers and debt restructuring. Jun’an Securities Company is a

good example in its promotion of the IPO of Liaohe fertilizer plant. But if

it could have made a bit more efforts, there will be more innovations in the

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investment banking.

In this year, 10 billion new shares will be issued through IPOs and

around the same number of shares will also be allotted by pre-existing listed companies. If the government sums up the experience and promotes the Liaohe mode, will it be an innovation that the reform of

state-owned enterprises is intensified by developing the capital market? The government can consciously play a guiding role to direct a certain proportion of raised capital (say one third) in the stock market to acquire

over-indebted but profitable companies. It can not only realize industrial consolidation but also provide quality stocks for the stock market.

In July 1997, when Premier Zhu Rongji went on an inspection tour to Liaoning

Province, he praised the Liaohe model. The CSRC, thus, decided to popularize this model among listed companies. Since then, to purchase highly indebted but

promising companies by collecting capital in the stock market became a popular

choice to support state-owned enterprises in reducing debts and increasing capital.

But this boom went astray later. Arbitrary bundle listings under administrative orders appeared in many cities or provinces and companies were ordered to

acquire a loss-making company when going public. The burden of unprofitable enterprises was placed on listed companies, which seriously harmed the asset quality of public companies. This was contrary to not only the spirit of CSRC’s document but also my original intent.

Therefore, I wrote another article “It Is Not a Cure-All: On the Promotion of

the Liaohe Model” on November 2, 1997, to point out the existing problem.

I think that the Liaohe model which combines listing with acquisition does not suggest that mergers should be indiscriminate. As to the question

of which kind of business can or cannot be acquired, there should be a criterion. This principle, as expressed by Premier Zhu Rongji in his tour to

Liaoning Province, is to both enhance the power of listed companies and bring out new advantages of acquired companies.

To carry through this principle, the merged company has to fulfill the

four requirements.

First, it is obligatory to comply with industrial policies. Second, its products have a market.

Third, the company should own advanced technology and realize

economies of scale.

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Fourth, the enterprise must have prospects for development. Although

at the present stage, the company is burdened with excessive debts and only makes small profits or even generates losses, its business is able to pick up and become profitable after the takeover.

Only this kind of merger can realize a win-win deal between acquiring

and acquired companies. Otherwise, the company cannot be regarded as an acquisition target. Takeovers against this principle will only result in great losses to both sides. So, if we stick to strict examination and insist

on listing standards, the difficulties of state-owned enterprises will not be imposed on society or exert negative impacts on the secondary market.

Local government-led reverse takeovers The reverse takeover between non-listed companies and listed companies through

asset restructuring is a kind of mergers aiming to maintain the allotment right

of the public companies. This was once a hot spot in China’s stock market in the

mid-1990s. At that time, China’s stock market required that if a listed company has recorded losses in three consecutive years, it should be delisted. Listed companies must maintain a rate of equity (ROE) above 10% in order to have the right to allot shares. A realist condition in China’s stock market was that small

businesses were ordered as targets for listing in the pilot phase. More than 100

problematic stocks left over from history were listed in the market. Due to a lack

of economies of scale, those small firms either suffered a drop in profits or lost

competitive advantages, and thus they became a large number of shell companies. Meanwhile, many companies were unable to go public under the restriction of listing quota, so they came up with the idea of buying shell companies to go public. In fact, it is to make a well-performed non-listed company become the

major shareholder of a listed company through asset swap and injection of quality assets. As a result, the listed company will be able to attain a ROE of over 10%

and secure its right of share allotment. Certainly, it is not a fair capital operation

in which a non-listed company controls not only the majority of shares in a public company through internal asset exchange but also a substantial amount of social funds raised at the market price. However, the results of this takeover are to

enable the shell company to secure its status as a public company while providing the acquiring company with a chance to go public and raise capital through stock issuance. The profitable merged company survives the market competition and the investor obtains quality shares. This is a win-win deal. Despite the fact that

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the operation is unjust in some way, it reflects the market function of resource optimization to a certain extent.

But the practice of borrowing shell to go public, or reverse takeover, should be

a market behavior, how could it involve a large number of government operations? Now, let us talk about the evolution of the reverse takeover.

The takeover of Yanzhong by Baoan: Costly market acquisition In 1993, the acquisition of Shanghai Yanzhong Industrial by Shenzhen Baoan

Enterprises initiated the nation’s first takeover in the stock market. At that time,

the stock regulators worried that the equity flow would cause the drainage of state assets in China, so takeovers were not favored in laws and regulations. It was provided that Baoan should make an announcement as long as it bought

more than 5% of Yanzhong’s shares, and the percentage was lowered to 2% at a later time. After several announcements were made, the stock price of Yanzhong

rose substantially, which would in turn increase the takeover costs. As Baoan and

Yanzhong were both listed companies, there was no such a thing as borrowing a shell company. The significance of this incident is that it started the first market takeover in China and made people realize the possibility of merging companies in

the stock market. It also revealed that business mergers under existing regulations and laws have a hard time succeeding. After that, there were several so-called takeovers, but they were in name but not in deed.

The merger of Lingguang and Hengtong: Negotiated acquisition Now that the market takeover was not easy, some people began to consider state-

owned shares and legal person shares. In 1994, Zhuhai Hengtong Group acquired Shanghai Building Materials Group. It was the first case of state-owned share transfer. The transferee purchased the shares at a low price according to their

agreement before issuing stocks at the market price to raise funds. It pioneered

the reverse takeover in China. No matter if it turned out to be a success or failure, the method of negotiated acquisition outside market transactions created by the

takeover paved the way for the internal transfer of state-owned shares and the

transfer of legal person shares by agreement. However, the unfair capital operation was widespread, and the negotiated transfer of non-negotiable stocks became a potential risk to the just operation of the stock market. This will be detailed in a later section.

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Asset swap: From partial replacement to complete replacement The negotiated transfer of state-owned shares became popular in 1997 after the

stock market transformed into a bull market. As the listing quota was tight and a group of listed companies performed poorly, cases of reverse takeover frequently emerged. Examples included the mergers between Tianjin Teda and Tianjin

Meilun Chemical Fiber Plant, Shandong Lanling Chenxiang Jiuye Co., Ltd. and Shandong Huanyu (Group) Co., Ltd., and Sichuan Pharmaceutical Company Ltd. and Sichuan Quanxing Company Ltd. At that time, the Shanghai Municipal

Government ordered asset restructuring in 100 listed companies. It raised the issue

of reverse takeover promoted by local governments under the pressure to bail out state-owned enterprises. Governments played a dominant role in the transfer of state-owned shares, asset restructuring, and seasoned issue of state-owned

enterprises. To participate in state-owned capital operation became a way for governments to deepen industrial reorganization in the capital market. The best representative cases were the takeover of Shanghai Industrial United Holdings

Co., Ltd. by Shanghai Industrial Investment (Holdings) Co., Ltd., the purchase of Shanghai Iron and Steel Transportation Limited Corporation by Shanghai Jiao Yun

Group Co., Ltd, and the asset swap of Shanghai Dragon Corporation in its four subsidiaries.

Now, I will talk about the complete asset swap and new stock issuance in

Shanghai Dragon Corporation (SDC). It is a typical example of a government-led

reverse takeover. At that time, around one fourth of textile enterprises had excess

production capacity in China. The government carried out a series of preferential

policies to support these companies. In 1998, the Shanghai Municipal Government ordered the reorganization of five textile companies. Large shareholders had to replace low-quality assets with quality assets and new shares would be offered.

The SDC engaged in cotton textile business and mainly focused on the production of cotton yarn, cotton thread, and cotton cloth. Influenced by the economic

downturn in the textile industry, sales slowed down. Under the planning of

competent government departments in Shanghai, the SDC used its holding of a 100% stake to swap for high-quality stakes in its four wholly owned subsidiaries

(Threegun Group and Chrysanthemum Group, Mingguang International Group

Co. Ltd., and Conch Clothing Co., Ltd.). These four companies were famous brands in the manufacturing of knitted underwear, shirts, and bedding. After the asset swap, the earnings per share of SDC grew from RMB0.002 to RMB0.328. In addition, 120 million in new shares were issued to raise RMB600 million capital,

which was used to purchase two profitable companies with profit-making capacity

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of RMB42 million. As a result, the company’s asset was septupled and the earnings per share were expected to be maintained at RMB0.3 in 1998. At the same time, a group of other companies also underwent asset restructuring, including Shanghai

Shenda Co.,Ltd., Wuxi Taiji Industry Co., Ltd., Shanghai Sanmao Enterprise Group

Co. Ltd., and Shenzhen Wellzone Chemical Fiber and Industry Co. Ltd. All of these companies chose complete asset swaps and allotted new shares.

This kind of reverse takeover generally takes place when the government picks

up a profitable non-listed company, which will exchange its equity with another disadvantageous company (a shell company) in order to obtain the control of the latter. In addition, to get the control over the public company, the private company

will also gain a profit by substituting its quality assets for the low-quality assets of

the public shell company. This exchange, however, is unfair. It operates the capital from the open market through private agreements under the banner of making use of the capital market to bail out state-owned enterprises. The prerequisite of this

asset swap is to save the shell company, namely to make sure the company is still a listed company and maintain a reported ROE above 10% for three consecutive years in order to secure its stock issuance rights.

The reverse takeover through equity exchanges enjoys substantial preferential

policies from local governments. For one thing, government-owned enterprises assume both the capital and liabilities of shell companies; for another, a portion of profits from quality assets enjoyed by large shareholders (namely, the government) are distributed to other shareholders. In fact, local governments are the dominant stakeholders in local state-owned enterprises, and the concessions made by the

governments are the necessary prices paid for protecting the eligibility of listed state-controlled companies to raise capital in the stock market. Therefore, this swap should be limited to the exchange between enterprises within a same city or province in order to avoid profit spillover. This internal assets exchange will result in a change in the main business of listed companies. To prevent this situation,

the CSRC stipulated later that the asset swap which causes a shift in core business and in turn changes the qualification of the listed company must undergo a reexamination according to IPO issuance provisions.

Generally speaking, the M&As of China’s enterprises are dominated by

governments, be it debt-laden mergers between state-owned enterprises and

private enterprises, listing combined mergers of Liaohe model, bundle listings of

loss-making enterprises, or government-led reverse takeovers. This governmentled merger realizes resources optimization while easing excessive debts of

enterprises, so it receives support and encouragement from different parties. But, it

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also contains some obvious drawbacks.

First, government-led takeovers curb the basic role of the market in resource

allocation. For a period of time after the mid-1990s, the trend of substituting

administrative behaviors for market operation grew considerably in the economic transition towards a market economy. The replacement for financial market

mechanisms by government documents was frequently seen in the practices of debt-for-equity swaps, enterprise M&As, suspended payment of loans

and interests, write-offs of bad debts, discount loans for enterprises’ technical innovations, and state share reduction in the stock market, etc. It brings new

challenges and risks to China’s transition towards and development of a Socialist market economy, especially the reform and growth in the financial field.

It should be also noted that as the policy of debt-for-equity swaps was

announced four years after the promotion of mergers and bankruptcies in bailing

out state-owned enterprises by competent departments, the unreasonable merger of disadvantageous companies increased the debt to equity ratio of some acquiring companies with no affluent capital and reduced their financial strength.

Second, it inhibits the development of investment banking. Governments take

over the role of investment banks in business M&As which should be organized

by investment banks in the market economy as a means to solve non-performing loans. Corporate mergers become repetitive administrative acts implemented

by governments. What can be frequently seen are the bureaucratic habits of ingratiating with power rather than the financial innovations and intelligence services customized by investment banks for different projects.

Third, there is a significant negative impact of the government-led reverse

takeover featuring equity swap and negotiated transfers. The takeover is, in reality, to inject capital into the listed state-controlled companies which have run into

trouble due to an inappropriate operation mechanism through reverse takeovers.

The assistance from governments to state-owned companies has evolved into

a habit of completely exchanging assets as long as management is poor, which results in endless government-led mergers.

Fourth, there are many non-standardized practices in the government-led

reverse takeover, especially in asset swap and asset pricing. The government-led negotiated transfer of state-owned shares and assets restructuring totally relied on government departments in planning and operation and involved a wide range

of staff, which makes it hard to keep the takeover a secret. Besides, it usually takes half a year or even one year for the preparation to be done. Rumors of unsmooth

restructuring may frequently be heard during this process, which will lead to over-

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speculation. Large shareholders will take the chance to manipulate the stock price

by making heavy purchases of the stock at a low price, which will generally bid up the price by 50% to 100%. This is fraud and cheats the small and medium investors.

Unfortunately, the supervision department fails to implement rigid regulation on insider trading, stock price manipulation, and speculation in the reverse takeover.

The Tonghua Iron and Steel Group Riot: The Fight over Control and the Steel-Centered Economy In July 2009, thousands of angry workers rioted at the Tonghua Iron and Steel

Group (TISG) in Jilin Province to protest a takeover by the privately owned Beijing Jianlong Steel Holdings. The boss of TISG Chen Guojun was beaten to death in

the event.2 While the murder case was handled by the court, the protest attracted

widespread public attention. The center of the dispute concerned corporate control in the takeover of the business. But it would not be accurate to interpret this mass disturbance as a reflection of workers’ attachment to the system of state ownership.

In history, the contest for control in a privately-controlled company which has

been transformed from a state-owned one was usually manifested as an aftereffect

of a systematic reform. When a state-controlled company was driven into a corner

under the old system, the company had to seek help from private capital. Once the

company was out of trouble, however, the agents of the company would force the

private company management to step down on the excuse of prohibiting the loss of state assets. To this end, the state-controlled companies should maintain strict

management and restrictions over their agents. Although the agents of state shares, especially the high-level management, can usually receive considerable benefits when operating the company, they may still hold a wish of pursing future wealth

through management buyout (MBO). Therefore, the regulatory authorities, such as

the local State-Owned Assets Supervision and Administration Commission, have to impose firm control over talented and ambitious managerial personnel as well as provide them with appropriate incentive mechanisms.

Caijing Magazine reported that the steel-centered economy comprised of

TISG and its upstream and downstream industries engendered collusion and

corruption between the managers of TISG and its business partners, which I

believe is the real cause and obstacle in the reform of state-owned enterprises. I have a friend who owns a company and he told me that when his company tried to acquire a producer of traditional Chinese medicines, he found that the upstream and downstream companies of the drug firm worked in collusion with

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the top management of the pharmaceutical factory and local government officials. This drug factory-centered economy created many barriers for business mergers

and corporate restructurings. It seems that the economic pattern centering on a certain state-owned company may be universal. This will give rise to corruption

around the center company and this should be paid special attention to in the reorganization of state-owned enterprises and the anti-corruption struggle.

Another implication of privatizing a state-owned company is to convert the

equity exchange into the corporate control transfer. In fact, the capital market of any country can never be called mature if no corporate control is traded and transferred. Only with the flow of corporate control can resources be really

optimized, and asset restructuring, adjustment of industrial structure, and synergy

effects be truly realized. Being state-controlled is not always the story, transactions of corporate control cannot be avoided and must be tackled by either absorbing

private capital or MBOs during the strategic adjustment in the distribution of the

state-owned economy and the reduction of state-owned stocks. Meanwhile, the government should protect the active participation of private capital in order to

ensure that the state asset was willing to withdraw from ownership of the business

while the private capital could come in as a replacement and enjoy development without discrimination and disruption from force of habit.

How to structure the top management of the acquired company is an important

question. In Western countries, top executives will be given “golden parachute” packages and laid-off workers will be compensated by seniority buyouts when the company is taken over by another firm. In contrast, China’s state-owned

enterprises practice a bureaucracy-oriented system with companies’ leaders being quasi-bureaucrats. So, it involves a larger and more complex question of business redemption than the employee buyout compensation system.

When we look back, it seems that Jilin Province had been too indecisive

and disordered in dealing with the acquisition of TISG and the corporate rights transfer. The government took a bureaucratic attitude and even showed total indifference towards the steel-centered economy which created corruption.

Market-Oriented Merger Boom under Full Circulation The mergers of domestic enterprises, although driven by the government

departments, did not develop rapidly. Prior to 2001, there were less than 50 mergers in the stock market. The takeover activity accelerated after 2002, and in 2005 the total number of M&As grew to 500, involving more than RMB60 billion.

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The launch of the equity division reform in 2005 signified a transition in the

basic system of securities markets, and the role of the market in resource allocation

has been greatly enhanced. In 2006, there were 1,173 listed companies which had undergone restructuring, and the total capital involved amounted to over

RMB240 billion. In contrast, 1,759 listed companies were reorganized in 2007,

an increase of 50%; and the total money involved was nearly doubled to reach RMB450 billion. Among this figure, mega-mergers totaled RMB398 billion. In 2009,

China’s M&A market completed 294 mergers, a year-on-year increase of 59.8%, and the total disclosed amount was USD33.15 billion. Of this number, 38 were

overseas purchases with a disclosed value of USD16.10 billion, a rise of 90%. In the first half of 2010, the number of domestic mergers in China was as high as 194, involving USD4.81 billion, up 64.4% from the same period a year ago. The number

of deals reached its peak after 2008. People from the China Securities Regulatory Commission (CSRC) disclosed that from 2006 to 2010, the merger volume of

China’s listed companies totaled RMB989 billion. This manifested the fact that

the capital market had become increasingly important in business mergers and reorganizations.

In the future, China’s M&As will have a new upsurge. I think there are mainly

three contributive factors:

1. It is necessary to meet the development of urban agglomeration in

metropolitan areas and promote industrial concentration and consolidation in order to facilitate the economic integration in metropolitan areas. The

construction of metropolitan areas which had been discussed for a long time in

the economic circle was finally stated in the 11th Five-Year Guideline passed in

October 2005. The guideline required that “the regions that have the conditions of urban agglomeration development shall strengthen unified planning and with megalopolis and megacities as the leaders, exert the functions of central

cities and form several new city agglomerations with less land utilization, more

employment, strong element concentration ability and rational population distribution.” According to the Chinese premier Wen Jiabao, the government must “pay attention to bringing out the economies of agglomeration of city clusters.”

Here, the city agglomerations include the Beijing-Tianjin-Hebei region, Yangtze

River Delta, Pearl River Delta, and Chengdu-Chongqing Experimental Zone. Later, the State Council approved the construction of Wuhan City Cluster (consisting of nine cities within 100 km of Wuhan, including Wuhan, Huangshi, Ezhou, Xiaogan,

Huanggang, Xianning, Xiantao, Qianjiang, and Tianmen) and Changsha-ZhuzhouXiangtan City Cluster as Comprehensive Supporting Reform Trial Areas to build

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a resource conserving and environmentally friendly society in order to promote

balanced regional development, the rise of Central China, and the coordinated development of the eastern, central, and western regions in China.

China was expected to build 20 city agglomerations by the end of 2010. A

larger growth opportunity is that many urban agglomerations are now building rail rapid transit (RRT) systems. This growth will become a new driving force or catalyst in promoting the development of high-level industrial structure (high value-added) and reducing the business costs to the minimal level after the

industrial consolidation and division of labor within a region. It will push ahead regional economic integration by changing the high similarity of industries within

the same region. By strengthening industrial consolidation and agglomeration, economies of scale will be achieved, and international competitiveness will be

enhanced. For Wuhan City Cluster, after the consolidation of industrial integration and division in the region, leading and pillar industries in the area will form

several industrial clusters. For example, to integrate the iron and steel production

in Wuhan, Ezhou, and Huangshi, we can build an international iron and steel industrial belt along the Yangtze River; to form a national biopharmaceutical

industrial cluster by combining Wuhan East Lake High-Tech Development Zone

(EDZ), Guannan Medicine Base, and Gedian Biotechnology and New Medicine

Industry Base; to construct an international optoelectronics industry cluster by relying on Wuhan Optics Valley; and to build a regional chemical industry base

by taking advantage of gypsum and well salt factories in Yincheng County. In addition, Wuhan as the core city in the city agglomeration, strives to build a

developed regional network of infrastructure, promote the integration of the traffic

network, information network, circulation network, and financial network, and

develop a greater Wuhan tourism circle. The regional industrial gathering and consolidation will inevitably bring about a climax in business mergers.

2. The low-carbon economy will be a new growth point. Statistics showed

that the annual industrial energy consumption in China grew by an average of

5.8% between 1993 and 2005, and accounted for 70% of the nation’s total energy consumption. The adjustment of economic structure and the improvement of industrial production technology and energy utilization efficiency are major tasks for the Chinese government. The low-carbon economy, in essence, is the

effective use of energy, the development of clean energy, and the pursuit of green GDP. What is at its core is the innovation of energy technologies and energy-

saving emission reduction technologies. To this end, it is necessary to try out new

technical equipment and replace plenty of machines, which will produce a lot of

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corporate merger opportunities and create a new economic growth point.

3. With the constant improvement of the strategic economic layout in the

state-owned sector, a new merger wave will show up amid the new round of privatization. In the future, a portion of the state-owned economy will gradually

withdraw from the competitive field and a considerable part of the originally non-tradable shares will be allowed to be circulated. As a result, a new round of

market-oriented business M&As will emerge and the transactions of control rights

will become increasingly active. In particular, the participation of private capital and overseas equity investment capital will turn the M&A into an important force in promoting the resources optimization in China’s stock market. Meanwhile, state-owned companies have started a share incentive mechanism to senior

executives. This will change the current situation of insufficient motivation in the state-controlled listed companies which account for two thirds of China’s quoted companies. The employee stock ownership plan has worked as a lubricant in the

capital formation mechanism of listed companies. As top executives and workers were turned from employees into shareholders, it will definitely release some

potential of economic growth. Besides, the launch of MBOs will add a new force

in promoting optimized resource allocation and tapping enormous potential in China’s stock market.

The stock market reform in China has eliminated the division between tradable

shares and non-tradable shares. As a result, business M&As will be completely different from the government-led ones in the past. To remove the difference

in the prices between tradable and non-tradable shares in corporate takeovers

will deprive the price advantage of negotiated acquisitions which are usually conducted at a price the same as the net asset value price, but which still maintain

50% of shares held by the state. Although in a certain period, to acquire stateowned shares through negotiation is still the most direct and important way to take control of a public company, market-oriented acquisitions, corporate control

transfers, tender offers, and banner acquisitions will gradually develop into the

mainstream methods of M&As in the non-competitive field where the state-owned economy has withdrawn and in other areas where state-owned shares have no absolute dominance.

As a side note, the development of China’s stock market has not been fast and

the resource allocation in listed companies has been insufficient. These factors

are greatly related to the lack of proper financing tools. China has not opened

subprime bonds, namely the so-called “junk bonds” of the Western countries. In fact, the junk bond is the bond that carries a high risk of default and, as a result,

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offers a high yield. It is an important financial instrument that cannot be ignored. In April 2010, Guo Shuqing, Chairman of the China Construction Bank (CCB), said in an interview with Financial Times that China should introduce junk bonds and

provide a new financial channel for small- and medium-sized private enterprises.

However, he suggested giving the bond a better name, “innovation bonds” or “high-yield bonds.” Guo Shuqing made this comment because the banking industry dominated by governments has usually been unwilling to offer funds

for private start-up companies. In spite of that, I believe the introduction of junk bonds will probably play a larger role in promoting market-oriented enterprise

M&As. Of course, we should bear in mind the lessons learned from the junk bond

disaster in the 1980s in which the loose regulation of the U.S. government on junk

bonds led to the collapse of the overheated LBO market. Therefore, I suggest that

China should open junk bonds on certain conditions. First, the issuers of the bonds should be limited to private companies, especially when the capital is raised for

the purpose of the acquisition of state-owned companies. The bond can be directly

named as a “private enterprise high-yield bond.” Second, for the takeovers by

state-owned enterprises, especially in monopolized sectors, junk bond issuance must not be allowed since they already possess a lot of favorable financing methods.

Under the current situation, the Proposal of the CPC Central Committee for

Formulating the 12th Five-Year Plan for National Economic and Social Development proposed to “carry out strategic adjustment of the state sector, and improve

the mechanism for increasing investment of state capital in some sectors while

reducing it in others to ensure its sound flow; to speed up the reform of large state-owned enterprises; to deepen the reform of monopoly industries; and to

support and guide the development of the non-public sector and encourage the

participation of non-public enterprises in the state-owned enterprises reform.” I think, if this policy is truly put into practice, it can be anticipated that the rise of

private capital and non-public enterprises will create a new round of business mergers, which will in turn promote the strategic adjustment of the state sector and improve the mechanism for the sound flow of state capital. A new era of market-oriented industrial consolidation centering on the transactions of

corporate control will come, and it will provide new opportunities for optimizing a company’s resource allocation. Fully implementing the State Council’s policy

of keeping financing from all sources at an appropriate level and speeding up the opening of the high-yield bonds issued by private enterprises under the guidance of the government as a financial tool for business mergers, I believe, will effectively

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increase the proportion of direct financing while maintaining a reasonable volume of social financing and facilitate the transformation of economic development mode. It will probably give rise to a new corporate merger boom and accelerate the arrival of the next bull market. This process will bring about numerous business opportunities for investment bankers. It is worth noting that the government still plays a leading role in major enterprise mergers and reorganizations. For example, in May 2008, the Ministry of Industry and Information Technology, the National Development and Reform Commission, and the Ministry of Finance jointly issued a circular about the reform of the telecommunications system. The circular allows China’s six telecommunications companies (China Telecom, China Netcom, China Mobile, China Unicom, China Satcom, and China Tietong) to merge their assets to create three operators (China Telecom, China Mobile, and China Unicom). It was a manifestation of administrative monopoly. On June 3, the stock prices of the three merged companies and China Netcom dropped sharply in heavy trading with the average decline of 12% to 14%. This showed the market’s strong dissatisfaction with government-led mergers. In particular, the appointment of the top executives in the merged companies aroused a lot of controversy. Southern Weekly made a report about the market’s response to this personnel arrangement. People asked, “How could Zhang Chunjiang, the head of China Netcome, be moved to China Mobile? Sang Bing, the Chairman of China Unicom, has become the manager of China Telecom? And how can we ensure fair competition when the top executives of competitive companies have taken a position in their rivals’ firms after the companies went public and business secrets have been made known to each other?” It was evident that people are looking forward to the discontinuation of the monopoly and government dominance of the market.

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Chapter

Mutual Funds: An Alternative to Bank Loans

THE CAPITAL MARKET IN CHINA: A 60-YEAR REVIEW VOLUME 2

Prologue: Legendary Investor Philip L. Carret and Mutual Fund Pioneer John Templeton Two major financial events in the 20th Century were the emergence of mutual funds and asset-backed securities. These two things were the pillars in the development of the international capital market and the virtual economy. Human society had now made the final leap from an age of money to an age of capital and so achieved the final step of the financial revolution. When it comes to mutual funds, Philip L. Carret must be mentioned. Warren Buffett once praised Carret by saying that Carret had established “the best longterm investment record of anyone in America.” Philip Carret was born in 1896, the same year the Dow Jones industrial average was launched and he died at the age of 101. He witnessed 31 bull markets, 30 bear markets, 20 economic recessions, and the Great Depression. He advocated the concept of value investing in 1927. In the following year, Carret created the world’s first mutual fund, the Pioneer Fund, which he managed with great success for more than half a century. Carret mainly invested in companies which are able to maintain sustained growth in profits and have dedicated management teams. His investment approach is still used by numerous professional investors to this day. The book written by him in 1933 — The Art of Speculation — was recommended by Morgan Stanley as a classic in 2005. In 1963, he founded Carret Asset Management, which achieved remarkable results. In those years, the company also set up a joint-owned subsidiary in China which mainly engaged in venture capital and private equity investment. Another investment guru is John Templeton who is considered the pioneer of mutual funds. He was picked by Money magazine in 1999 as the “20th century’s greatest stock picker.” He died from pneumonia at the age of 95. Templeton’s iron principle of investing was “to buy when others are despondently selling and to sell when others are greedily buying.” Templeton was famous for investing 100 shares in 1939 on every stock (104 companies) which was trading for less than USD1 on the stock market. He reaped huge profits by holding the stocks for an average of four years. In 1954, Templeton launched the first globally-oriented growth fund which posted a 13.3% annualized average return. It was estimated that a USD10,000 investment in the Templeton Growth Fund in 1954 will grow to USD8 billion today. He sold the Templeton Funds in 1992 to the Franklin Group for USD440 million, which was then the largest merger of an independent mutual fund company in history.

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A common trust fund is another word for a trust fund. It is generally believed that the Foreign and Colonial Government Trust, founded in 1868 in London marks the beginning of mutual funds in the Anglo-Saxon countries. Later, the idea of investment funds made its way to the U.S. where investment banks emerged in 1920. After the Great Depression in the 1930s, the U.S. government passed the Investment Company Act of 1940, which separated investment banks from commercial banks and set separate standards to regulate the operation of mutual funds. However, the funds did not develop rapidly in the U.S. The assets under management of the U.S. mutual funds only totaled USD2.5 billion in 1950. After the 1980s, capital surplus in the financial market grew larger and larger while a huge demand for money emerged in the securities market and derivatives market. Investment bankers, being particularly sensitive to investment opportunities and capable of effectively managing capital and generating profits, constantly developed new kinds of funds and creatively transformed mutual funds into personalized investment services. They accumulated a great variety of surplus funds from individuals, corporations, and institutional investors under the principle of risk-return tradeoff. Besides, in accordance with prior agreements, they formulate investment strategies, purchase stocks, bonds, and derivatives, invest in non-listed companies with high payout ratios, or undertake equity investments and venture investments in industries with growth potential. In 1987, the volume of mutual funds only accounted for one-tenth of the personal deposits in the U.S. In 2005, the mutual funds amounted to USD8.9 trillion, 1.5 times the amount of personal savings (USD5.73 trillion). In the past 30 years, investment funds have constantly created new varieties and provided the market with new investment tools and financial products, including various public funds, private equity funds, property investment funds, hedge funds, venture capital funds, securities investment funds, closed-end funds, open-end funds, as well as the funds of different currencies, uses or investment manners. The development of investment funds has in turn, promoted the growth of new financial vehicles, investment methods, and financial markets.

The Securities Investment Fund Law of China is now under revision, and after that, the concept of funds will be broadened. It is generally believed that any portfolio of financial instruments such as currencies, equity instruments, stocks, derivatives, bonds, and other securities that are invested in various fields can be called securities investment funds (or “funds” for short).

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The Securities Investment Fund and Its Innovations in the Capital Formation Mechanism The securities investment fund has a history of over a hundred years in Western

developed countries. In 1926, Massachusetts Financial Services (MFS) Company of Boston set up a “Massachusetts Investors Trust,” America’s first mutual fund in

the modern sense. After the 1940s, many developed countries strengthened their supervision on mutual funds through legislating and improved the protection for investors.

During the 13 years between 1974 and 1987, mutual funds increased from

USD64 billion to USD700 billion. Meanwhile, U.S. funds went beyond investments in common stocks and corporate bonds which had been in practice for over half a century, and introduced the first money market fund, The Reserve Fund, in

1971. Following that, municipal bond funds and long-term bond funds, tax-free

money funds, and international bond funds were launched in 1977, 1979, and 1986, respectively. By the end of 1987, there were a total of more than 2,000 different funds in the U.S., held by nearly 25 million people.

After the 1980s, securities investment funds were popularized around the

world and the rapid expansion of the fund industry became a global phenomenon.

According to the report of the Investment Company Institute (ICI), the assets of

the U.S. mutual fund industry rose from USD2.8 trillion in 1995 to USD12 trillion in 2007. It had quadrupled in 12 years with a growth rate of over 12.88%. This

trend, however, underwent a noticeable change after the global financial crisis.

Mutual fund assets decreased to USD10.68 trillion in the U.S. in September 2008

and further declined to USD9.6 trillion in October. In addition, according to the statistics from the Federal Reserve, U.S. bank savings were up 1.7% in May

2009, the ninth largest monthly increase since 1973. In June, deposits in the U.S. commercial banks totaled USD7.5 trillion. Based on the above data, mutual fund

assets were 1.28 times more than personal deposits. This indicates that the surging

growth of mutual funds tended to mean revert during the financial crisis while personal savings moved up considerably.

In the following part, I would like to detail the development of securities

investment funds.

Securities investment funds are a collective investment scheme through

which fund managers sell shares of funds to pool money from investors for the

purpose of investing in stocks, national debts, corporate bonds, financial bonds, convertible bonds, warrants, asset-backed securities and other financial products

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in the securities market in the form of portfolios. The same with stocks, bonds, term deposits, foreign exchanges, and other investment tools, securities investment

funds provide investors with an investment channel and establish a investment relationship of benefit-risk sharing.

Securities investment funds organize both individual investors and

institutional investors to form a systemic financing channel, which increases

the stability of the stock. A healthy stock market would not be possible if it was established on the basis of blind investment by tens of millions of individual investors. It must rely on mutual funds to convert dispersed individual investors into more rational institutional investors. There are tens of millions of private

investors in China’s stock market, and their income comes primarily from salaries

and wages. They have limited capital, time, and investment experience and in the face of sharp stock price fluctuations, their risk-bearing capacity is low. A lot of people eye short-term price differences and easily follow suit blindly. By doing so, it has encouraged the blindness and speculative nature of the stock market.

This is the reason why China’s stock market has a high turnover rate and strong

speculative motive. Accordingly, regulatory authorities have been encouraging the

rapid development of mutual funds in the securities market, the way bank savings and loans were developed in the financial market, in order to turn mutual funds into a capital-creating mechanism for direct financing.

The innovations by the securities investment fund in the capital formation

mechanism are manifested in the value judgment, investment selection, and market trading of stocks, which will bring out the full display of the market

functions of value discovery and resources optimization. Through this process, social capital of one industry will be diverted to another industry and it will in turn push forward the adjustment of industrial structure.

The securities investment fund completely renovated the capital formation

mechanism. It realized commodification, industrialization, socialization, and marketization throughout the whole process of capital collection and utilization,

from investment agglomeration, object selection, asset management, to fund

managers. Through a more flexible approach, the fund is able to collectively manage a huge amount of capital and satisfy the investors’ demand for

personalized services. This represents the most important market-oriented reform in the investment regime.

There are five unique aspects of securities investment funds: 1. Fund

procurement involves collective management and large-scale operations and management. 2. The investment methods include professional research, portfolio

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investment, and the diversification of risks. 3. The relationships with investors are built on shared interests and risks. 4. The funds hold shares but do not interfere

with production of the investment targets. 5. Fund operation features independent custody, strict supervision, transparency, and safety guarantees.

Since securities investment funds are collected from multiple investors

who entrust their money to fund managers to make collective investments, it is beneficial for the exploitation of the advantages of capital to the full and for

reducing investment costs. At the same time, by employing a lot of professional investment researchers and a powerful information network, the fund houses are able to conduct all-round dynamic tracking and analysis of the securities market.

In addition, fund investments are made through a portfolio of a wide range of stocks to spread risks. Fund investors are the owners of funds. Fund managers are

responsible for managing investment portfolio trading activities, but they do not get involved in asset custody. It is required that mutual funds must be held by a

custodian (such as a commercial bank) who is independent from fund managers.

This check-and-balance mechanism provides important protection for investors. Fund custodians and managers can only charge a certain amount of custodian fees and management fees in accordance with beforehand agreements and do not participate in the fund income distribution. Fund investors are entitled to all

returns from fund investments after certain expenses are deducted. Fund earnings will be distributed among different investors according to the proportion they hold

in the mutual fund. To protect the interests of investors, the securities regulatory

authority of China has implemented strict supervision on the fund industry, imposed severe punishment on activities that can harm the interests of investors, and forced mutual funds to provide sufficient information disclosure.

There are three sources of mutual fund income: 1. dividends and interests from

investment targets (such as stocks and bonds); 2. capital gains, namely, the increase

in the value of a financial product held by investors; and 3. gains saved by cutting costs and expenses.

Investors of securities investment funds can make their own investing

decisions while assuming risks. The risks of the fund are diversified into different

securities. A special function of securities investment funds is to help banks to spread financial risks. Banks absorb savings from millions of households to make loans to enterprises that need capital. In this way, risks are concentrated in

banks. Moreover, due to maturity and risk mismatches between banks’ assets and liabilities, risks excessively converge on banks. It is in this regard that investment funds significantly change the defect of excessive risk concentration on banks

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in the commercial bank-centered financial structure and, to a large extent, meet

the capital demand of socialized mass production. The main risks for securities investment funds are: first, the risk from price fluctuations, namely the changes in the net asset value caused by the price movement of investment targets. Second,

the liquidity risk. For example, a closed-end fund may be sold at a discount price when it is difficult to sell. When an open-end fund encounters huge redemption, its fund manager may delay the payment of redemption money, which will affect the capital arrangement of the fund holder. But generally speaking, as fund assets are invested in a dispersed manner, the risk from buying funds is lower than that from directly buying stocks. It is not likely that a sharp decline in a single stock will generate huge losses to fund investors.

Investment funds must adhere to principles of justice, fairness, openness,

and honesty. The funds must serve investors, and put the interests of fund

investors first. Fund companies must straighten out the relationship between large

shareholders and fund investors and at no time should the funds become a tool of fraud and market manipulation used by certain related interest groups.

If operated properly, the securities investment fund can stabilize the stock

market. But the fund has no obligation to stabilize the stock price or rescue the market, and it has never been and never should have been a tool for the government to regulate the market.

The key for developing investment funds lies in whether unique distribution

and compensation mechanisms can be formed to attract and retain management talents. There were too many restrictions in the reform of China’s distribution and compensation systems, causing inextricable difficulties and contradictions.

The investment fund adheres to the principle of “reward lures talents” by

implementing a performance-linked remuneration system, stock option plans, and

partnerships or limited partnerships. By forming a new incentive mechanism, it took a step forward in the reform of distribution and compensation systems.

China’s investment funds started in 1992. However, the standard fund did

not appear until March 1998. Despite this long period of time, the development of

funds in China experienced many ups and downs. The investment fund witnessed not only the ephemeral bull market on May 19, 1999, and a historical record high

of 2,245 points in the Shanghai Composite Index, but also a low ebb of 998 points in the index in July 2005. From June 2001 to January 2002, when the Shanghai

Composite Index fell from 2,245 to 1,451, the net asset value of closed-end funds decreased by 19.18%. Between April 2, 2004, and June 3, 2005, as the Shanghai Composite Index dropped from 1,768.65 to 1,013.64, the net asset value of 29 open-

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end funds slumped by an average of 20.42%. This portion of funds did not recover their losses until eight months later at the end of February 2006.

In 2005, equity division reform was launched, which brought a bull market

in 2006–2007 as well as the extraordinary development of securities investment funds. In 2006, the A-share market had 321 securities investment funds, with 622 billion shares under management which had a net asset value of RMB856.4

billion, respectively, up 32% and 83% from 2005. In 2007, there were 363 securities

investment funds held by 58 fund companies which managed 2,232 billion shares

with a net asset value of RMB3,275 billion, an increase of 2.58 times and 2.82 times from 2006. However, risks from the stock market also affected the fund market.

The stock market slump in 2008 caused 473 securities investment funds with 2,573 billion shares to hold only 1,930 billion in net asset value. In comparison to 2007, the

number of shares grew by 15.26% but the net asset value decreased sharply, more than one-third less than the share volume. At the end of 2009, the net asset value

(excluding QDII fund) of 58 fund companies was reported to be RMB2.6 trillion, up

from 35.64% in 2008. According to the data provided by the fund research center of China Galaxy Securities, the whole fund industry decreased from RMB2.69 trillion at year-end 2009 to RMB2.52 trillion at year-end 2010, a gap of 174 trillion.

The growth of investment funds in two years showed great significance in two

aspects, however.

First, it turned investment funds into the most popular investment tool for

households. Individual investors who held open-end funds accounted for 52.98% at the end of 2005, but this proportion jumped to 74.21% in 2006. After 2007,

individual investors generally made up over 99% of fund investments and this percentage went up further to 99.88% in 2009.

Second, investment funds bypassed banking intermediaries and strengthened

financial disintermediation. In 2007, the net asset value of China’s securities investment funds was RMB3.27 trillion, equal to 19% of the residential deposits (RMB17.25 trillion) of the same period. The global financial crisis in 2008 led to a

downward trend in the stock market. Consequently, the net asset value shrank to

RMB2.51 trillion, only about 8% of RMB30.3 trillion resident savings during this period. There was still a large space before China realized a larger fund volume than deposits as it now is in the U.S.

In the future, money capitalization and asset securitization will be the two

forces driving the development of China’s capital market. The development of investment funds will change the over-concentration of risks on banks and to a great extent accommodate the capital need of socialized mass production.

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In light of the history of domestic and foreign investment funds, the

investment fund innovated traditional knowledge of ownership, and created a

more socialized capital formation mechanism than the stockholding system. Not only is the investment fund collectively owned, but the invested enterprises and projects are held jointly. I think the fund displays, as stated by Marx, the nature of “capital of directly associated individuals,” and thereby becomes a form of social capital with a greater socialist nature.

Private Equity Funds When talking about innovations in the capital formation mechanism, we have to mention private equity funds.

What is a private equity fund? A private equity fund, or PE, typically includes venture capital funds (venture capital) invested in startup companies at the seed or growth stage, direct investment funds for companies at the expansion stage, and buyout funds

involved in takeover activities including management buyouts (MBOs). In

addition, bridge funds invested in transitional or pre-listed companies and equity investment acquired before a company is listed are also counted in as private equity funds.

Distinct from the securities investment fund, the private equity fund is often

initiated by investment managers to be subscribed to only by qualified investors and focuses on the equity investment of non-listed companies. It is not distributed to dispersed public investors and will not be quoted on a public exchange. In

general, the private equity fund does more than investment. It is also involved

in corporate management and will exit its investments for a return after creating value. In a mature market, private equity funds are just like hedge funds, raising

money in the market on the basis of fund managers’ own credit. The private equity fund usually involves two entities in the structure. The first is fund management companies which act as fund managers and the second is the funds themselves.

In foreign countries, private equity funds generally adopt a limited partnership.

Fund managers with strong investment management capacity will act as a general

partner and contribute 1%–2% of overall capital and be fully responsible for the use, operation, and management of funds with unlimited liability. Fund investors as a limited partner will shoulder the remaining 98%–99% of investments. Similar to stakeholders of a joint-stock company, they assume limited liability. In profit

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distribution, fund managers will take out annually about 2% of the total committed capital as a management fee, and the ultimate profits will be split between general partners (20%) and limited partners (80%). Under such a structure, investors do

not participate in investment decision-making and fund managers enjoy full autonomy. The two assume clearly defined responsibilities, which well stimulates and restricts fund managers.

Two ups and downs of private equity funds in the past 30 years After the upsurge of junk bonds and leveraged buyouts (LBOs) in the 1980s,

around 60% of private equity funds engaged in LBOs. The most common practice

was to purchase a listed company through junk bonds, many of which were

hostile takeovers. After being delisted for a period of time, the acquired company underwent staff reduction and debt restructuring before being listed again in the

market at a higher price. At the end of the 1980s, the junk bond bubble burst. The private equity fund also suffered setbacks and remained lifeless for about a decade.

Another boom happened during the new economy wave in the 1990s as

private equity funds became active again in the IT industry mainly in the form of

venture capital. This time they were invested in start-up high-tech enterprises and

made a profit by helping the businesses to their initial public offerings (IPOs) and then the shares were sold to the public. This boom ended as the dot-com bubble burst in 2000.

In recent years, the prosperity of private equity funds has been related to

the international transfer of industrial capital in Western countries. The private

equity funds have successfully seized the business opportunities created by poor corporate governance and low efficiency in the capital markets in emerging

countries. In particular, China’s state-owned enterprise reform and the equity division reform in the capital market presented huge business opportunities. This round of private equity fund activities mainly takes the form of acquisition and reorganization, and the funds will participate in the management of the acquired

companies as strategic investors who will retreat after improving efficiency and creating value-added.

Foreign private equity funds dipped their toes into China’s market in the 1990s Foreign private equity funds have invested in the new breed of Internet and media

companies ever since the 1990s, and turned to the real estate industry afterwards.

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In June 2004, Newbridge Capital Inc. of the U.S. took over management control of

Shenzhen Development Bank Co., the first step of increased takeovers by foreign private equity funds. Subsequently, more and more foreign funds got involved

in the business mergers of China’s enterprises, and the deal size was consistently

increasing in a broader range of fields. The foreign participation was no longer

limited to restructuring state-owned enterprises, but expanded to investment in the consumer goods industry (such as beverage enterprises), channel enterprises (such as chain stores for household appliances), and cyclical resource-based

industries (such as iron and steel factories). It also showed a tendency towards financial and real estate industries. In the past few years, what we heard were that Warburg Pincus of the U.S. had purchased more than half of the shares from

Harbin Pharmaceutical Group, and that the Carlyle Group bid to merge Xugong Construction Machinery Group and The Pacific Life Assurance Co., Ltd.

Foreign private equity funds first focused on creating value-added after share

acquisition by taking advantage of China’s special conditions of equity division and undervalued non-tradable shares. Later, some powerful funds such as Newbridge Capital, were targeted at enterprises with good market positioning and

high growth (like Shenzhen Development Bank). By bringing in new management

teams and advanced management techniques, Newbridge Capital had introduced its experience of risk control and management to Shenzhen Development Bank. The funds rapidly enhanced the value of invested companies and profited by getting the companies listed or selling their shares.

Relevant data The global private equity fund totaled USD738 billion according to the statistics of 2006, with the majority of money coming from institutional investors, the

composition of which became increasingly diversified. In particular, pension funds, endowment funds, insurance companies, commercial banks, and other

institutional investors. Individual investors generally contributed less than 10% of the total investment. Statistics showed that the proportion of private equity funds to annual GDP in 2009 was 0.6% in the U.S., 0.35% in Europe, 0.2% in Asia, whereas

the proportion in China was less than 0.1%. About 27% of the U.S. takeover were

completed by private equity funds. After the global financial crisis, new statistics indicated that the total capital raised through private equity funds worldwide

amounted to USD246 billion, down from over 60% in 2007 and 2008. According to Dow Jones LP Source, the total capital raised by private equity funds in the U.S. in

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2009 was the lowest ever since 2003, with 331 funds collecting USD95.8 billion, a decrease of 68% compared to USD299.9 billion collected by 508 funds in 2008.

Relatively speaking, China is a new place for private equity funds and

venture capital. China Business Network (CBN) Institute published a report, The

New Development Pattern of Industrial Investment Fund and Private Equity Market, in September 2007, which indicated that in 2006, foreign private equity funds

invested in 129 cases in Mainland China with 77 institutional investors and USD12.97 billion involved. The venture capital of USD1.78 billion has not yet been included in the calculation. Statistics showed that among the total venture capital

invested in China’s market in 2006, only 18.4% was from domestic investors.

Moreover, in China’s capital markets, more than 95% of private equity funds were foreign capital while domestic capital accounted for less than 5%.

In March 2010, Thomson Reuters released a report on the private equity funds

in the Asia-Pacific region, which showed that in 2009 Chinese enterprises were the largest beneficiaries of private equity funds in the Asian and Pacific region

(excluding Japan), attracting a total of USD3.6 trillion in investment, 32% of the aggregate amount in the region. Australia and India were closely chasing behind.

In terms of industrial distribution, the energy industry obtained the lion’s share in 2009 with USD2.9 billion, accounting for 26% of the region’s total investment, followed by financial services and consumer industries.

A new feature of investment was that investment banks have made strategic

withdrawals, such as when the Hong Kong stock market picked up, Goldman Sachs sold 3 billion H shares it held in Industrial and Commercial Bank of China

(ICBC) and transferred all its holdings in the project of Shanghai Garden Plaza to Shanghai Forte Land. Morgan Stanley Real Estate Fund agreed to sell its 52-story

office building, The Exchange, on Shanghai’s West Nanjing Road to the mainland developer SOHO China.

According to the statistics from Zero2IPO Group, in 2009 the year following

the financial crisis, 105 renminbi funds successfully raised USD12.30 billion (around

RMB83.94 billion). The number of and the money raised by new renminbi funds, respectively, accounted for 84.7% and 65.4% of those of overall newly established funds during the same period. The renminbi fund for the first time dominated the total capital amount collected through newly increased funds.

According to EZCapital, there were 156 new funds in China’s venture capital

market in 2010, 61 more than the number in 2009. The assets of newly increased funds amounted to RMB187.74 billion, an increase of 11.91% from the last year

(RMB19.98 billion). Among these, the number of renminbi funds was 123 with a

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fund size of RMB105.10 billion while the number of foreign funds was 33 with

a fund size of RMB82.63 billion. The renminbi fund is still playing a dominant role in the market of newly increased funds. The top three new renminbi funds

include: Tao Shi energy investment, which raised RMB10 billion in the first round and which plans to collect RMB100 billion in the next five years for supporting

the transformation of coal mines in Shanxi Province; Hony Capital RMB Fund

II, which closed its first funding round after collecting RMB7.3 billion; and Star Capital Investment Fund which raised RMB6 billion in the first round to

support the modern service industry and the growth of small- and medium-

sized enterprises. The three largest USD funds in China’s venture capital market contained: Carlyle Asia Partners III which raised a total of nearly USD2.55 billion

to become the largest fund in Asia in recent years; China-Africa Development Fund, which finished its second round of fund-raising, securing a USD 2 billion

loan completely from the China Development Bank but is envisioned to collect money from the market; and Sequoia Capital China which completed its third round of fundraising with a total amount of USD1 billion and an investment period of 10 years. 1

Foreign-invested and joint-venture private equity funds and venture capital in China’s market In recent years, the foreign-invested and joint-venture private equity funds and

venture capital which were active in China’s market included: Carlyle Group, Blackstone Group, Texas Pacific Group, Warburg Pincus, Bain Capital, SAIF

Partners, IDG Capital Partners, Sequoia Capital China, GGV Capital, FountainVest

Partners, Unitas Capital (formerly konwn as J.P. Morgan Partners Asia), and Apax Partners. However, China has long hoped to change the dominance of foreign capital in China’s takeover market and encouraged the development of domestic

private equity firms in order to generate a group of powerful local investment institutions. At present, representatives of domestic private equity funds include: CDH Investments, Hopu Fund, Hony Capital, CITIC Capital, and CITIC Private Equity Funds Management.

Although investing in different ares, the above private equity funds and

venture capital all have their own strengths.

Although the Carlyle Group finally failed to take over the Xuzhou

Construction Machinery Group, it invested in nearly 50 Chinese companies and real estate projects with a total investment of over USD2.5 billion.

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Blackstone was famous for China’s Sovereign Wealth Fund, in which

China Investment Corporation (CIC) took a 10% stake, and the CIC authorized

Blackstone with USD500 million to invest in the hedge fund. In August 2009, Blackstone launched the first renminbi fund in Shanghai.

Newbridge Capital, the Asia-based affiliate of Texas Pacific Group (TPG) held

17.89% shares in Shenzhen Development Bank (SDB) in 2004. In June 2009, TPG

transfered its 17% controlling stake in SDB to Ping An Insurance of China and acquired a 58% annual rate of return for five years. Another big move made by

TPG was to form a consortium with three other investment institutions including KKR to purchase the 34.3% stake held by Morgan Stanley in China International Capital Corporation (CICC) at a price of USD1 billion in February 2010.

Warburg Pincus, which was famous for its takeover of Harbin Pharmaceutical

Group, set foot in China after 1994 and invested USD1.5 billion in Chinese

companies, including Harbin Pharmaceutical Group, GOME Electrical Appliances,

Syuntra International, and Yintai Department Stores. Lepu Medical Technology, invested in by Warburg Pincus, was among the first batch of companies listed in the Shenzhen growth enterprise market (GEM) in October 2009.

Bain Capital mainly focused on four major areas including manufacturing,

retail chain, media, and high-tech industries. Its major investment projects comprise: the Goldman Sachs Group, Jiangsu Feixiang Chemicals, GA Pack, GOME, and Sunac China.

SAIF Partners is headquartered in Hong Kong and primarily invests in Internet

companies, franchise services, and new media. It has successfully completed the equity transactions of Shanda Interactive, Acorn International, Perfect World Co., Alibaba, Focus Media, Taobao, and many other famous enterprises.

IDG Capital Partners currently manage capital of USD2.5 billion. It primarily

focuses on leading companies in consumer products, franchise services, Internet

and wireless applications, new media, education, healthcare, new energy, and advanced manufacturing sectors. Its investment covers all stages of the company lifecycle from early stages to pre-IPO. Since 1992, as one of the pioneers of foreign

investors to enter the Chinese market, the company has invested in 200 diverse outstanding companies, such as Baidu, Sohu, Tencent, Soufun, Ctrip, Hanting,

Home Inns, Kingdee, Wu-Mart, Kanghui, and Andon. Among all the investments made by IDG Capital Partners in China, Only 19 projects turned out to be failures.

Around 50 investments were successfully exited through M&A or IPO in the U.S., Hong Kong, and the A-share market.

Since its inception in 2005, Sequoia Capital China has successively invested in

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over 50 companies, and realized multi-field coverage in pharmaceutical research,

proprietary Chinese medicine, biotechnology, public health service platforms, and many other fields.

GGV Capital has provided financial support for nearly 40 companies with

around USD300 million and achieved a balanced investment layout by focusing

on four areas of Internet and digital media, consumer goods and retail services, commercial services, and clean technologies and advanced manufacturing.

CDH Investments focuses on investments in many domestic well-known

private enterprises, and it has invested in not only retail goods manufacturers including dairy producer Mengniu, food marker Yurun, footwear retailer Belle,

and leading sport brand Li Ning, but also companies in emerging industries,

such as mobile retailer D. Phone and display-advertising firm Focus Media. The

National Social Security Fund is also a major investor in the renminbi funds of CDH Investments.

Hony Capital is the private equity arm of Lenovo Holdings with RMB20

billion in assets under management. The National Social Security Fund is also a

major investor of Hony’s renminbi funds. Hongyi investment pays close attention to the buyout and privatization of Chinese SOEs and focuses on sectors where it

has developed expertise: financial services, building materials, pharmaceuticals, machinery, consumer goods, and franchise services. It has invested in 35 projects

and the most representative cases include Simcere Pharmaceutical Group, China Glass Holdings, Zoomlion, CSPC Pharmaceutical Group, New Century Department Store, and Jiangsu Xinhua Distribution Group.

Hopu Investment Management was set up with the backing of Temasek

and Goldman Sachs. In September 2007, the company cooperated with Suzhou

Ventures Group to roll out the first renminbi-denominated China-Singapore HighTech Industrial Investment Fund, which raised RMB5 billion (USD677.3 million)

initially and there were plans to increase that to RMB10 billion. In December of

the same year, Temasek injected USD1 billion into the Hopu USD Master Fund. The new fund mainly invested in small- and medium-sized high-tech enterprises located in the Yangtze River Delta. Overseas capital of Hopu is by and large

buyout funds to finance the mergers and reorganization of Chinese enterprises. These funds not only make equity investments in large state-owned enterprises,

but also seek investment opportunities in business growth by expanding into overseas markets among Chinese companies. The most well-known case was in January 2009 when foreign strategic investors were successively withdrawing from

the Chinese banking industry, Hopu Investment Management took over the stakes

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in the Bank of China (BOC) and CCB from the hands of Royal Bank of Scotland

(RBS) and Bank of America. In July of the same year, Hopu teamed up with China

National Cereals, Oils and Foodstuffs Corporation (COFCO) to buy a 20% stake in China Mengniu Dairy Co., thereby becoming the largest shareholder in Mengniu. In October 2009, Hopu bought 4.9% of an Indonesian-listed real estate and hospital developer PT Lippo Karawaci for USD45 million from China Resources Holdings.

It was the first deal made by Hopu outside China and it revealed Hopu’s intention to extend its business in Vietnam, Malaysia, and other emerging economies.

CITIC Capital Holdings Limited was established in 2002 with over USD3

billion capital under management. Its core businesses cover direct equity investment, real estate funds, structured finance, and asset management. At

present, apart from its management which holds 5% shares, CITIC Capital is

collectively owned by CITIC Group Corporation (55%) and China Investment

Corporation (40%). In 2006, CITIC Capital launched its first China private equity fund, managing USD425 million capital. In February 2010, it finished the

fundraising of its second China fund and collected USD925 million. The first fund

focused on the merger opportunities in the consumer products and manufacturing

sectors while the second is committed to buyout and privatization investments in Chinese companies benefiting from the long-term development of the Chinese domestic economy.

CITIC Private Equity Funds Management Co., Ltd. (CITIC PE) was founded

in June 2008. As the strategic onshore private equity platform of CITIC Group and CITIC Securities, CITIC PE is able to make use of the industrial network

of its shareholders and the resource advantages of the government. In January 2010, CITIC PE raised a RMB9 billion (USD1.32 billion) private equity fund called Mianyang Scientific City Investment Fund, the first direct investment funds under

the company. Up to now, it has made investments of RMB2.2 billion cumulatively

in 10 portfolio projects, including Kuaiji Shan Shaoxing Liquor, Wind Info, and Zhejiang BeingMate. The company targets companies at growth, expansion, and

maturity stages. Among all the investment projects made by CITIC PE, state-

owned enterprises accounted for two thirds. In the future, projects aiming at the privatization of state-owned enterprises will be another investment focus.

The above-mentioned 10+ foreign-invested or Sino-foreign joint PE funds

which are relatively active in China’s market share one feature in common: They

lay particular stress on the talents and aptitude of the management teams. For example, Fang Fenglei, who is the Founding Partner and Chairman of Hopu

Investment, previously served as Vice President of China International Capital

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Corporation (CICC), Chief Executive Officer of Bank of China (BOC) International, and Chief Executive Officer of ICEA Finance Holdings; Wu Shangzhi, the founder of CDH Investments, was the Head of CICC’s private equity group

and responsible for managing direct investment; Zhu Jia was CEO of the China business of Morgan Stanley Asia Limited and Huang Jingsheng was Managing

Direct of China branch at SAIF before they joined Bain Capital; the Partner and

Managing Director of TPG Capital, Ma Xuezheng, served as Chief Financial Officer and Senior Vice President of Lenovo Group Limited; Fu Shan who is the Chief Representative of Blackstone’s Beijing Office worked in the Department of Foreign Investment in China’s National Development and Reform Commission

(NDRC) and the State Economic and Trade Commission of China; prior to serving

as the Chief Executive Officer of CITIC PE, Liu Lefei was Chief Investment Officer at China Life Insurance Co. Ltd, and the President of CITIC PE, Wu Yibing, once

worked as Managing Director of Legend Holdings (later known as Lenovo) and was a Senior Partner of McKinsey; Tang Kui, Hu Yongmin, Zhuang Jian, and Zhao

Chenning of FountainVest Partners were all directors at Temasek; and Lian Xiaolu, now the Managing Director of Unitas Capital, spent 11 years at BNP Paribas as

the Managing Director and the Head of Shanghai Corporate Finance. The above

fund institutions attracted many professionals working at well-known equity investment institutions, investment banks, and consulting firms both at home and abroad when forming the management teams. Warburg Pincus owns more than

30 professional investors; and the management team of CITIC PE consists of over 60 people, including strategic management and M&A experts from McKinsey &

Company, supply chain professionals from General Electric Company (GE), and brand marketing specialists from P&G.

According to the analysis made by Yuan Mingliang in his article “Private

Equity and Venture Capital in China,” investment with real market-oriented operation, targeting growth stage enterprises in China’s direct investment market is mostly from foreign-invested private equity funds, and both financing and exit activities happen on the offshore market. Even though investment managers

become more and more localized, China’s investment teams exert limited

influence over investment decision making and resources allocation, let alone own an independent continuous back-up services system. After the exit from many

investment projects, the connection between the funds and the fund management firms was basically ended. It is precisely for this reason that the onshore private

equity fund is expected to serve as a solution, which explains the advantage of CDH Investments, Hony Capital, Hopu Investment, CITIC Capital, and CITIC PE.2

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Chinese characteristics of domestic private equity funds: Bohai Industrial Investment Fund The reform of China’s state-owned enterprises, the reorganization of statecontrolled listed companies, as well as the capital expansion and development of

private enterprises bring huge market demand for private equity funds. The State Planning Commission (SPC) had proposed to draft an ordinance for industrial investment funds (namely the private equity funds) ever since 1995, but no

document was issued after a few years. Besides, privately offered funds did not dare to expand its scale in fear of being labeled as illegal fundraising. The problem of that time was not a shortage of money. According to a report made by the

People’s Bank of China, the total volume of privately offered funds was around

RMB700–RMB900 billion, and most of them were invested in the securities market for the purpose of speculation instead of working as startup or buyout funds for

small- and medium-sized enterprises and private companies. Meanwhile, many

venture capital funds also did not stick to the investments in startup companies but entered the securities market in pursuit of short-term returns from speculation featuring little investment and quick results.

At year-end 2006, the State Council approved the establishment of Bohai

Industrial Investment Fund (Bohai fund), which was said by the financial media to be “an extraordinary creation.”

The development of domestic private equity funds seriously lagged behind,

which exposed the two problems with Chinese characteristics in the ideology and system of government-led investment. The ideological question is whether

the government or the market should play a leading role in industrial investment funds. The systematic one is when organizing industrial investment funds, which kind of system should be applied, corporate, contract, or limited partnership.

The core question boils down to: Can industrial investment funds be a tool

of the government? The Bohai fund provided an answer to those questions: to adopt a mixed system of corporate and contracts when raising money for

local governments. To be exact, the contract system offers a guarantee for the management of government-involved funds.

Why did the Bohai fund finally choose a corporate system while implementing

contract-based management? The Bohai fund was initiated by Tianjin Binhai

New Area in May 2006. Its fund size had amounted to RMB20 billion (USD2.8

billion), with an initial closing of RMB6.08 billion (USD860 million). Different from the foreign pattern of hiring managers before financing, the Bohai fund first

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collected money from China Life Insurance Group, Bank of China International Holdings Ltd. (BOCI), and Social Security Fund of China, and then set up the

fund management firm and management team. Major sponsors included the

National Council for Social Security Fund of China, BOCI, China Development Bank, Postal Savings Bank of China, China Life Insurance Group, and Jinneng Investment Shareholding Co. Ltd. The fund adopted a mixture of corporate and

contract systems, and investors are at the same time the shareholders in the fund management firm, exerting significant influence over the fund management.

In the West, private equity funds generally implement the limited partnership,

because fund managers need full autonomy in decision making whereas investors should not interfere in investment decisions. The two shoulder clearly-defined

accountabilities. If it is a corporation, investors will easily intervene in investment

decision making and the responsibilities of investors and fund managers will be

intertwined, which will harm the independence and enthusiasm of fund managers. China revised the Partnership Enterprise Law to add limited partnership and

the new law was announced to take effect on June 1, 2007. However, the Bohai

fund rejected the system of limited partnership. The reason behind this, as some

observers said, is that the local government is the main sponsor and it wants to have a say in the investment direction in order to direct the fund to support the

financing needs of local projects. The Bohai fund determined to devote 80% of

its funds to Binhai New Area and the Bohai Rim. Besides, most of its investors

are state-owned institutions and backed up by governments. They are unwilling

to make passive investments and show a strong interest in management. On the other hand, any investment wants government endorsement and is not inclined to undertake risks from limited partnerships. Last, people can hardly accept the

compensation mechanism of a limited partnership. In particular, general partners are able to receive a high return of 20% with just 1%–2% capital contribution.

According to the “two and twenty compensation structure,” a general partner will

charge a flat 2% of total asset value as a management fee and an additional 20% of any profits earned. But as a result, the operation of Bohai fund was not successful.

Tianjin City failed to attract funds to finance local projects but had to ask local well-performed enterprises to fill the fund. A compensation dispute between fund managers and shareholders dogged Bohai fund as well. So, the ideological and institutional challenges faced by industrial investment funds and the solution

provided by the Bohai fund both showed the Chinese characteristics of investment being led by the government.

Why does the private equity fund in Western countries favor a limited

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partnership? Why do Western investors place great trust in fund managers who have strong investment and management capabilities and even agree to the two and twenty compensation structure? This involves the culture of capital. Capital

culture is established through long-term social practice in dealing capital and people will share mutual trust and understanding in capital transactions. The

financing through rotating credit associations (Qianhui 錢會) which prevails

in Wenzhou, Zhejiang Province is a good example. When a countryman is in

urgent need of money, he will invite nine people among his neighbors, friends,

and relatives who will form a rotating credit association. The participants will contribute capital to the organization 10 times with an offering of RMB10,000 each time. The RMB100,000 collected from the 10 congregants in the first gathering will be used by the convener and the capital raised in later meetings will be disposed

of by other congregants whose order is decided by bidding or drawing lots. This is also a reflection of capital culture. Outside of Wenzhou, the practice was

brought by Wenzhou people in France and became a major financing channel among Wenzhou people living in Paris. Similarly, in Western countries, fund

managers with good management skills, high risk-taking spirit for high returns, good performance and great market reputations will be entrusted with large capital under the system of limited partnerships. It is the capital culture of a mature market in Western countries. In contrast, the rotating credit associations of Wenzhou involve more human factor or human sentiment among average

Chinese people while the limited partnership in the Western market tends to be more professional by pursuing profit maximization. The problem faced by China now is the country’s long-term avoidance of talking about capital which has led

to insufficient interaction with capital and a lack of capital culture which protects investors and trust capital managers, as possessed by the mature market.

According to “A Challenge to Capital” published in Century Weekly,3 after

the global financial crisis in 2008, the unspoken rule of offshore private equity funds was quietly changing. It was said that the Institutional Limited Partners Association (ILPA) which consisted of 215 investment institutions and managed

USD1 trillion of private equity assets was established. The association released

a set of guidelines, the Private Equity Principles, for global public endorsement. These principles aim to realign the interests of the limited partner with the general partner, enhance fund management, and provide greater transparency

to investors. It acts more like a proposal for investor rights protection and is particularly favorable to investors. In the age of excess liquidity, fund managers

were at an advantageous position and chased after by capital. But this situation

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was changed by the financial crisis, and capital regained its dominance in the market. It is still unknown in which areas will capital and fund managers reach

a consensus. Information said that there are already more than 100 institutional

investors who have endorsed the principles, including California State Teachers Retirement System and California Public Employees Retirement System.

Although the principles are not compulsory, attracting so many financially powerful institutional investors, they will inevitably exert a significant impact on

the private equity industry and even become the unwritten rule for new funds. Certainly, the author remains doubtful about whether it will lead to a complete

victory for a limited partnership. Once the financing environment is improved and fundraising difficulties are reduced, general partners will demand a revision of the rule.

Local governments regard private equity funds as a financing platform for restructuring state-owned enterprises The implementation of revised Partnership Enterprises Law and the pilot of Bohai

Industrial Investment Fund paved the way for the development of China’s private equity funds. After the Bohai fund, the National Development and Reform Commission (NDRC) approved nine industrial funds for investors including Shanghai Financial Fund, Guangdong Nuclear Power Fund, Shanxi Energy Fund,

and Sichuan Mianyang High-Tech Industrial Fund. But the corporate management and most capital serving for local uses of the Bohai fund did not set a good example.

After Beijing unveiled a RMB4 trillion (USD586 billion) stimulus package at

year-end 2008, numerous municipal governments subsequently rushed to set up funds and financing platforms of their own. According to the “National PE rush” published in Century Weekly in 2010, at present, the regulatory department, local

governments, or state-owned investors, the banking industry, entrepreneurs, and

both foreign financial giants and Chinese talents “are expanding boundaries and developing standards of the PE industry in chaos.” The Chinese characteristic

of government-led investment has generated a “corresponding operation in

accordance with China’s national conditions in every stage from fund setup,

financing, investment to market exit.” The new features of China’s private equity fund industry are:

First, numerous municipal governments rushed to turn private equity

funds into a platform for state-owned enterprise reform. China Huarong Asset

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Management Corporation and Chongqing Yufu Assets Management Co. jointly established a RMB10 billion industrial investment fund with the first phrase

targeting RMB2–RMB3 billion. China Merchant Xiangjiang Industrial Investment Co., Ltd. was jointly set up by China Merchants Securities and Hunan Xiangtou

Holdings Group. The company planned to raise RMB20 billion, RMB5 billion of which would be collected in the first round. Lianyungang municipal government

set up the Lianyungang CSM Huanghai Sea Private Equity Fund, a RMB5 billion

investment fund. It aimed to raise RMB1 billion in the first phase, among which RMB150 million was contributed to by municipal finances while the rest would be raised by China Science & Merchants (SCM) Group outside Lianyungang. Most

especially, just under Shenzhen Capital Group Co. Ltd., there are more than 10 funds having received investments from different municipal governments. The

Zhongguancun Venture Capital Leading Fund launched by Beijing Zhongguancun

Science Park in 2007 has developed more than seven sub-funds. For large- and

medium-sized cities, to have well-known private equity funds settled in their domains will definitely be advantageous.

In a single fund, the government usually contributes 10%–20% of the total

amount and demands a large portion of capital to be invested in local enterprisesor government-backed projects.

Second, fund managers also seek cooperation with local governments and

even foreign-invested private equity funds are willing to win favor from local governments in order to enhance the competitiveness of the funds in the local

market. Fund companies can rely on their connection with local governments to

facilitate the application for industry investment fund in National Development and Reform Commission (NDRC), obtain cooperation opportunities with local

investment platforms and enterprises, and receive information of investment projects. A great deal of foreign capital is gradually realizing that being accustomed to Chinese-style PE is a shortcut to raising a renminbi-denominated fund.

Finally, PE corruption which features the granting or transfer of investment

opportunities to fund firms during the pre-IPO financing of companies, or tunneling as it is called in the financial world, appeared. PE corruption roots in the improper listing approval system. It is because of scarce listing resources that

pre-IPO companies have to resort to private equity funds for listing opportunities

and financial support. It is an exchange of interests. As the small and medium enterprise (SME) board was launched in Shenzhen, the huge price difference between the primary market and the secondary market earned by private equity

funds was exposed, which provoked heated disputes. According to the report

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of Century Weekly, based on the statistics of the Shenzhen Stock Exchange, by

the end of July 2009, among the first batch of 22 private equity funds which had invested in the companies approved to be listed in the GEM board, 16 funds joined the pre-IPO companies for less than three years and 4 funds for only one year.

There were even 2 investment funds which found their investment targets right before the closing day of GEM board application in June 2009. The average priceearnings ratio (P/E ratio) of the 42 enterprises which completed pricing in 2009

was 64.46. When the market closed on December 31, 2009, the average P/E ratio of 36 listed shares reached 105.38. In accordance with the issue price of invested

enterprises, three companies which had received direct investment from securities firms generated an investment return of 478% on average. A PE institution told

the reporter of Century Weekly that even though some enterprises are financially

affluent, they will still absorb tens of millions of renminbi for private placement in order to secure their social and business connections. The maintaining of “social

and business connections” is a synonym for “Chinese-style transfer of interests.”

As with any corruption, the PE corruption also needs bribery. The only difference

is that this bribery is achieved by offering investment opportunities which will become pecuniary benefits after the IPO of invested companies. Therefore, the root problem of PE corruption does not lie in PE investment but the rent-seeking of government officials. PE corruption, similar to other kinds of corruption, has deep social causes.

New trends of bank-backed private equity funds Commercial banks in China were prohibited from participating in direct

investment, so several large domestic banks all adopted the practice of registering a financial platform in Hong Kong before establishing a private fund management firm in Mainland China. Shortly after the founding of BOC International, ICBC

International, and CCB International, Agricultural Bank of China (ABC) set up

ABC International in Hong Kong in 2009. Since then, the four major commercial banks have built investment platforms in Hong Kong, denoting a forthcoming upsurge in bank-backed private equity funds.

At present, private equity funds sponsored by the banking industry display

two features.

First, various bank-backed investment funds have been established in the

search for new investment opportunities, which enhances the competitiveness of

each bank in local areas and the banking industry. For example, BOC International

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not only holds a stake in Bohai Industrial Investment Fund, but also is raising

money for China Culture Industrial Investment Fund. ICBC International teamed

up with Jiangxi Provincial Investment Group to build JiangXi Poyanghu Industry

Investment Management Company. The company first raised RMB400 million as a

conservative fund for the Shangrao project, mainly for the purposes of supporting the new countryside construction and upgrading reservoirs in Songshan Village.

CCB International cooperated with several relevant institutions to register CCB

International Health Care Investment Management with an initial fundraising of RMB2.6 billion. It was the first health care fund in Mainland China. Following that, CCB International established Wanjiang Demonstration Area Industrial

Transfer Investment Fund and aimed to raise RMB1 billion in the first round. The

fund was jointly sponsored by The Peoples’ Government of MaAnShan, CCB International, and Anhui Huishang Industry Investment Fund Management Co. The involvement in private equity funds and direct investment serves as a

supplement to the business of commercial banks and is beneficial for the business diversification of banks.

Second, the interaction between private equity funds and loan transactions is

a new mode widely welcomed by commercial banks. The reason is very simple. Currently, most enterprises face difficulty in fundraising and once a bank can solve the equity financing problem for their clients, it will be in an advantageous place in

the competition for loan business. Century Weekly reported that CCB took the lead in this regard by pooling together equity financing demands of its clients which

will become major targets of the fund management firms under CCB International.

On the other hand, the project companies funded by CCB International were also asked to open an account in CCB to achieve better supervision of the invested companies. The magazine said that bank-backed private equity funds attracted

much attention, because “direct investment generates substantial profits for banks,

on the one hand; on the other hand, this practice can help banks to balance risks. The targets of bank-affiliated private equity funds are usually borrowers of banks. Although banks are exposed to double risks associated with bank debt and equity

financing, they, as stakeholders, can supervise the invested companies and share corporate profits and the return from investment usually surpasses that from loans.”

This mode reminds me of the “main bank system” and “bank holding and

bank-centered enterprise groups” prevalent in Japan in the 1960s. At that time,

Japan implemented an indirect financing-oriented system which was to focus on bank loans, which ensured the capital demand of enterprises during the period of

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rapid economic growth in Japan. However, it also caused high debt ratio, which

was called “excessive loans” by the Japanese people. The capital liquidity was low and banks bore huge risks. This situation captured a lot of attention from

Japan’s banking industry and banking holding was adopted, which was expected to be an effective means in controlling indebted companies. Therefore, a number

of bank-invested enterprise groups emerged, including the long-established zaibatsu of Mitsui, Mitsubishi, and Sumitomo, and newly-established business conglomerates of the Industrial Bank of Japan and the Fuji Bank. The formation

of business conglomerates in turn promoted the investment increase in the

member companies, which was called “conglomerate financing.” Between 1956 and 1960, among the total loan amount of major Japanese banks, 31 Fuji Bank-

affiliated enterprises accounted for 13%, 37 Mitsui Banking-invested enterprises took up 24%, 41 enterprises associated with the Mitsubishi Bank contributed

19%, and 35 enterprises under the Dai-ichi Bank group constituted 16.7%. The conglomerate financing fostered the formation of several bank-centered business groups in major industrial sectors of Japan. Statistics said that in the proportion

of shareholding of listed companies in Japan, the banking industry usually held

over 20% and financial institutions (excluding trust firms) composed more than

40%. Therefore, Japan is labeled as a typical country which allows shareholding by banks. It was right on the basis of bank shareholding and bank-centered conglomerate financing that the main bank system was formed. It created a

special combination between financing capital and industrial capital between the 1960s and 1980 in Japan. The Japanese financial circle once believed that this mode

could reduce financial risks and better protect bank assets. Later, the Southeast Asian Financial Crisis caused a decade-long economic recession in Japan, but

people’s attention was focused on the disaster brought about by the burst of the

real estate and stock market bubbles. Actually, this special main bank system and

the conglomerate financing of bank holding and bank-centered enterprise groups played a significant role in concentrating too much risk on banks. Century Weekly

quoted the comment of an insider of a foreign-invested private equity fund, who said “on the one hand, the financial need of some bank clients is middleor short-term basis whereas the capital demand of private equity is generally long-term fund of five to seven years; on the other hand, bank clients usually

cannot distinguish between private equity and banks, which will induce future disputes.” So, when weighing the merits and faults of bank-backed interaction

between private equity and loans, we need a comprehensive understanding and critical evaluation, as well as risk assessment.

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RMB60 billion fund of funds: Apply commercial means in development finance On December 28, 2010, China’s first fund of funds (FOF) sponsored by China

Development Bank Capital Corporation Ltd. (CDB Capital), a wholly-funded subsidiary of China Development Bank (CDB), was officially established. Named

Guochuang FOF, it was a joint creation with Suzhou Ventures Group, with an

authorized capitalization of RMB60 billion. In the first phase, Guochuang FOF was expected to raise RMB15 billion in 12 years, mainly investing in renminbi

private equity in China’s market. Chen Yuan, Chairman of CDB and CDB Capital, expressed hope that “this RMB60-billion fund can function as seed investment and leverage economic and social development, especially the development of innovative enterprises and industries.”

CDB is the largest infrastructure funding bank in China. By the end of October

2010, it owned total assets of RMB5 trillion, second only next to the four major

state-owned banks (ICBC, ABC, and CCB). Since year-end 2007 when CDB undertook its commercial transformation plan, it established CDB Capital in

August 2009, with a registered capital of RMB35 billion and set up CDB Securities

one year later. Since then, CDB formed an all-round bank structure with CDB as the main body and CDB Capital and CDB Securities as two wings.

The founding of CDB Capital was viewed as a significant achievement

made by CDB since its commercial transformation and the founding drew much

attention from the banking industry. The private equity industry looked forward to this launch while the banking circles envied CDB’s large direct financing platform. Century Weekly published three articles on the first issue of 2011 — “Who

Will Be Leveraged by the RMB60-Billion FOF,” “Do Development Finance through

Commercial Means: Interview with CDB Chairman Chen Yuan,” and “Upgrading

Local Financing Platform.” These articles raised many questions which are worth further study and practice.

How to blend market mechanism with governments’ advantage in

organization? Chen Yuan gave an answer: “to apply commercial means in

development finance,” “adhere to the principles of market operation, devote to promote the sound development of China’s private equity market, build world-

class FOF brands, and offer high return on investment to investors.” This is an innovation in the ideas of CDB and also the best vision.

However, Xie Ping, Executive Vice President of China Investment Corporation

(CIC), responded that “in the international market, the development of private

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equity features private ownership, but China’s private equity is based on state

ownership; most investors come from state-owned companies and invested

companies are also mostly state-controlled companies.” These words warn us that

we cannot blindly borrow the practice from the Western world regardless of the

practical situation. Under China’s unique national conditions, what we frequently see is that people rely on the state’s capital to realize their own future and destiny, which will result in large corruption crimes committed by bank officials. The

question is how to realize Chen Yuan’s wish that “if one institute or individual can

tie its own emotion and efforts to the country’s future and destiny, the smallest risk will generate the largest return and the highest recognition.”

Undoubtedly, the key still lies in talents. A good investment specialist not only

is able to properly judge a project, but can also provide value-added services to companies’ growth and even participate in corporate management to a certain

degree. It imposes a high demand on the comprehensive quality of the specialist.

Chen Yuan mentioned that “the investment banking industry is highly marketized and many investment institutions provide generous compensation systems and

favorable institutional arrangements.” I believe that the manifested advantages

are more than just the compensation system and incentive mechanisms. In the international private equity industries, the fund management is closely related

to the interests of fund managers and the success and failure of a fund are linked to the careers of the fund managers. Therefore, foreign private equity funds

underline fund managers and the success of a fund is inseparable from the good management of fund managers. In contrast, the failure of private equity

funds will not affect the wealth accumulation of fund managers in China. So,

if China wants to do development finance with commercial methods, it has to create effective mechanisms and measures in integrating market mechanisms with the government’s advantages in organization. Only with a democratic and

scientific decision-making procedure, effective supervision, and sound constraint mechanisms, can the private equity industry of China develop successfully.

Fund supervision Among the disputes concerning the private equity fund, one is about the direction of fund supervision. As a matter of fact, a great variety of regulatory authorities

agreed that the private equity fund is a highly marketized organizational form, so the check-and-balance mechanism between limited partners and general partners should be given full play and the government should provide an appropriately

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loose supervision environment for the industry’s development. But due attention should be paid to the trade of interests and PE corruption.

The current problem faced by China is a lack of corresponding laws and

regulations in the private equity industry. The Law on Securities Investment Fund

of China failed to cover private equity funds, and neither did other financial regulations provide evidence for the establishment of private equity funds.

Therefore, the priority of the government is to solve the problems in the development and supervision of private equity funds through revising the Law on

Securities Investment Fund.

Hedge Funds The roots of the modern day hedge fund industry date back to 1949 and run up until the 1980s when the hedge fund became a popular asset in the U.S. When

hearing about hedge funds, people cannot help but think of its severe impact on the British pound sterling and Thai baht, which resulted in financial crises. So, the hedge fund has always been considered a “bad kid.” In fact, the hedge fund

is devised as a kind of investment method to protect capital. Its innovation in the

capital formation mechanism is to protect the capital of investors even during market downturns. Initially, it seeks to find a lower volatility than the market

volatility and realizes market neutrality by offsetting (hedging) the risk and

volatility of one investment position by investing in a companion investment. 。 Since the hedge fund was created as an investment product for the rich at first, the minimal investment requirement for most hedge funds was no less than USD1

million. Being private non-traditional investment vehicles, hedge funds are neither registered with regulatory authorities nor supervised by the U.S. Securities and Exchange Commission (SEC).

The investment of hedge funds mainly involves the trading of not only

securities, bonds, foreign exchange, and commodities, but also complex financial

derivatives. Some of the investment strategies employed by hedge funds are very simple, and others may be extremely complicated. Both debit-credit mechanism and short selling mechanism (short positions will enable investors to make profits when the stock falls in price) can be used by hedge funds.

After the 1990s, with the integration of the world economy, the development

of emerging markets, the relaxation of financial regulation, and the massive emergence of innovative financial tools, hedge funds ushered in the golden age of development. By the end of 1990, there were 1,500 hedge funds in the U.S. with a

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total capital of less than USD50 billion. What made hedge funds famous was the

attack of the Bank of England by George Soros who earned USD1 billion from the speculation. In 1997, Soros took the lead to launch a speculative attack against the Thai baht, which also generated a huge return for the hedge funds. For a time, the

fame of the Quantum Fund, the Tiger Fund, and other hedge funds was beyond that of mutual funds, the mainstream product in the market. But hedge funds are

not always accompanied by high profits, and this may prove a great risk. After the

Southeast Asia Financial Crisis, hedge funds suffered major losses in Hong Kong, Russia, and other areas. The collapse of Long-Term Capital Management (LTCM)

would bring disaster to the entire U.S. financial system, if not for the multi-billiondollar bailout of LTCM by Alan Greenspan and dozens of investment banks. In the following years, the Tiger Fund was shut down, and even the legendary Quantum Fund of George Soros remained sluggish. Since then, hedge funds have left an impression of high risks on investors.

Hedge funds were most aggressive in the commodities futures market.

Between 1995 and 1996, several European and American large funds led by Soros initiated massive speculative selling against Sumitomo Corporation, a

Japanese copper trader, after carefully analyzing the supply and demand on the copper market. In 1996, 34 trading days after May 31, the copper price in the

London Metal Exchange plummeted to USD1,740 from USD2,712, and Sumitomo Corporation recorded a loss of USD2.6 billion. This was followed by the market

panic resulting in a massive sell-off and Sumitomo’s loss was further expanded to

USD4 billion. In previous years, China National Aviation Fuel Group Corporation (CNAF) lost money in selling call options and its rivals were veterans who had

been engaged in the derivatives market for a long time. Later, the oil price soared suddenly for no reason and fell rapidly after the options were exercised, indicating that foreign speculators probably jointly cornered the market. In this case, hedge funds may also play a driving role.

After the Southeast Asia Financial Crisis, hedge funds retreated from Hong

Kong and Russia. Many hedge funds shifted from the pursuit of unreasonable excess returns to specialized development. The hedge fund aimed to offer stable

triple-digit annual earnings for the market. As a result, it attracted attention from many university endowments, insurance companies, and retirement funds.

Huang Xiaoping said in “A Short History of Hedge Funds: A Ten-Year Review”

that “from 2001 to 2006, the assets of hedge funds expanded from USD564 billion to USD1.5 trillion and the number increased from 4,500 to 12,000, a growth rate of 200%.” After the global financial crisis in 2008, Peter Clarke, CEO of Man Group,

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estimated in May 2009 that the assets under the management of global hedge

funds had decreased from USD2 trillion to USD1 trillion in 2008.4 According to the report by Wang Zhoujie from Shanghai Securities News in March 2010, the

economic stimulus plans successively carried out by governments around the

world in 2009 had helped the global stock markets, bond markets, and hedge fund industries to bounce back. The global hedge fund assets increased sharply by

USD751 billion to reach USD1.96 trillion at year-end 2009, almost on a par with the size before the global financial crisis.

After the global financial crisis in 2008, a new trend emerged in the market:

the convergence of the originally distinct mutual funds and hedge funds. In “New Fusion of Funds,” a report made by Gao Chaosheng in the Century Weekly in 2010, the author introduced the idea that in 2009, many traditional hedge fund

firms had launched mutual funds targeted at the general public, for example AQR Capital Management rolled out its first mutual fund in 2009. At the same time,

some mutual funds also released quasi-long/short hedge funds, including the famous 130/30 fund (the fund is 130% in the long portfolio and 30% in the short

portfolio, and realizes excess returns by taking advantage of the hedging effect of short positions and leverage effect of long positions). Fund companies including T. Rowe Price, J. P. Morgan, Legg Mason, Dreyfus Corporation, and Leuthold Group

had launched their long/short funds in the past two years. The reason behind this was that after experiencing the stock market slump in 2008, more and more investors came to realize the importance of protecting investment principal and

thus diverted away from traditional diversified investment products towards new investment breeds with absolute returns. Within less than 10 years from 2001 to

2008, the stock market suffered two 40% losses and these made many investors doubt the long cherished investment ideas.

In addition, there was a contradiction in the ideas of hedge fund regulation

between different countries. During the G7 meeting in Essen, Germany, in February 2007, the gathered finance ministers believed that hedge fund activities

were becoming “more complex and challenging” and “given the strong growth of the hedge fund industry and the instruments they trade, we need to be vigilant.” Although regulatory standards and codes were not passed in the meeting due

to strong objection from the U.S., the attitude of the U.S. government changed greatly after the 2008 global financial crisis. The U.S. indicated awareness that strengthening the supervision and regulation of hedge funds was inevitable.

A report made at the end of 2010 said that international investment banks were

severely affected by the financial crisis. In particular, the release of the Dodd-Frank

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Wall Street Reform and Consumer Protection Act in June 2010 adopted the Volcker Rule which prohibits depository banks from proprietary trading and just allows

banks to invest up to 3% of their Tier 1 capital in private equity and hedge funds.

But relevant acts imposed loose regulation on hedge funds by only demanding them to register and disclose parts of information. The new act stipulated that

hedge funds must register their investment consulting activities with the Securities and Exchange Commission (SEC), and report their assets volume, leverage ratio,

transaction information, and investment portfolios on a regular basis. However, this rule was not applicable to “offshore hedge funds” which did not conduct transactions within the territory of the U.S. or which had less than 15 domestic customers. The Volcker Rule set clear standards for hedge fund activities within

investment banks, but failed to offer adequate supervision to the whole hedge fund industry. In such a way, the new act provided a chance for regulatory arbitrage.

Due to a decline in both trade volume and flexibility of investment banks, hedge funds and private equity funds would be major beneficiaries. In addition, the outflow of talents from investment banks would divert more advantages to those

industries. It is predicated that hedge funds would be the “next king of Wall

Street.” Even Simon Johnson, the former chief economist of the IMF, wrote that “major hedge funds are presumably looking for ways to become bigger and take

on ‘systemic importance.’ Ideally — from their point of view — they will bulk up

without attracting regulatory scrutiny, i.e., no ex ante limits on their risk-taking activities will be imposed. If all goes well, these hedge funds — and of course

the banks that are already undoubtedly Too Big to Fail (TBTF) – get a great deal

of upside.” The author gave his article an eye-catching title: “Creating the Next Crisis.”5

According to the industrial report by Hedge Fund Research, Inc. (HFR), in the

past two decades, the number of hedge funds in the global market increased from 610 in 1990 to approximately 9,000 in the first quarter of 2009; and the assets under management also grew significantly from USD39 billion in 1990 to around USD2

trillion in mid-2008. Now, the hedge fund industry has got rid of the business

slowdown which started after October 2007 and the total assets bounced back to USD1.78 trillion.

Currently, China still practices capital account control, and there are not any

laws or regulations on hedge funds. With the gradual opening of China’s capital market and the relaxing of QFII and QDII quotas, it is necessary to strengthen the consultation and coordination among different regulatory authorities in order

to formulate laws and regulations of hedge funds. Some scholars suggested that

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the content of regulations could refer to the three objectives proposed by IMF in

1998: (a) the protection of investors; (b) ensuring that markets are fair, efficient, and transparent; and (c) the reduction of systemic risk. Under the principles of standardization, fairness, and equality, and the encouragement of financial

innovations, the supervision department should set up clear regulations on market

access, operation, information disclosure of hedge funds, and anti-fraud and anti-

market manipulation provisions, as well as prohibitions against insider trading and related-party transactions. The hedge fund activities should be allowed only when the conditions permit.

The Rise of Sovereign Wealth Funds A sovereign wealth fund (SWF) is a state-owned investment entity that is

commonly established from tax and budget surpluses, proceedings from renewable natural resources, and international balance of payments surpluses.

It is controlled and managed by the government and usually held in foreign

currency. The rise of SWFs brings about structural changes in capital composition,

market operation, and investment modes in the global financial market. Standard Chartered Bank (SCB) called the rising SWF “state capitalism” in one of its reports.

The SWF is no stranger to the Chinese people. In the 1980s when China founded

six large investment firms, Singapore’s Temasek Holdings, one of the world’s largest sovereign wealth funds, was the role model that was followed by China’s national investment companies.

The SWF is the outcome of the wealth transfer during economic globalization.

By the end of 2008, there were approximately 40 countries which founded SWFs with USD3.9 trillion under management. Among the total assets, Middle East oil-

producing nations constituted 45%. The SWF developed very quickly, because economic globalization increased the demands for energy and minerals, leading

to a surge in the prices of oil and mineral products. Countries with rich resources, such as the Gulf countries and Russia, rapidly accumulated huge national

wealth. In addition, cross-border capital flows of the manufacturing industry from developed countries to Asian countries turned a batch of export-oriented emerging countries and areas which relied on their manufacturing industries into

the world’s factories. Those developing countries generated large export surpluses and accumulated huge foreign exchange reserves through fiscal and foreign trade surpluses. The best examples are China, Singapore, South Korea, and Malaysia. The SWF of those countries mainly came from foreign exchange reserves, budget

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surpluses, pension reserves, and earnings from privatization.

SWFs now are growing at a speed of USD0.8 trillion to USD0.9 trillion per

year. According to the estimates by Deutsche Bank, it is expected that the size of

global SWF will exceed USD5 trillion in five years and USD10 trillion in 10 years. Besides, Morgan Stanley anticipated that global SWFs will outgrow global foreign

exchange reserves and reach USD12 trillion in 2015. The proportion of SWFS to global financial assets will grow from 2.5% at present to over 9%.

The year 2008 was an agonizing period when the world was suffering from the

financial crisis. The assets of major SWFs shrank dramatically with an average loss of 10% to 30%. The stocks, real estate, and other assets held by SWFs fell as much

as 25% in value, leading to losses of USD500 billion–USD700 billion. As a result, the total value of SWFs declined to USD230 million–USD250 million.

Traditionally, European retirement funds favored fixed-income assets, such as

the U.S. Treasury bonds. In the past 30 years, petrodollars and Asian dollars were the biggest buyers of the U.S. debts. They are providers of low-cost capital and creators of the low interest rate environment for the U.S. and are also pillars for

the world’s economy under the overall trade imbalance. But due to the restrictions from liquidity and security, those funds cannot receive desired returns by solely

relying on the interest on the U.S. government bonds. Based on the estimates by

Tao Dong from Credit Suisse Group in 2007, if the investment return from China’s

excessive foreign exchange reserves (approximately USD900 billion) could increase from 4% to 8% (not unrealistic), the newly increased wealth would exceed the total budget on national education, healthcare, and environmental protection. Therefore, to divert the capital of SWFs from national bonds to other long-term equity investment in order to seek higher returns within a bearable and controllable range of risks is the new trend.

However, there are two fatal weaknesses of SWFs. First, the national nature

will easily cause political sensitivity and political and national security concerns will bring out non-commercial distractions. In 2005, the attempted buyout of U.S. Unocal Corporation by China National Offshore Oil Co. (CNOOC) failed due to the obstruction from the U.S. Congress. In 2006, the sale of port management

businesses in six major U.S. seaports to the Dubai Ports World, a company owned

by United Arab Emirates (UAE), met strong opposition from the U.S. public and

Congress. In the same year, the rumor about a takeover of a British multinational

utility company (Centrica) by Russia’s Gazprom triggered great public concern in the U.K. which had been known for opening to foreign acquirers. Second, the

size of SWFs are usually very large with each single investment being as many as

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USD1 billion. In the markets of stocks and gold, any purchase move of SWFs will

cause a price spike, and thus hinder the subsequent transactions, an unimaginable difficulty to other funds. Besides, SWFs are concentrated in the hands of the few, each managing an asset of hundreds of billions of dollars. Any changes in their asset allocation will exert an enormous impact on the prices in financial markets.

Most recently, SWFs prefer to invest in the financial institutions which Wall

Street is proud of. For instance, Abu Dhabi Investment Authority (ADIA) injected USD7.5 billion into Citibank through convertible stocks. CIC bought USD5

billion Morgan Stanley convertible equity units which would be transformed into common shares upon maturity. Before 2010, Morgan Stanley promised to guarantee CIC a 9% annual return on the units, well above the 3% dividend of

common stocks. Singapore’s sovereign wealth funds also sank money in two

international securities companies: first injected USD3.97 billion in UBS and then purchased USD6.2 billion of Merrill stock. In 2007, the transactions conducted by

SWFs also included: CIC acquired a 10% stake in Blackstone; Dubai International

Capital LLC (DIC), the international investment arm of Dubai Holding owned by Sheikh Mohammed bin Rashid Al Maktoum the Ruler of Dubai, bought parts

of the stakes in Och-Ziff Capital Management Group LLC (Och-Ziff); Qatar Investment Authority (the QIA) acquired a 20% holding in the London Stock Exchange.

In the eyes of Americans, they have always been the crisis handler of troubles

triggered by other countries around the world. In the 1970s, the Japanese buying

vital pieces of American assets, including Rockefeller Center and Columbia

Pictures provoked resentment from the American people, but those purchases did

not touch upon financial assets, the bottom-line of the citizens. The U.S. subprime mortgage crisis brought disasters to many well-known financial institutions and caused the acquisition of America’s financial assets by SWFs. This inevitably

aroused worries and panic from Wall Street. Joseph Quinlan, a senior market analyst

for Bank of America, joked that SWFs were almost a “fire brigade.” He estimated that since the second quarter of 2007, those funds had injected approximately

USD60 billion into Western financial firms. It indicated that those funds were

more confident about the growth prospects of banks, stock exchanges, and asset management industries than other investors.

Since the latter half of 2007, in fear of excessive foreign capital infusion

destroying capital flow, America and European countries proposed to regulate the investment operations of SWFs. In October 2007, when the G-7 finance ministers met central bank governors, they agreed to identify the best practices

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for SWFs voluntarily abided to by each country. In the annual meeting of the IMF in 2007, to enhance the transparency of such funds was also listed in the agenda.

Unfortunately, the subprime mortgage crisis of 2007 quickly transformed into a global financial tsunami and spread from the U.S. to Europe, which forced those

countries to change minds. In January 2008, when British Prime Minister Gordon Brown visited China, he openly expressed his wish of China considering the U.K. as its preferred choice in SWF investment. It cleared the way for SWFs in the

international market and signified SWFs becoming an important force in averting

a crisis and stabilizing the economy. It turned out that Joseph Quinlan’s words of turning SWFs into a “fire brigade” came true.

In March 2008, The United States, Abu Dhabi, and Singapore jointly released

a set of Policy Principles for Sovereign Wealth Funds and countries receiving

SWF investments, also known as the “Washington Agreement.” The agreement, aiming at both investor and recipient nations, contained two parts of nine rules. It stipulated that “SWF investment decisions should be based solely on

commercial grounds…Countries receiving SWF investment should not erect

protectionist barriers to portfolio or foreign direct investment.” In October 2008, 23 major countries with SWFs jointly announced the “Santiago Principles,” which

demanded that SWFs and recipient countries should display high accountability and transparency through the means of information disclosure of invested areas,

proper reporting systems, and annual audits. This meant generally agreed upon principles and practices surrounding SWFs had been established.

It now seems that SWFs cannot get out of the shadows. Being held by

sovereign states, SWFs are born to be non-transparent, which inevitably cause some doubts and worries. If SWFs want to succeed in the international financial market, their investment cannot contain any strategic political intention. The day

when the CIC came into existence, a lot of people made all sorts of assumptions. This indicated that people were vigilant and sensitive to SWFs. So, it is important to remove doubts by enhancing investment transparency. Lou Jiwei, Chairman of CIC, frequently addressed the need that the CIC would carry no political motivation and strictly pursue commercial goals in order to clear up people’s

doubts. In many investment practices, the CIC repeatedly stressed its role as a

financial investor. Similarly, Singapore’s Temasek stated that it would play a role of negative investor by neither owning the corporate control nor gaining a seat on the board of directors in its capital infusion in Merrill Lynch & Co.

SWFs must hold the principle of long-term investment and strategic

commercial investment in their investment activities. People frequently talked

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about the losses of CIC’s investment in Blackstone. Actually, short-term

fluctuations in the market are not vital as long as invested companies are the

leaders in a growing industry in the long run and SWFs can become strategic investors through private placement. In this way, investors can not only avoid the

liquidity concern in the secondary market but also occupy the height of the capital market. This is always the secret of success of strategic investors.

Meanwhile, SWFs have to insist on commercial, professional, and independent

operation. It is better for those funds to place their money under third-party

management. It will lighten political hue, establish multi-strategic and multi-

channel investment portfolios, and compensate the weakness of those funds in resources, talents, and internal supervision.

Segregated Account Management of Funds and Wealth Management of Banks Since the beginning of the 21st Century, segregated account management

developed quickly in the U.S. as a result of the increase of the high-income group in society. It became a highlight of the investment fund industry. In 1995, the assets managed through segregated accounts were around USD10 million in the U.S. but this number grew to USD678 billion in 2005, up 17.7% from 2004.6

It is said that the development of the U.S. segregated accounts can be attributed

to four factors. First, the long-term prosperity in America’s stock market during

the 1980s–1990s created a group of rich people and the following dot-com bubble

taught investors to choose proper investment strategies. Second, the threshold of wealth management was lowered. In the past, investment managers usually

set high minimum asset level requirements in the range of USD5 million–USD10 million 2-5 million per account. The level was reduced to USD100,000 in recent years. This made segregated account management more accessible to ordinary

investors. Consequently, the market size bulked up rapidly. Third, previously,

only brokerage firms and investment consulting firms offered segregated account management services, but now banks, and insurance companies, securities, and fund and investment management companies engaged in this market. In this

way, the accessibility of segregated account management was largely improved. Fourth, fees of segregated accounts were lowered. In the 1970s, the charge rate of

the U.S. segregated accounts was near 3%, twice the fee charged by mutual funds. According to the statistics from Money Management Institute (MMI), irrespective

of consulting fee, the average rate of mutual fund fees is now around 1.56% and

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the average charge rate of segregated account management is 1.25%. This range is deemed as being reasonable.

The development of segregated account management in China was also very

fast. As has been mentioned in the previous part, the total amount of China’s

private equity funds invested in the securities market was between RMB700 billion and RMB900 billion in 2005, representing the huge demand of the market for segregated account management. But those privately-offered funds were

legitimate. They usually operated in the name of investment agencies, investment consulting companies, and investment management firms and provided capital

management services for investors. Due to a lack of legal protection, most privately-offered funds opened accounts in the names of individuals and the accounts existed in flexible forms. Therefore, those funds were bound to entail risks.

Banks were ahead of other financial institutions in wealth management

in China. Some commercial banks started to offer professional consulting

and personal foreign exchange management services at the end of the 1990s. After September 2004, parts of commercial banks launched renminbi financial

management services. In September 2005, China Banking Regulatory Commission

(CBRC) announced the Guidelines for the Risk Management of Personal Financial Management Services Provided by Commercial Banks, which took effect on November

1, 2005. The measures stipulated commercial banks should make comprehensive analyses on possible impacts of investment products they sell on clients and determine different investment products’ and financial plans’ minimal investment requirements, which should be no less than RMB50,000 for renminbi accounts and USD5,000 (its equivalent in any foreign currency) for foreign currency accounts.

Later, the CBRC passed the Measures for the Administration of Trust Companies’ Trust

Plans of Assembled Funds, also known as sunshine financial management, in year-

end 2006. It was implemented on March 1, 2007, and provided that the minimal amount of trust plans should be no less than RMB1 million.

At the end of November 2007, China Securities Regulatory Commission (CSRC)

initiated the pilot programs of segregated accounts in fund firms and announced Trial Measures for Asset Management Business of Fund Management Companies for

Specific Clients. Five related regulations were later issued successively. Pilot projects of segregated account(s) for a single specific client (widely known as “one-to-one”) and multiple specific clients (“one-to-many”) were carried out. It was stipulated

that initial entrusted assets of a single client should be no less than RMB50 million. After three years of pilot works, 37 fund management companies were qualified

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for specific asset management with RMB100 billion in assets under management

by the end of June 2011. In August 2011, CSRC officially released Measures for Fund

Management Companies to Provide Asset Management Services to Specific Clients on

a Pilot Basis and its supporting rules, which took effect on October 1, 2011. The measures required that the minimal level of initial assets should be no less than

RMB30 million for one-to-one business and the maximum number of a single asset management plan should be no more than 200 investors with total initial assets no less than RMB30 million.

Wealth management developed very quickly in China. At year-end 2010, the

assets managed by the industry of trust plans of aggregate funds (sunshine private

funds) for the first time exceeded RMB200 billion, up 150% year-on-year. By the end of June 2011, the value of pooled wealth management products of securities brokers was around RMB140 billion, an increase of RMB17 billion from year-end 2010.

Comparatively speaking, the growth rate of banks’ financial management

products is astonishing. According to the statistics, between January and September of 2011, financial institutions launched a total of 14, 751 kinds of wealth management products the value of which exceeded RMB1.1 billion. In the past

four years, the investment size in those products reached RMB2.6 trillion in 2008 and RMB5 trillion in 2009, before further growing to RMB7.05 trillion in 2010.

Moreover, within just nine months of 2011, the value of wealth management products increased by approximately RMB4 trillion.

Fund Financing Fund financing once aroused huge disputes in China. This is not hard to understand. In the modern financial market, it is undeniable that all the operation of financial products has the demands for financing. Just as banks need to raise

capital in the interbank market when dealing with currency, investment funds also

have financing needs in capital goods operation. Both are out of normal operation

needs. Therefore, it is common that countries of market economy around the world allow investment funds to borrow short-term loans from commercial banks. But

what the market economy considers common sense requires a gradual realization process for China which is at the stage of economic transition. During more than

30 years of the Reform and Opening Up era, examples of this were frequently

seen. For instance, although the issuance of national debts was resumed in 1980, it was not until eight years later that the transfer of such debts was allowed. Take

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another example: When the stock market opened in 1990, financial activities of

securities firms were outlawed. The flow of bank funds into the stock market against regulations was prohibited. The regular financing needs of securities firms in operating capital goods, similar to those of banks, were not recognized until

10 years later. Similarly, there will also be a process of improved understanding towards fund financing.

A major reason against fund financing was that funds are considered trust

products rather than operating institutions, therefore they are disqualified for

financing. In essence, the Chinese government feared that the risks from funds would drag down banks. However, investment funds in foreign countries with a

market economy are also trust products, and they are generally allowed to seek short-term financing from banks. It is clear that funds have financing needs in the market operation and being trust products cannot be a reason to reject their

financing demand. Moreover, open-end investment funds are similar to demand deposits that can be subscribed and redeemed at any time. Investment funds have to borrow money from banks during big redemptions just as banks need to appeal for help in the interbank lending market during bank runs.

Another reason for prohibiting funds from seeking money from banks was

out of the concern of financial risks. If fund financing is allowed, especially largescale financing, it will enlarge the size of funds as well as the risks of operation. The government is worried that allowing funds to invest in stocks would divert

parts of the fund risks to banks. But this worry was unnecessary, just as depositors will not be bothered too much about when bank loans will transfer risks to them.

Moreover, the securitization of real estate and consumer credit, as well as all kinds

of financial innovations, have turned credit assets of banks into securities to be traded for capital in the market. On the one hand, this practice expands financial scale and increases financial risks. On the other hand, asset-backed securities

liquidize non-performing assets, give full play to the value discovery and optimized resource allocation functions of the securities market, and give huge

active capital new investment opportunities in the financial market. Comparatively

speaking, investment funds apply for bank loans with securities as collateral which have good liquidity. In addition, banks can examine loan applications and decide whether to lend funds money or not. On the whole, therefore, risks from fund financing are not big and can be controlled.

In the modern financial market, investment funds gradually replaced bank

deposits to be an important channel in absorbing national savings and also a major capital source for the capital market. If the capital market and investment funds

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really want to develop, to open up fund financing, stock index futures, and short selling are indispensable steps. Although the capital market in China has allowed financing bonds, stock index futures, and fund financing, the reason why this book is still talking about fund financing is to remind readers that in the reform and opening of the capital market, China has made many factual errors, as well as a big fuss over a minor issue.

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Notes Chapter 8 1. 2.

3.

China Quality Supervision News is the only official website in the field of quality and is managed by the General Administration of Quality Supervision, Inspection, and Quarantine. Taihui is a transformation of credit association which offers mutual help in principal but is profit-oriented in reality; members of taihui supplied large sums of capital and there were cases of absconding conveners between 1985 and 1987. Marx, “Genesis of the Industrial Capitalist,” Chap.31 in The Process of Production of Capital, Vol.1 of Das Kapital.

Chapter 9 Deng Xiaoping, Selected Works of Deng Xiaoping, Vol.2, 29. Deng Xiaoping, Selected Works of Deng Xiaoping, Vol.3, 79. Guo Tongxin, “Problems on the Statistics and Ratio of the Domestic Services Industry.” Petras, “Past, Present and Future of China: From Semi-Colony to World Power?” Ibid. Ibid. Ibid. Ibid. Ibid. He Maochun, “Only an Open Country Can Ensure Economic Security.” Ge Shunqi, “How Big Is the Economic Threat from Foreign Investment?” The English version is from the website of Ministry of Commerce of the People’s Republic of China, accessed August 1, 2013, http://english.mofcom.gov.cn/aarticle/policyrelease/announceme nt/200712/20071205275755.html. 13. The English version is from the website of Ministry of Commerce of the People’s Republic of China, accessed August 1, 2013, http://english.mofcom.gov.cn/article/policyrelease/Businessregulatio ns/201303/20130300045909.shtml 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Chapter10 1. 2. 3. 4. 5. 6.

Borland, “Bill Gates Pledges to Leave His £30billion Fortune to Charity... Rather Than His Children.” Harvey, “I’m Not Leaving the Money to My Kids... It Wouldn’t Be Good For Them or Society.” Tynan, “Bill Gates 10 Memorable Moments.” Starr, “The Creation of the Proletariat,” Chap. 10 in A Worker Looks At History. Chen Yu, “The Development of Human Capital.” Guo Shuqing, “Internal and External Balance of China’s Economy.”

241

Notes

Chapter 11 1. 2.

3. 4. 5. 6. 7. 8.

9.

Liu Wei, “30-Year of China’s Housing Reform: The Dream and Reality of Home Ownership.” It refers to the activities of putting together several blocks of land used for rural construction that are to be cleared up and reclaimed as arable land (land blocks where old buildings shall be dismantled), the land blocks to be used for urban construction (land blocks where new buildings shall be built) and other areas on the basis of the overall land use planning to compose a project area of dismantling old buildings and building new ones, to finally achieve the objective of increasing the effective area of arable land, improving the quality of arable land, economically and intensively using the construction land, and implementing a more reasonable layout of the urban and rural land use through such measures as dismantling old buildings and building new ones, land clear-up and reclamation, and on the basis of ensuring the balance of areas of all kinds of land in the project area. Hernando de Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. Ibid. Chen Zhiwu, “If Dead Wealth Becomes Active Capital.” Chen Zhiwu, “The Mystery of Capitalization.” Soviet Union Ruble. The scandal stemmed from Fuxi Investment Holdings Co. which was the first listed private company to issue short-term financing bills. In March 2006, Fuxi issued RMB1 billion of one-year financing bills. However, the company was accused of illegal borrowing of RMB3.2 billion from Shanghai pension funds to bid for the operation of a Shanghai-Hangzhou expressway. When the scandal was exposed, the major assets of the company were frozen by the court, and the RMB1 billion debts faced a solvency risk. Li Yang, Wang Guogang, and Wang Songqi, Blue Book of Finance: Annual Report on China’s Financial Development (2008–2009).

Chapter 12 1.

2.

Zhang Nan, “Mike Milken: Search for Gold from Junk Bonds;” Ye Lingchun, “Mike Milken: A Role Model of Discarding Evil for Good;” Peng Xin, “The Legend of Junk Bonds;” Daniels, “The Man Who Changed Medicine.” Luo Changping, Zhang Bolin, Ouyang Hongliang, and Zhang Bing, “The Pain in the Restructuring of Tonghua Iron and Steel Group.”

Chapter 13 1. 2. 3. 4. 5. 6.

242

EZCapital, “Annual Report of 2010 China Venture Capital.” Yuan Mingliang, “Private Equity and Venture Capital in China.” He Jie, and Sun Congkun, “A Challenge to Capital.” Yang Yang, “The Two Trends of Hedge Funds: Transparency and Deleveraging.” Qu Yanli, “Rebirth of Hedge Funds.” Please refer to the report released by the U.S. Money Management Institute (MMI) on February 14, 2006.

References Chapter 8 Chinese materials: Feng Xingyuan 馮興元. “Zhongguo de difang wenhua yu difang jingji fazhan moshi de yanhua” 中國的地方文化與地方經濟發展模式的演化 (The Evolution of Local Culture and Local Economic Development Pattern). Caijing Magazine 財經, (20) (2010). Li Ya 李亞. “Minying jingji gaige sanshi nian” 民營經濟改革三十年 (Thirty-Year Reform of Private Economy). China Economic Times 中國經濟時報, August 7, 2007. Ma Licheng 馬立誠. Da tupo 大突破 (Major Breakthroughs). Beijing: China Industry & Commerce Associated Press, 2006. “Pianjian daozhi ‘yuanzui’ shuo” 偏見導致“原罪”說 (Prejudice Leads to “Original Sin”). China Business Times 中華工商時報, November 3, 2004. Qiu Feng 秋風. “Minqi yuanzui shuo shi wudao xing gainian” 民企原罪說是誤導性 概念 (The Statement of Private Enterprises Having Original Sin Is Misleading). BlogChina. Com 博客中國, February 5, 2007, http://qiufeng.blogchina. com/233844.html. Research Organs of the All-China Federation of Industry and Commerce 全國工 商聯研究室. “2002–2006 nian Zhongguo minying jingji fazhan qingkuang zongti fenxi” 2002–2006年中國民營經濟發展情況總體分析 (Overall Analysis of China’s Non-State Economy between 2002 and 2006). China Business Times 中華工商時報, November 6, 2007. Xia Xiaojun 夏小軍. “Wenzhou minjian ‘hui’ de gongguo” 溫州民間“會”的功過 (The Merits and Demerits of Private Rotating Credit Associations in Wenzhou). Economic Highlights 經濟學消息報, May 2002. “Zhongguo de minying jingji: Fengyu tongxing liushi nian” 中國的民營經濟：風雨 同行六十年 (China’s Private Economy: A 60-Year Review). China Business Times 中華工商時報, September 9, 2009. Zhu Wenna 朱文娜, and Nian Guangjiu 年廣九. “Zhifu guangrong shidai de tanluzhe” 致富光榮時代的探路者 (Pathfinders in the Age of Wealth Being Glorious). Faren Magazine 法人, (3) (2008).

243

References

English material: Marx, Karl. The Process of Production of Capital, Vol.1 of Das Kapital. Moscow: Progress Publishers, 1887. http://www.marxists.org/archive/marx/ works/1867-c1/ch31.htm.

Chapter 9 Chinese materials: Cao Erjie 曹爾階. “Liyong waizi he yinjin jishu” 利用外資和引進技術 (The Use of Foreign Capital and Introduction of Technologies). Speech at Xiamen Technology and Trade Seminar of Economic and Technological Development Research Centre of the State Council. Review of Economic Research 經濟研究 參考資料, (186) (1984). “Chanye zhuanyi: Xiangxiang yu xianshi” 產業轉移：想像與現實 (Industrial Transfer: Imagination and Reality). Century Weekly 新世紀, (38) (2010). Chen Wenhong et al. 陳文鴻 等. Dongya jingji hechu qu?東亞經濟何處去 (Where Is East Asian Economy Going?). Beijing: Economy and Management Publishing House, 1998. Cheng Siwei 成思危. “Chanye anquan de jidian” 產業安全的基點 (Prerequisites of Industrial Security). Beijing Daily 北京日報, December 24, 2007. Ci Bin 慈冰, Zuo Lin 左林, Hu Wen 胡雯, Wang Ningning 王甯甯, Li Weina 李緯娜, Wang Qihua 王奇華, and Gao Shengke 高胜科. “Fushikang ‘bianfa’” 富士 康“變法” (Reform of Foxconn). Caijing Magazine 財經, (15) (2010). Deng Xiaoping 鄧小平. Deng Xiaoping wenxuan 鄧小平文選 (Selected Works of Deng Xiaoping). 3 vols. Beijing: Peoples’ Publishing House, 1989-93. “Fushikang daigong diguo beiqian, Shenzhen ji jumin jiang mianlin zhuanxing zhitong” 富士康代工帝國北遷，深圳及居民將面臨轉型之痛 (Northward Migration of Foxconn Brings About Painful Transformation of Shenzhen and Its Residents). Chinanews.com 中國新聞網, July 22, 2010. Ge Shunqi 葛順奇. “Waizi de jingji weixie daodi you duoda?” 外資的經濟威脅到底 有多大 (How Big Is the Economic Threat from Foreign Investment?). China Economic Times 中國經濟時報, July 7, 2011. Gu Lieming 顧列銘. “Zhimian guoji chanye zhuanyi langchao” 直面國際產業轉 移浪潮 (Dealing with International Industrial Transfer Trend). Guancha yu sikao 觀察與思考 (Observation and Reflection), October 16, 2008. Guo Tongxin 郭同欣. “Guanyu woguo fuwuye tongji he zhanbi de youguan wenti” 關於我國服務業統計和占比的有關問題 (Problems on the Statistics and Ratio of the Domestic Services Industry). Website of National Bureau of

244

References

Statistics of China 國家統計局網站, June 17, 2010, http://www.stats.gov.cn/ was40/gjtjj_detail.jsp?channelid=75032&record=35. He Maochun 何茂春. “Kaifang cai neng baozheng jingji anquan” 開放才能保證經濟 安全 (Only an Open Country Can Ensure Economic Security). Global Times 環球時報, May 12, 2007. Kang Han 唐漢. “Chongqing ‘fei dianxing’ zhaoshang yu Huang Qifan fang mei huaxu” 重慶“非典型”招商與黃奇帆訪美花絮 (Atypical Business Development in Chongqing and Titbits in Huang Qifang’s Visit to America). China Economic Times 中國經濟時報, June 10, 2011. Wen Jiabao 溫家寶. “Zhiyou kaifang xiangrong, guojia caineng fuqiang” 只有開放 相容，國家才能富強 (Only an Open and Inclusive Nation Can Be Strong). Address at National University of Singapore, November 19, 2007.

Translated material: Petras, James. “Zhongguo de guoqu, xianzai he weilai: Cong ban zhimindi dao shijie daguo?” 中國的過去、現在和未來：從半殖民地到世界大國？ (Past, Present and Future of China: From Semi-Colony to World Power?). Selected and Trans. Li Dongmei 李冬梅. Foreign Theoretical Trends 國外理論動態, (5) (2007).

Chapter 10 Chinese materials: Cao Erjie 曹爾階. “Fengxian touzi: Jishu jingbu de tuidongqi” 風險投資：技術進 步的推進器 (Venture capital: Propeller of Technological Advance). China Economic & Trade Herald 中國經貿導刊, (14) (1998). ———.“Yinhang yu fengxian touzi” 銀行與風險投資 (Banks and Venture Capital). Shanghai Touzi 上海投資 (Shanghai Investment), (1) (1995). Chen Yu 陳宇. “Renli ziben lilun de fazhan” 人力資本理論的發展 (The Development of Human Capital). Zhongguo zhiye ji’neng kaifa yu jianding 中國職業技能開發 與鑒定 (China Vocational Skills Development and Assessment), (9–10) (1994). China Venture Capital Research Institute. “2009 fengxian touzi baogao zhaiyao” 2009風險投資報告摘要 (Summary of 2009 Venture Investment Report). Quanjing wang 全景網 (Panorama Network), February 3, 2010. Dai Xin 代星. “Zhongguo: Shijie VC de tiantang” 中國—世界VC的“天堂” (China: The Paradise of Global VC). China Economic Times 中國經濟時報, August 22, 2007. Guo Shuqing 郭樹清. “Zhongguo jingji de neibu pingheng he waibu pingheng wenti” 中國經濟的內部平衡和外部平衡問題 (Internal and External Balance

245

References

of China’s Economy). Economic Research Journal 經濟研究, (12) (2007). Ling Zhijun 淩志軍. Zhongguo de xin geming 中國的新革命 (New Revolutions in China). Beijing: Xinhua Publishing House, 2007. Qian Yinyi et al. 錢穎一 等. Zou chu wuqu: Jingjixue jia lunshuo guigu moshi 走出誤區： 經濟學家論說矽穀模式 (Out of Misunderstanding: The Silicon Valley Mode from the Perspective of Economists). Beijing: China Economic Publishing House, 2000. “Shidifen Qiaobusi” 史蒂芬‧約伯斯 (Steve Jobs). Baidu baike 百度百科 (Baidu Encyclopedia), http://baike.baidu.com/view/5300085.htm?fromTaglist. Tao Wenzhao 陶文釗. “Sulian moshi zhongjie yu zixun shidai de liming” 蘇聯模 式終結於資訊時代的黎明 (Tragedy at the Dawn of the Information Age: A Reflection on the Ending of the Soviet Union Model). Yannan wang 燕南網 (Yannan net), January 24, 2005. Wu Jinglian 吳敬璉. “Zhongguo zenyang cai neng you ziji de guigu?” 中國怎樣才能 有自己的矽穀？ (How Could China Own Its Own Silicon Valley?). Caijing Magazine 財經, (6) (2000). Wu Jisong 吳季松. Zhishi jingji 知識經濟 (Knowledge Economy). Beijing: Beijing Science and Technology Publishing Company, 1998. Yang Yiyong 楊宜勇. “Dui kuoda zhongdeng shouru zhe bizhong de shidian renshi” 對擴大中等收入者比重的十點認識 (Ten Opinions on Expanding the MiddleIncome Group). China Economic Times 中國經濟時報, August 23, 2005. Zhu Baocheng 朱保成. “Zhongguo fengxian touzi de zhuangkuang ji duice” 中國 風險投資的現狀及對策 (The Current Situation and Strategies of China’s Venture Capital). Guangming Daily 光明日報, August 28, 2006.

Translated materials: Becker, Gary S. “Renli ziben san jieduan” 人力資本三階段 (Three Stages of Human Capital). Caijing Magazine 財經, (20) (2010). Negroponte, Nicholas. Shuwei hua shengcun 數位化生存 (Being Digital). Trans. Hu Yong 胡泳, and Fan Haiyan 范海燕. Haikou: Hainan Publishing House, 1997. Friedman, Thomas L. Shijie shi ping de 世界是平的 (The World Is Flat: A Brief History of the Twenty-first Century). Trans. He Fan et al. 何帆 等. Changsha: Hunan Science and Technology Press, 2006.

English materials: Borland, Sophie. “Bill Gates Pledges to Leave His £30billion Fortune to Charity... Rather Than His Children.” Daily Mail. Last updated June 20, 2008, http://

246

References

www.dailymail.co.uk/news/article-1027878/Bill-Gates-pledges-58billion-fortune-charity--children.html. Harvey, Oliver. “I’m Not Leaving the Money to My Kids... It Wouldn’t Be Good For Them or Society.” The Sun, http://www.thesun.co.uk/sol/homepage/ features/3144438/Bill-Gates-Im-not-leaving-my-fortune-to-my-children. html. Starr, Mark. A Worker Looks at History. Accessed September 19, 2013, http://www. marxists.org/archive/starr-mark/worker-looks-history/index.htm. Tynan, Dan. “Bill Gates 10 Memorable Moments.” PC World, http://www.pcworld. idg.com.au/article/224910/bill_gates_10_memorable_moments/?pp=3.

Chapter 11 Chinese materials: Cao Erjie 曹爾階. Zhongguo zhengquan shichang yanjiu yu zhanwang 中國證券市場 研究與展望 (The Research and Prospects of China’s Securities Market). Beijing: China Financial and Economic Publishing House, 1994. Cao Fengqi 曹鳳岐. Gufenzhi yu xiandai qiye zhidu 股份制與現代企業制度 (Joint-Stock System and Modern Corporate Systems). Beijing: Enterprise Management Publishing House, 1998. Chen Zhiwu 陳志武. “Ruguo si caifu biancheng huo ziben” 如果死財富變成活資本 (If Dead Wealth Becomes Active Capital). Shanghai Securities News 上海 證券報, December 3, 2007. ———. “Zibenhua de aomi” 資本化的奧秘 (The Mystery of Capitalization). The Economic Observer 經濟觀察報, June 18, 2007. Han Zhiguo 韓志國. Zhongguo ziben shichang de zhidu quexian 中國資本市場的 制度缺陷 (The Institutional Defects in China’s Capital Market). Beijing: Economic Science Press, 2001. Li Yang 李楊, Wang Guogang 王國剛, and Wang Songqi 王松奇. Jinrong lanpishu: Zhongguo jinrong fazhan baogao (2008–2009) 金融藍皮書：中國金融發展報告 （2008–2009） (Blue Book of Finance: Annual Report on China’s Financial Development [2008–2009]). Beijing: Social Sciences Academic Press, 2009. Liu Ligang 劉利剛. “Zhunque pinggu difang zhaiwu fengxian” 準確評估地方債 務風險 (Correctly Assess the Risks from Local Government Debts). Caijing Magazine 財經, (14) (2011). Liu Wei 劉薇. “Zhongguo zhufang gaige 30 nian: Ju zhe you qi wu de mengxiang yu xianshi” 中國住房改革30年：居者有其屋的夢想與現實 (30-Year of China’s Housing Reform: The Dream and Reality of Home Ownership). Beijing Times 京華時報, October 20, 2008.

247

References

San Yuqing 單羽青, and Wang Yuejin 王月金. “10.7 wanyi difangzhai zongti kekong” 10.7萬億地方債總體可控 (The RMB1.07 Billion Local Government Debt Is Controllable Overall). China Economic Times 中國經濟時報, June 29, 2011. Shang Fulin 尚福林. “Jixu jiaqiang ziben shichang he chuangyeban shichang jichu zhidu jianshe” 繼續加強資本市場和創業板市場基礎制度建設 (To Continuously Strengthen the Construction of Basic Systems of Capital Market and GEM). China Securities Journal 中國證券報, January 8, 2011. Wang Peicheng 王培成. “Zhaishi hulian kunju” 債市互聯困局 (The Predicament of the Interconnection between Commercial Banks and Stock Markets). Caijing Magazine 財經, (23) (2010). Wen Xiu et al. 溫秀等. “Ming xuan pingtai daikuan” 命懸平臺貸款 (Fatal Risks from Loans to Financing Platforms). Century Weekly 新世紀, (23) (2011). Wu Jinglian 吳敬璉. Shi nian fenyun hua gushi 十年紛紜話股市 (A Ten-Year Review of Stock Market). Shanghai: Shanghai Far East Press, 2001. “Xin sanban zai qi zaofu jiqi” 新三板再啟造富機器 (The New Third Board Restarts the Wealth Creation Machine). Century Weekly 新世紀, (10) (2011). Yuan Dong 袁東. Zhongguo zhengquan shichang lun 中國證券市場論 (On China’s Securities Market). Beijing: Eastern Press, 1997. Zhang Weiying 張維迎. “Lijie he hanwei shichang jingji” 理解和捍衛市場經濟 (Understand and Defend the Market Economy). China Economic Net 中國經 濟網, December 19, 2007.

Translated materials: de Soto, Hernando. Ziben de mimi 資本的秘密 (The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else). Trans. Wang Xiaodong 王曉冬. Jiangsu: Jiangsu People’s Publishing, 2005. Martin, Peter N., and Hollnagel, Bruno. Ziben zhanzheng 資本戰爭 (Die Gro en Spekulationen der Weltgeschichte). Trans. Wang Yinhao 王音浩. Tianjin: Tianjin Education Press, 2008.

Chapter12 Chinese materials: Cao Erjie 曹爾階. Zhongguo zhengquan shichang yanjiu yu zhanwang 中國證券市場 研究與展望 (The Research and Prospects of China’s Securities Market). Beijing: China Financial and Economic Publishing House, 1994. Guo Shuqing 郭樹清. “Zhongguo ying yinru laji zhaiquan” 中國應引入垃圾債券 (China Should Introduce Junk Bonds). Sina Finance 新浪財經, April 19, 2010.

248

References

Li Yi’ning 厲以寧. Zhongguo ziben shichang fazhan de lilun yu shijian 中國資本市場 發展的理論與實踐 (The Theory and Practice of China’s Capital Market), Beijing: Beijing University Press, 1998. Luo Changping 羅昌平, Zhang Bolin 張伯玲, Ouyang Hongliang 歐陽洪亮, and Zhang Bing 張冰. “Tong gang gaizhi zhi shang” 通鋼改制之殤 (The Pain in the Restructuring of Tonghua Iron and Steel Group). Caijing Magazine 財經, (17) (2009). Peng Xin 彭昕. “Laji zhaiquan chuanqi” 垃圾債券傳奇 (The Legend of Junk Bonds). Finance Series 金融實務, (7) (2010). Tian Jin 田進, and Qian Hongdao 錢弘道. Jianbing yu shougou 兼併與收購 (Mergers and Acquisitions). Beijing: China Financial Publishing House, 2000. “Yahu weiruan hezuo nan han guge diwei” 雅虎微軟合作難撼穀歌地位 (The Cooperation between Yahoo and Microsoft Can Hardly Shake the Status of Google). Tencent Technology 騰訊科技訊, August 11, 2009. Ye Lingchun 葉淩春. “Maike mierke: Qi e cong shan de biaoshuai” 邁克‧米爾肯： 棄惡從善的表率 (Mike Milken: A Role Model of Discarding Evil for Good). Caifu feichang dao 財富非常道 (Fortune Talkshow), August 17, 2007. Zhang Nan 張楠. “Maike mierken: Cong laji zhaiquan zhong xunzhao huangjin” 麥克爾‧米爾肯：從垃圾債券中尋找黃金 (Mike Milken: Search for Gold from Junk Bonds). China Securities Journal 中國證券報, December 17, 2007. Zhao Bingxian 趙炳賢. Ziben yunying lun 資本運營論 (On Capital Management). Beijing: Enterprise Management Publishing House, 1997. Zhou Ting 周婷. “Binggou chongzu guimo wunian jin wanyi” 並購重組規模五年 近萬億 (The Value of Acquisitions and Reorganizations Amounted to Nearly RMB1 Trillion Within Five Years). China Securities Journal 中國證券報, February 17, 2011.

English material: Daniels, Cora. “The Man Who Changed Medicine.” CNN Money. Accessed November 12, 2013, http://money.cnn.com/magazines/fortune/fortune_ archive/2004/11/29/8192713/.

Chapter 13 Chinese materials: Ba Shusong 巴曙松. “Haiwai jijin denglu Zhongguo luxiantu” 海外基金登陸中國路線圖 (The development of Foreign Investment Funds in China). China Securities Journal 中國證券報, March 14, 2006.

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Cao Erjie 曹爾階. “Huan yige jiaodu tan kaifang jijin rongzi” 換一個角度談開放基金 融資 (Talking about Open-End Funds from Another Prospective). Zhengquan touzi 證券投資 (Securities Investment), (23) (2003). ———. “Touzi jijin san lun” 投資基金散論 (An Essay on Investment Funds). Guotai jijin 國泰基金 (Guotai Funds), (1) (2001). Chen Huiying 陳慧穎, and Wang Ning et al. 王寧 等. “Quanmin PE re” 全民PE熱 (National PE rush). Century Weekly 新世紀, (19) (2010). Chen Xue 陳雪. “Toushi haiwai simu jijin zhongguo gushi, PE yingli you sizhong moshi” 透視海外私募基金中國故事，PE 盈利有四種模式 (Four Profit Models of Private Equity Funds in China). China Securities Journal 中國證券報, March 14, 2006. EZCapital 恒峰合力. “2010 nian Zhongguo chuangye touzi niandu baogao” 2010 年中國創業投資年度報告 (Annual Report of 2010 China Venture Capital). Website of EZCapital 恒峰合力網站. Accessed December 2, 2013, http:// news.ezcap.cn/2011/012540182.html. Gao Chaosheng 高潮生. “Jijin de xin ronghe” 基金的新融合 (New Fusion of Funds). Century Weekly 新世紀, (31) (2010). He Jie 何傑, and Sun Congkun 孫叢坤. “Ziben de tiaozhan shu” 資本的挑戰書 (A Challenge to Capital). Century Weekly 新世紀, (35) (2010). He Xiaofeng 何小鋒, Dou Erxiang 竇爾翔, and Kong Xiangxin 孔祥鑫. “Zhuquan caifu jijin de fazhan qiantu” 主權財富基金的發展前途 (The Prospect of Sovereign Wealth Funds). JinRong Street Private Equity Weekly 金融街 PE 週刊, April 10, 2009. Huang Xiaoping 黃曉萍. “Duichong jijin jianshi: Zhuiyi sishui shinian” 對沖基金 簡史：追憶似水十年 (A Short History of Hedge Funds: A Ten-Year Review). 21st Century Asset Management 21世紀贏基金, September 7, 2007. Jiang Guocheng 江國成. “Zheng jian hui tixing: Liaojie jijin lixing touzi” 證監會提 醒：瞭解基金理性投資 (China Securities Regulatory Commission Reminds Investors to Understand Funds and Make Rational Investments). China Securities Journal 中國證券報, February 06, 2007. Qu Yanli 曲豔麗. “Duichong jijin xinsheng” 對沖基金新生 (Rebirth of Hedge Funds). Caijing Magazine 財經, (25) (2010). Research Group of Segregated Account Management of GF Fund Management 廣發基金公司專戶理財課題組. “Zhuan hu licai yin he fazhan xunmeng?” 專戶理財因何發展迅猛 (Why Does Segregated Account Management Develop So Rapidly?). China Securities Journal 中國證券報, August 11, 2006. ———. “Meiguo zhuan hu licai jianguan moshi” 美國專戶理財監管模式 (Supervision

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Model of the U.S. Segregated Account Management). China Securities Journal 中國證券報, August 11, 2006. Tao Dong 陶冬. “Zhuquan jijin de jueqi” 主權基金的崛起 (The Rise of Sovereign Wealth Funds). Hexun Net 和訊網, November 16, 2007. Yang Yang 楊楊. “Duichong jijin ‘lianghua’ qushi: Touming hua yu qu ganggan hua” 對沖基金“兩化”趨勢：透明化與去杠杆化 (The Two Trends of Hedge Funds: Transparency and Deleveraging). 21st Century Business Herald 21 世紀 經濟報導, May 9, 2009. Yuan Mingliang 袁銘良. “Guquan touzi Zhongguo ju” 股權投資中國局 (Private Equity and Venture Capital in China). Financial Series 金融實務, (5) (2010). Zhang Yuzhe 張宇哲, and Lin Huawei 淩華薇. “Yi shangye hua shouduan zuo kaifa xing jinrong: Duihua guojia kaifa yinhang dongshizhang Chen Yuan” 以商業化手段做開發性金融—對話國家開發銀行董事長陳元 (Do Development Finance through Commercial Means: Interview with CDB Chairman Chen Yuan). Century Weekly 新世紀, (1) (2011). Zhong Wei 鐘偉, and Huang Hainan 黃海南. “Duichong jijin zai woguo de fazhan ji jianyi” 對沖基金在我國的發展及建議 (The Development of Hedge Funds in China and Relevant Suggestions). China Finance 中國金融, February 2008.

Translated material: Biggs, Barton. Duichong jijin fengyun lu 對沖基金風雲錄 (Hedge Hogging). Trans. Zhang Hua 張樺, and Wang Xiaoqing 王小青. Beijing: CITIC Publishing House, 2010.

251

Index A-share market 113, 151, 208, 214 Abu Dhabi Investment Authority (ADIA) 234 acquisitions 54-5, 58-62, 91, 123, 125, 132, 156, 167-9, 171-3, 175, 177-9, 181-5, 187-91, 195, 199 active capital 111, 121-3 Agricultural Bank of China (ABC) 223, 226 asset reorganization 123, 179 asset securitization 134, 160, 208 asset swap 183, 189, 191-3 assets household 114 net 86, 112, 114, 132, 134, 148 authorities financial 21, 137, 141, 150-1, 154, 158 regulatory 131, 194, 205-6, 227-8, 231 Bain Capital 213-14, 217 Bank of China (BOC) 21, 28, 106, 146, 159, 216-18 banks indirect financing of 83-4, 124, 128, 156 township 180 village 28 Blackstone 113, 214, 234, 236 blue chips 151-2 Bohai Industrial Investment Fund 218, 221, 224 bond market 84, 117, 124, 128, 136-7, 141, 143-9, 161, 174, 230 junk 175-6, 178 bonds high-yield 175, 180, 199 low-grade 174-6

national 136, 233 bonus shares 107, 126, 133 business mergers 125-6, 187, 190, 195-7, 199, 211 businesses, off-balance sheet 129, 158 capacity, profit-making 74, 113, 191 capital fictitious 84, 110, 124, 126, 160-1 initial 15, 72, 88 physical 70, 74-6, 100-1, 110, 126, 159 capital accumulation 22, 123 capital construction 158, 164 capital formation mechanism 70, 72, 84, 878, 114, 116, 123-6, 129, 133-4, 149, 1645, 170, 172, 174, 204-5 capital market 70, 78-80, 82-4, 108-12, 118, 122-30, 132-6, 148-54, 156-65, 170-2, 184-6, 190-2, 194-6, 210, 238-40 capital market system, multi-level 151 capital shortage 66, 109 capital surplus 159, 203 China Business Network (CBN) 212 China Banking Regulatory Commission (CBRC) 28, 138-40, 146, 237 China Construction Bank (CCB) 30-1, 116, 142, 151, 199, 216, 224, 226 CCB International 223-4 China Development Bank (CDB) 213, 219, 226 CDB Capital 226 CDH Investments 213, 215, 217 China Financial Futures Exchange (CFFEX) 152 Committee on Foreign Investment in the

253

Index

United States (CFIUS) 61 China-Africa Development Fund 213 China Business Network (CBN) 212 China Culture Industrial Investment Fund 224 China Development Bank Capital Corporation Ltd 226 China Financial Futures Exchange (CFFEX) 152 China Huarong Asset Management 221 China Insurance Regulatory Commission 28 China International Capital Corporation (CICC) 214, 217 China Life Insurance Group 219 China Mobile 112, 200 China National Offshore Oil Co. (CNOOC) 233 China National Petroleum Corporation (CNPC) 57, 151 China Netcom 200 China Telecom 112, 147, 200 China Unicom 200 China Venture Capital Research Institute (CVCRI) 91 China Investment Corporation (CIC) 214, 216, 226, 234-5 China International Capital Corporation (CICC) 214, 217 CITIC Capital 213, 216-17 CITIC PE 216-17 city agglomerations 196-7 China National Offshore Oil Co. (CNOOC) 233 China National Petroleum Corporation (CNPC) 57, 151 commercial banks 28, 60, 83-4, 128-9, 139, 141, 143, 146-7, 155, 158, 176, 203-4, 211, 224, 237-8 corporate mergers 169-72, 177-8, 182-3,

254

187, 193 credit associations, capital of rotating 19-20 credit guarantee companies 87 China Securities Regulatory Commission (CSRC) 61, 143-4, 146-8, 185, 187-8, 192, 196, 237-8 China Venture Capital Research Institute (CVCRI) 91 debt financing 109, 120, 123, 125, 127, 146 debt-for-equity swaps 151, 183, 193 derivatives markets 128, 203, 229 direct financing 83-4, 118, 123-4, 128-30, 134-5, 144-6, 149, 151, 154, 157, 159, 200, 205 direct investment 34, 158, 160, 223-4 economic globalization 54, 57-8, 99, 172, 232 economies, low-carbon 197 enterprise bond market 142, 146 enterprise bonds 141-6 equity division reform 91, 114, 130, 132-5, 151-2, 164, 196, 208, 210-11 exchange bond market 147 exchange market 143 extralegal mercy 24-5 fictitious economy 47, 58, 124, 160-1, 163 financial innovations 83, 154, 157, 160-2, 170, 172, 193, 232, 239 financial products 125, 131, 154, 163, 2034, 206, 238 financial risks 94, 157-8, 161, 165, 206, 225, 239 foreign capital 13, 29-33, 35, 37-45, 47, 49, 51-3, 55-7, 59-63, 91-2, 102, 130, 212-13, 222 foreign investment 14, 31, 41-4, 53-4, 58, 109, 130, 217

Index

Foxconn 44-6, 48, 51 fund companies 147, 162-3, 175, 207-8, 222, 230 fund financing 238-40 fund managers 163, 204-7, 209-10, 219-22, 227 funds closed-end 203, 207 idle 128, 155, 163 general partners 79, 209, 219-20 Gross Domestic Product (GDP) 33-5, 44, 80, 101, 117, 138, 143 growth enterprise market (GEM) 70, 86, 91, 149-50, 152, 161, 163, 165, 214 GGV Capital 213, 215 government bond markets 124 government bonds 25, 136-7, 163, 233 government-led investment 165, 218, 221 hedge funds 203, 209, 214, 228-32 Hernando de Soto 118-20, 123 Hony Capital 213, 215, 217 Hopu Investment Management 215 housing mortgage loans 115-17 housing reform 114-15, 117 human capital 65-7, 69-77, 79-81, 83, 85, 87, 89, 91, 93, 95, 97, 99-104, 113, 175, 179-80 human resources 34, 58, 75-6, 100-1 human resources development 99-100 IDG Capital Partners 213-14 Industrial and Commercial Bank of China (ICBC) 106, 151, 212, 226 Investment Company Institute (ICI) 204 Institute for Liberty and Democracy (ILD) 120 income stream 118, 121-2 individual investors 135, 205, 208, 211

industrial investment funds 218-19, 222 industrial parks 82-3, 90 industrial revolutions, third 95 industrial transition 44, 48-51 industries, pillar 114-16, 197 industry segments 55-6 institutional investors 79, 128, 147-8, 152, 162, 203, 205, 211-12, 221 insurance companies 147, 175, 211, 229, 236 integration, industrial 170, 186, 197 interbank market 143, 147-8, 238 investment banks 113, 121, 156, 160, 165, 171-2, 176-80, 183-4, 193, 203, 212, 217, 229, 231 Investment Company Institute (ICI) 204 investment-grade bonds 174-5 initial public offering (IPO) 85-6, 125, 135, 146, 150, 163, 188, 210, 214 junk bonds 174-80, 198-9, 210 knowledge economy 66, 70-4 labor, low-end 101-3 labor-intensive industries 35-6, 41, 44, 48-9 legal person shares 120, 134, 150, 190 leveraged buyouts (LBOs) 74, 170, 172, 174, 176-81, 210 Liaohe Chemical Fertilizer Plant 185-6 limited partnerships 79, 83, 207, 209, 21821 liquid assets 159-61 listed commercial banks 146 Long-Term Capital Management (LTCM) 229 market, main-board 149, 151-2 market capitalization 113, 117, 120, 123, 128, 131, 134-5, 143, 165

255

Index

market economy 14, 83-4, 95, 122-3, 126, 133, 149, 159, 165, 170, 183, 193, 238-9 market functions 134, 163, 190, 205 market manipulation 162-3, 207 market-oriented reform 122, 156 management buyouts (MBOs) 156, 176, 194-5, 198, 209 merger wave 171-2 mergers debt-laden 184, 192 government-led 182, 192-3, 200 market-oriented 156, 182-3 mergers and acquisitions (M&As) 156, 167, 169-73, 175, 177, 179, 181-3, 185, 187, 189, 191-3, 195, 198, 214 market-oriented 156, 170, 182 middle-term notes 145, 148 Ministry of Chemical Industry 184-7 Ministry of Commerce 43, 55, 61-2 Ministry of Finance 134, 136-8, 143, 164, 200 Money Management Institute (MMI) 236 multi-level capital market 149-51 Nat io nal De vel o pment and R efo r m Commission (NDRC) 43, 142, 144, 148, 200, 217, 221-2 negotiable instruments 110, 124, 141, 144, 155 New York Stock Exchange 106 Newbridge Capital 211, 214 non-public economy 6, 11, 151 non-public sector 2-3, 5-11, 13-15, 17, 19, 21-3, 25, 27, 199 non-tradable shares 114, 132-4, 198 Organization for Economic Cooperation and Development (OECD) 34 original equipment manufacturers (OEMs) 44-5

256

Pearl River Delta (PRD) 13-14, 34, 36, 41, 44-6, 48-9, 102-3, 196 pilot project 73, 108, 126, 130-1, 137, 145, 149, 183, 237 planned economy 14, 25, 32, 92-6, 110-11, 114, 120, 122, 136-7, 142, 155, 158, 161, 165, 182 private equity funds 85, 113, 178, 180, 203, 209-13, 216-24, 227-8, 231, 237 property rights 73-4, 91, 116, 121-2, 127, 164, 182 real estate market 115-16 renminbi funds 212-13, 215 reverse takeover 171, 189-94 government-led 191-3 risk investors 66, 79, 81 rotating credit associations 14, 16-20, 22-3, 220 small business investment companies (SBICs) 89 Shenzhen Development Bank (SDB) 106-7, 111, 126, 149, 211, 214 Shanghai Dragon Corporation (SDC) 191 securities investment funds 203-9, 228 Sequoia Capital China 213-14 Shanghai and Shenzhen stock exchanges 108-10, 112, 120, 123, 130, 133-5, 14950, 165 Shanghai Automotive Industry Corporation (SAIC) 42 Shanghai Stock Exchange 106, 130-1 Shanghai Stock Exchange Composite Index 134-5 short-term financing bills 144-6, 158 Sovereign Wealth Funds (SWFs) 214, 2326 State Planning Commission (SPC) 142, 218

Index

state-owned assets, loss of 132, 134 stocks, full circulation of 134-5 subprime bonds 172, 174-6, 179 technological innovations 70-3, 77-8, 80-1, 84-5, 89, 94 Tonghua Iron and Steel Group (TISG) 1945 title deeds 121-2 Texas Pacific Group (TPG) 181, 213-14 tradable shares 114, 132-4, 164, 198 venture capital 65-7, 69-71, 73, 75, 77-9, 813, 85-91, 93, 95, 97, 99, 101, 152, 209-10, 212-13 venture capital firms 70, 80-7, 89, 149 venture capital funds 15, 19, 22, 79, 82-6, 91, 163, 203, 209, 218 venture investment 66, 70, 72, 77-80, 85, 8890, 92, 203 virtual economy 153-4, 157-8, 164-5, 202 Warburg Pincus 211, 213-14, 217 wealth management 160, 236-8 wealth management products 238 welfare housing system 115-16 Wenzhou model 13-15

257

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Chinese original edition © 2012 by China Renmin University Press Translated by Barbara Cao Edited by Barbara Cao and Glenn Griffith 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 and retrieval system now known or to be invented, without prior written permission from the Publisher. ISBN (Hardback)

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Contents Chapter 14 Asset Securitization: A Treasury of Investment Banks

Chapter 15 Futures Markets Chapter 16 The Investment Banking Mentality and Capital Operation at Investment Banks

1 29

47

Chapter 17 Time-Space Compression Leads to the Urban Era: Capital Accumulation and the Urban Economy

101

Chapter 18 Financial Globalization: Opportunities and Challenges for the Renminbi as a Global Currency

139

Chapter 19 Socialist Workers and Capital

183

Notes

227

References

231

Index

245

14

Chapter

Asset Securitization: A Treasury of Investment Banks

The Capital Market in China: A 60-Year Review Volume 3

Prologue: The Origin of U.S. Mortgage-Backed Securities and Lewis S. Ranieri The earliest asset securitization originated from mortgage-backed securities (MBSs) in the United States in 1968. At that time, banks were not allowed to operate across state lines in the United States, and home mortgage loans issued by banks totally relied on the deposits of local residents and enterprises. The term of some loans was as long as 30 years, but the major source of these loans was one-year fixed deposits. For one thing, there was a discrepancy between deposit term and loan term. For another, the interest rate stayed high due to inflation while the prosperity of direct financing in the capital market diluted bank loans and deposits, and the role of banks as intermediaries was also gradually weakened. In order to get rid of the risk mismatch between “shortterm deposits and long-term loans,” banks created portfolios of home mortgage loans, on the basis of which banks issued bonds to institutional investors. Through this practice, the financing channel of banks and the liquidity of credit assets were suddenly expanded. Thus, home mortgage loans owned a secondary market and banks increased their capacity in supporting house purchasing. It was the U.S. MBSs that raised the curtain on asset securitization. Since then, all kinds of asset-backed securities and securitized derivative products and unregulated off-exchange trading came out. MBSs not only eased the liquidity crisis, but also provided a new way out for surplus capital. Human society finished its final leap of the financial revolution by moving from an age of money to an age of capital. Among the derivatives of securitization issues, the one attracting the most attention was collateralized debt obligation (CDO), which was created by bundling a batch of MBSs and also one of the “chief culprits” in this global financial crisis. Wang Zhaoyang termed CDOs as “bundled mortgage bonds” and gave a full description of the history of the packaged mortgage bonds in his article “Home Ownership for All” published in New Century. In March 2008, when talking about the global financial crisis, Nobel Prize laureate in Economics Robert Mundell included Lewis S. Ranieri in his list of the “five goats who contributed to the financial crisis of 2008,” together with former U.S. president Bill Clinton, former American International Group (AIG) head Hank Greenberg, Ben Bernanke, and Henry Paulson. The now obscure Lewis S. Ranieri was once the head of the mortgage department at Salomon Brothers in the 1970s. According to Wang Zhaoyang, the earliest version of bundled bonds dated back to 1977. And Lewis was irrefutably believed to be the founding

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Asset Securitization: A Treasury of Investment Banks

father of bundled bonds. Wang Zhaoyang had taken two securities training classes of Lewis on mortgage bonds. Wang wrote in the article: In my mind, he (Lewis) did not mention much about housing and mortgage but focused on explicating the concept of “fungible.” In English, the adjective “fungible” is very rarely used, meaning repeatable, quantifiable, and substitutable. Generally speaking, families and houses cannot be easily replaced. But, every American dreams that one day he or she should and is able to own his or her own house. It can be said that housing is at the center of the American dream. In accordance with the universally applicable principle of fungibility, all collective and material dreams can be extended, combined, repeated, quantified, and exchanged. To put it simply, the brilliant concept coined by Lewis S. Ranieri means to convert the future expectation for house ownership of Americans into floating securities that can be traded in a large scale on the market. The operating principle of bundled mortgage bonds is as simple and obvious as the red suspenders Lewis likes to wear: A lends money to B and receives an IOU in return; if A lends money to 10 people at the same time, A will get 10 IOUs; based on loan terms, interest rate curve, and credit ratings, A packs the 10 IOUs into two portfolios which will be sold to bank C at a discount; then, Bank C will further group 30 portfolios (including 300 IOUs) it has gathered from different people or institutions into six series and resell these series to Citibank; Citibank will repackage those series into new bundles of IOUs with new terms before selling them to AIG; following that, those IOU packages will probably be sold to three different hedge funds. This cycle continuously repeated itself. Eventually, the subprime mortgage crisis broke out 20 years later, shaking the whole world. The so-called toxic assets which filled the accounts of transnational banks and investment funds were no other than bundled mortgage bonds, or CDOs created and promoted by Lewis. This creation was widely imitated by others later on. Unfortunately, besides the economist Robert Mundell, others rarely spoke of Lewis S. Ranieri and his prominent contribution to the financial history of human beings. But anyway, asset securitization is the most important innovation in international financial history. Asset securitization together with mutual funds constitutes two pillars in the development of the 20th century’s international capital market and fictitious economy. At present, China is at its primary stage of asset securitization and it still has a broad space for future development.

3

The Capital Market in China: A 60-Year Review Volume 3

Innovations of Asset Securitization in the Capital Formation Mechanism Asset securitization usually refers to raising funds by issuing securities backed by assets in the capital market with the future cash inflows of the underlying assets as guarantees. It re-injects liquidity into assets with future income through securitization, thereby revitalizing the global financial industry and greatly enriching the capital culture. The United States started MBSs in 1968. This new type of securities played an important role in solving the liquidity crisis of residential mortgage loans and turned out to be one of the significant financial innovations in the late 20th century. Then, in the 1980s, asset-backed securities1 (ABSs) were also gradually developed. In 1985, automobile loan-backed securities began to be issued and these securities played a part in promoting the prosperity of the European and American car markets. In 1988, banks released securities backed by credit card receivables. Shortly after that, financial securities backed by student loans, leases, and business credit were launched successively in 1993, and this trend was gradually extended to the securitization of enterprise account receivables. In 1995, the International Finance Corporation (IFC) under the World Bank Group, issued USD400-million non-recourse securities, using its long-term assets in South American and other developing countries as collateral. This was application of asset securitization to large- and medium-sized capital construction projects by taking the future earnings of these projects as collateral. It immediately sped up asset liquidity while lowering financial risks and enlarging available loan volume. In particular, it should be mentioned that in the implementation of the Basel Accords in each country, financial institutions increasingly attached great importance to capital adequacy ratio (CAR) and strove to get rid of redundant assets and corresponding liabilities. This, in turn, stimulated the rapid development of asset securitization in Europe, the United States, and other Western countries. In addition, the ABS, as a new kind of financial instrument, swept over Europe and U.S. with the reputation of “silver-edged bonds,” which not only attracted a huge amount of capital, but also offered new investment opportunities. Statistics showed that the value of U.S. outstanding MBSs and ABSs was USD5.3 trillion and USD1.7 trillion, respectively. If combined, the total amount of the above two bonds could reach USD7 trillion, which accounted for 32% of the USD22-trillion U.S. debt market, surpassing treasury bonds and enterprise bonds to make the largest share in the U.S. bond market.

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Asset Securitization: A Treasury of Investment Banks

In 2005, the circulation of ABSs in the U.S. exceeded USD1 trillion. The housing mortgage loans amounted to USD2.46 trillion in 2006 and USD6 trillion in 2007, equivalent to 30% of all assets (USD20 trillion) owned by commercial banks. By definition, asset securitization means to transfer assets that can generate stable future cash inflows into negotiable securities in the capital market through structural design, credit enhancement, and other technical means. Asset securitization is said to be an important innovation in the capital formation mechanism mainly because: First of all, by restructuring illiquid assets which can produce stable future cash flow, it converts these assets into securities which can be sold and circulated in the capital market. By doing so, it revitalizes frozen assets and mitigates the liquidity crisis. Next, the development of asset securitization offers a wide range of financial products and this contributes to the healthy growth of the capital market. Meanwhile, commercial banks can translate long-term stocks of credit assets into negotiable securities, thus realizing the return of commercial banks’ functions. Third, asset securitization provides an important means for solving market fragmentation and expanding the scale of the capital market. It also broadens the channels of capital formation and creates new opportunities for the integration between banks and capital markets. Through issuing securitized products, banks are able to obtain capital from the capital market. And by investing in securitized products, insurance firms, fund management companies, and other institutional investors will get their money involved in the capital market, which effectively changes the fragmented state between capital markets, and banking and insurance markets. Fourth, asset securitization disperses financial risks. The ABS is constructed based on future income streams that arise from the use of the underlying assets and adopts bankruptcy remote, credit enhancements, and many other technical means in the structural design and distribution process. It, therefore, contains relatively low risks. Moreover, through securitization, risks from bank loans will be spread and transferred to investors, and, as a result, the problem of risks being overly concentrated in the banking sector is eased. The main investors of ABS products are large-scale institutional investors, who are relatively rational in their investments. This will enable a comparatively stable secondary market for securitized products. In this way, the market of securitized products can form a large pool of funds, leading to a lowering of the average risk of the capital market and a reduction of the overall market volatility. Last, asset securitization provides a new way out for surplus capital. After

5

The Capital Market in China: A 60-Year Review Volume 3

the United States first launched MBSs, the market of securitized products grew very quickly. In 1990, the total market value of ABS and MBS surpassed that of the enterprise bond market, and then outstripped the U.S. treasury bond market in 1998. In 2003, the issue amount of U.S. ABSs and MBSs totaled USD2.72 trillion, almost equal to half of that of the debt market (USD5.67 trillion). In the U.S. asset securitization market, the MBS market was over three times the size of the ABS market. Fannie Mae and Freddie Mac, two large governmentsponsored mortgage finance lenders, offered USD4 trillion in mortgage loans which accounted for more than 75% of national individual housing loans. These two lenders were the major participants in the asset securitization market.

A Great Variety of Financial Derivatives of Asset Securitization Products The further development of asset securitization was realized by the financial innovations made by investment banks on ABS. Accordingly, a great variety of financial derivatives came into being. In this section, I will focus on CDO and credit default swap (CDS). At this point, asset securitization became a cornucopia of wealth for investment banks. The financing mechanism for those financial derivatives is: Banks will sell mortgage loans to major investment banks, and then these investment banks will form special purpose vehicles (SPVs), namely to set up new institutions with multiple housing mortgage loans as asset pools, in order to raise funds by issuing securities in the market. Consequently, mortgage lenders will no longer bear the risks from granting loans. The underlying assets of CDO usually are credit assets or bonds. The earliest CDO was issued by an American company, Drexel Burnham Lambert, in 1987. A decade later, the CDO became one of the most rapidly developed asset securitization products. The CDO is a kind of securitization issues created by the investment banks on Wall Street by reliance on the cash flow of SPVs. For example, a variety of asset securitization products, such as housing and car mortgage loans and real estate investment trust (REIT) will be packaged into different kinds of CDOs. To be exact, the CDO involves the financing and refinancing activities, during which issuers will create a pool of diversified debt instruments and then offer marketable securities backed by the pool. The debt instruments that support CDOs include not only high-yield bonds and corporate bonds or government bonds in emerging markets, but also traditional ABSs, residential mortgage-backed securities (RMBSs), commercial mortgagebacked securities (CMBSs), and other securitized products. This kind of pool

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Asset Securitization: A Treasury of Investment Banks

of assets usually bundles mortgage loans of different types and from different areas into a package, and then based on the credit quality of cash flow, the package is “sliced” into discrete “tranches” that can be sold to the public and institutional investors in the form of pledged securities. The tranches in a CDO package vary substantially in their risk profile and are usually categorized as senior, mezzanine, and equity, according to their degree of perceived credit risk. Each category corresponds to different risks and rates of return. The senior tranches are the safest one because they have first priority on the collateral in the event of a default but offer the lowest coupon rates (interest rates) compared to the remaining two tranches. And mezzanine tranches are generally safer than equity tranches. There will be a credit sought for all but equity tranches. For senior tranches, at least an A rating is typically sought. For mezzanine tranches, a rating of BBB but no less than B is sought. Since equity tranches receive the residual cash flow, no rating is sought for this type of tranches. They may receive the highest return but also assume the largest default risk. Typically, senior tranches constitute the lion’s share, mezzanine notes take up 5%–15%, and equity notes represent 2%–15%. Conservative hedge funds, commercial banks, and pension funds would like to purchase the CDOs with the highest quality, while speculators and some security issuers prefer equity tranches. From a professional perspective, the CDO is an innovative structured financial product. Xia Xiaojun noted in the “Translator ’s Words” in the book Collateralized Debt Obligations: Structures and Analysis that CDOs can be interpreted as structured CDOs. Because “from investors’ points of view, the CDO refers to some sequential securities that are collateralized by the same pool of assets; they offer different rates of return following the principle of riskreturn tradeoff, make interest and principal payments in sequence based on seniority, and will be tracked by rating agencies during the whole process. The word ‘structured’ is used to emphasize the characteristic of CDO backed by debt obligations instead of that of debt obligations serving as collateral for the CDO, albeit sometimes debt obligations also should conform to the principle of diversified portfolios when used as collateral.” The number of CDO products presented an exponential growth trend in recent years. Statistics revealed that aggregate global CDO issuance totaled USD157 billion in 2004, expanded to USD272 billion in 2005, and finally went to USD549 billion in 2006. In the first half of 2007, CDO issuance already reached USD314 billion. From 2004 to 2007, the figure further grew to roughly USD1.3 trillion. Financial innovations emerged one after another in the market. After the CDO had swept the world, some investment banks created CDS on the basis of CDO. The CDS is considered an insurance product which hedges against

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the default risk of certain assets (mostly bonds, such as CDOs). In 1995, JP Morgan invented CDS with the aim of transferring the credit exposure of corporate bonds and loans in the balance sheet to the market. Through CDS, the credit risk between two parties will be shifted and restructured. Subsequently, International Swaps and Derivatives Association (ISDA) developed it into a standard form in 1998. The combination between CDS and CDO made things even more complicated. As long as buyers of CDS pay a certain amount of deposits, like insurance premiums, they will receive credit protection in the event of defaults by the counterpart. It is equivalent to shifting the default risk of fixed-income securities to the sellers of CDSs by using those over-the-counter (OCT) instruments.

The Securitization of Subprime Mortgage Loans and the Causes of the Subsequent Crisis Asset securitization, as a financial innovation, not only promoted the prosperity of financial markets, but also brought about financial risks. The U.S. subprime mortgage rose in the early years of the new century and after the short period of prosperity it exploded into a global financial crisis in 2007. After the United States suffered the September 11 attacks, the Federal Reserve Board Chairman Alan Greenspan initiated 11 interest rate cuts since September for fear of an economic slowdown. This was the most drastic round of interest cuts ever since 1981. In June 2003, the federal funds rate was reduced from 6.5% to 1%, the lowest level in the last 50 years. This rate cut gave rise to excessive liquidity surges and stimulated economic growth. In the third quarter of 2003, the growth rate of the country’s GDP reached 9.7 %, the highest since 1990. The low interest rate boosted the thriving U.S. real estate market and, in particular, offered excellent opportunities for the growth of subprime mortgage loans. Those loans were considered “subprime” relative to high-quality mortgage loans. The U.S. mortgage loans were generally rated in accordance with borrowers’ credit: 1. Prime mortgage loans are home loans given to superior customers who can earn stable incomes, assume a reasonable debt burden, and receive a higher credit rating (with a credit score of 660 or above); and those people mainly choose traditional 30-year or 15-year fixed-rate mortgages; 2. The mortgage loans between the safest and riskiest ones are called Alt-A mortgages; 3. The subprime lending category targets borrowers who have non-existent credit histories, low ability to repay loans, and a credit score below 620. The interest rate cuts stimulated the growth of subprime mortgages. In

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the United States, there were approximately six million poor people and new immigrants who did not have favorable credit ratings and nearly half of them had no proof of regular income. Under normal circumstances, clients like those can hardly obtain loans from banks. However, after the interest rate cuts in 2001, excess liquidity forced banks and lending institutions to risk expanding the subprime mortgage market to these over six million originally unqualified borrowers in pursuit of a high return on capital. Lenders lowered the threshold of the subprime mortgage market and opened a door for people who failed to meet the requirements of ordinary mortgages, for example, borrowers who had a loan-to-value (LTV) ratio above 85% or a payment-to-income ratio over 55%. Moreover, lending institutions constantly came up with new tricks to encourage subprime mortgage loans. Some proposed 3-year, 5-year, and 7-year adjustable rate mortgages, namely, these loans charge a low interest rate in the first few years and will readjust the rate based on the market interest rate after a stated period of time; some replaced the fixed interest rate with a floating one in order to adapt to the declining trend of interest rates; and others invented a 2/28 mortgage, whose interest rate is fixed for the first two years and then adjusted for the next 28 years (the interest rate is generally three percentage points higher than that of prime mortgages, around 9%–10%). Subprime mortgage loans brought about two effects. One was the stimulation of the purchasing of houses. This benefited low-income families the most. The U.S. homeownership rate was 64% in 1995 and it rose to approximately 69% in 2006. According to the statistics released by the U.S. Federal Reserve, between 1995 and 2004, the homeownership rate of low-income families increased by six percentage points while that of the high-income group only grew by four percentage points. The other contribution of subprime mortgages was that it pushed up house prices in the United States. Since early 2002, the annual growth rate of house prices exceeded 10%. By the end of 2005, the annual growth rate was as high as around 17%, which pumped real estate bubbles to the bursting point. Under the circumstances of constant interest rate cuts and rising home prices, loan borrowers were able to use the increased value of mortgaged houses to raise the loan amount in order to repay their old debts. Thanks to the continuous reduction of interest rates, the U.S. housing market boomed. Since the interest rate of subprime mortgages was at least two to three percentage points higher than that of ordinary mortgages, it helped to expand the size of the subprime mortgage market. The U.S. subprime mortgage loans only amounted to USD138 billion in 2000 and USD160 billion in 2001. Additionally, subprime mortgages and Alt-A mortgages accounted for less than 15% of the total mortgage loans in 2003. However, the value of the two kinds of

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loans rapidly grew to USD600 billion in 2006, representing 24.39% of the nation’s total mortgage amount. According to data from the International Monetary Fund (IMF), the figure soared to USD1.1–1.2 trillion in 2007, taking up one fifth of the value of the whole mortgage market and 6% of commercial bank assets in the United States. Unfortunately, interest rate cuts did not last long. Since June 2004, the U.S. Federal Reserve imposed a new monetary policy to cope with the excess liquidity and successively raised the interest rate 17 times. Up to June 2006, the federal funds rate more than quadrupled from 1% to 5.25%. The prime lending rate rose from 4% to 8.25%, which led to a sharp rise in the mortgage rate in the subprime mortgage market. Moreover, the policy of “interest rate readjustment” forced a surge in monthly payments, which in turn increased the repayment pressure on borrowers. From 2007 onward, among subprime mortgage loans issued between 2004 and 2006, 59% adjusted their monthly installment by increasing more than one fourth and 19% by over one half. This significantly increased the repayment pressure on borrowers and the default rate surged massively. Worse still, the interest rate hike pierced the real estate bubbles. The U.S. house prices soon plunged from a high level in 2005 and showed negative growth after the second quarter of 2006. Collateral declined in value while the repayment pressure of borrowers increased dramatically. House buyers of subprime mortgages who had planned to pay off their debts by relying on future house appreciation had to give up their real estate. In 2006, approximately 15% of all adjustable rate mortgages were overdue and this rate was five percentage points higher than that of fixed-rate mortgages. The number of defaulters increased constantly. According to a survey, there were 180,000 households whose houses were repossessed by lenders due to defaults on mortgages in July 2006 and this number almost doubled compared to the number in the same period of 2005. In 2008, around 2.2 million subprime mortgage borrowers had their homes repossessed by banks. Based on IMF statistics, the total value of American subprime mortgage loans was somewhere between USD1.1 trillion and USD1.2 trillion. As for the bad debts of those loans, it was estimated by Goldman Sachs that the total amount was about USD400 billion, only accounting for 2.6% of the country’s USD15 trillion GDP in 2006. In a developed financial market like that of the United States, this proportion did not seem to be a serious one when judging the size of the subprime mortgage loan. Then, why did the bust of the subprime mortgage market evolve into a global financial tsunami? A reason was that the financial market of the United States was very well developed. MBSs grew quickly in the United States and excess liquidity sped up financial innovations. Investment banks launched subprime mortgage-backed

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securities and their derivatives. These were structured finance products created by using subprime mortgages as the underlying assets. At first, investment banks packed up subprime mortgages into ABSs and sold these to investors with a very attractive fixed income. Later, housing and car mortgage loans and many other kinds of asset securitization products were packaged into various CDOs. For example, mortgaged securities backed by cars and houses with similar credit ratings would be bundled into one CDO. Then, multiple CDOs would be translated into CDSs. The CDS is originally an insurance product used to hedge against the default risk of bond holdings, but it has evolved into a new speculative product in the derivatives market. In the traditional securities market, if an investor buys bonds of a company, he will bear the default risk of the company. But, credit derivatives are designed to transfer the risks of investors in the form of multiple portfolios that will be sold and circulated in the market. Different from traditional bonds which are sold independently, credit derivative securities pool together mortgage loans of different types and from different areas into packages, and then sell them off to individual and institutional investors in various forms of pledged securities. This type of transaction can go on and on indefinitely. After a series of actions, the originally high-risk subprime mortgage-backed debts can carve out a portion to be rated as AAA. The interest rate of subprime mortgages is generally two or three percentage points higher than that of ordinary mortgages. In times of declining interest rates, the return from mortgage-backed debts is much more generous than the return from ordinary government bonds. The high rate of return, however, made investors forget about the underlying risks. Thus, those loans were greatly welcomed by institutional investors. After 2001, the return on the U.S. Treasury bonds was lowered and the stock market performed badly. Large investors around the world, especially hedge funds, snapped up securities backed by subprime mortgages and most of their investments were made in portfolios with the highest risks and returns. Under the circumstances of declining interest rates and rising house prices, these high-risk bonds and their derivatives not only received high ratings but also were able to generate high returns. Through effective operations of various loan products and derivative securities, those high-risk loans were securitized into subprime debts which further developed into CDOs and CDSs. In this way, the high risks embedded in high returns were spread around the world. Therefore, Alan Greenspan said in the article “World Finance and Risk Management” in 2002 that the rapid advances in the financial derivatives market “have significantly lowered the costs of, and expanded the opportunities for, hedging risks. These increasingly complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more

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flexible, efficient, and resilient financial system than existed just a quarter-century ago.”2 It should be said that the U.S. economy recovered quickly from the bursting of the Internet Bubble in 2000 and the 9/11 terrorist attacks, mainly because of the prosperity of the real estate market and the rise of the financial derivatives market. And it was the powerful hedging function of all kinds of derivatives that realized the risk transfer of the U.S. real economy. The financial products, derivatives, and financial innovation of America are the most advanced in the world. Lenders of subprime mortgage loans issued MBSs and ABSs repeatedly on the basis of the USD1.1–USD1.2 trillion in subprime mortgages. Then, based on the above securities, investment banks invented CDO, CDS, and derivatives — such as the ABX index — to be purchased by hedge funds, mutual funds, commercial banks, insurance companies, investment firms, and other institutional investors. Additionally, CDSs and ABX indices often bypassed formal exchanges and were traded over-the-counter, so they were basically not subject to market regulation. In this way, debts and risks were almost shifted out and expanded unlimitedly by virtue of the amplification mechanism of the derivatives market, and thus the transaction size of the subprime debt market was amplified tens of times. Those hedge funds and mutual funds generally employed highly leveraged tools in investment with a leverage ratio above 10 times and most of their funds were borrowed from the financial market. With the MBSs, CDOs, and CDSs being constantly transferred, investors from all around the world held a portion of the U.S. subprime mortgage backed securities and their derivatives. It was exactly because of the overflow of those bonds and their derivatives that the risks were shifted to the whole world. It was reported that by the end of 2006, those U.S. subprime mortgage bonds were basically held by five kinds of financial institutions. In general, banks accounted for 31%, asset management companies took up 22%, hedge funds represented 10%, insurance companies constituted 19%, and pension funds held 18%. However, the derivatives market was also a double-edged sword. While promoting the high prosperity of the virtual economy, the derivatives market also inflated bubbles, and raised and accumulated the systemic risks of its own. As the interest rate rose between 2004 and 2006 and house prices fell in the subsequent years, investors who expected to get a high return by investing in high-risk securities found their hopes a damp squib. A minor fluctuation in the financial field will be magnified multiple times to induce a global panic. This can significantly increase the negative impact of the subprime crisis. Take the CDS, a derivative of the U.S. subprime debt, as an example. The CDS was an innovative financial product designed to mitigate risks. Its sellers only charged a few percent of the value of the bonds they guaranteed as a margin. If the

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bonds depreciate substantially, the sellers will suffer several times the loss of the margin. For instance, a holder of a certain MBS purchases a CDS as a protection against risks with an annual margin rate of 2%. Once the bond becomes worthless, the seller of CDS will lose 100% of the security value, or 50 times of the margin; and if the bond falls by 50%, the loss will be 25 times the margin. In this financial crisis, many CDOs and the asset pools of many other securities received a high rating from rating agencies and therefore sellers of CDS dare make transactions at a low margin rate. However, the outburst of this real estate crisis and the existence of such a large number of low-quality subprime mortgage loans reflected that the margin rate was ridiculously low. Besides, the CDS is the same with other financial futures in that investors can speculate on the credit of sellers. As speculators can purchase CDSs without holding any corresponding debt instruments, the number of CDS was in fact larger than that of bonds in market transactions. Consequently, the CDS market swelled from USD900 billion in 2000 to USD45.5 trillion in 2007, equivalent to two times the size of the U.S. stock market. Those swaps which were originally used to reduce risks in reality contributed to speculation and risks. That was very ironic. In April 2007, the second-biggest subprime mortgage lender in the United States — New Century Financial Corporation — filed for bankruptcy. The U.S. subprime mortgage crisis began to emerge. In July 2007, a number of well-known international rating companies downgraded the ratings of more than 1,000 MBSs in the United States, which aroused market panic. On August 1, 2007, Bear Stearns announced the collapse of two hedge funds which invested in subprime mortgage-backed securities (the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund). Subsequently, American Home Mortgage Investment Corporation filed for bankruptcy protection. On August 15, the stock price of Countrywide Financial Corporation, the nation’s largest mortgage lender, started to slump. At that time, the market was not totally pessimistic. However, when Citigroup and Merrill Lynch disclosed their 2007 performances, Citigroup recorded the worst loss in its 196year history, far beyond Wall Street’s pessimistic expectations, and the deficit in the fourth quarter of Merrill Lynch was three times larger than the market exception. Since the number of bad loans had increased in those companies, banks demanded additional margins, which increased the risks of capital chain rupture. Since then, the subprime mortgage crisis quickly spread across the United States and even the global market, leading to a sharp plunge in major capital markets around the world, including stock markets, bond markets, and oil futures markets. Later, the liquidation of giant hedge funds or investment banks triggered market turmoil.

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The Capital Market in China: A 60-Year Review Volume 3

The problem of subprime mortgage loans spread to securities backed by these mortgages, which in turn exerted an impact on mutual funds, hedge funds, investment banks, commercial banks, and other kinds of financial institutions. On the face of it, commercial banks did not hold a large amount of subprime mortgage-backed securities, but hedge funds probably mortgaged that kind of security to get bank loans which were most likely used to purchase MBSs again. In addition, asset securitization products and relevant derivatives are large in quantity. The trade volume of those securities by institutional investors in the repurchase market reached several trillion dollars. This was unexpected considering the past condition of scattered individual depositors and smallscale interbank markets. However, once institutional investors start a bank run, the disaster is sure to be devastating.

Asset Securitization and Further Analysis of the Global Financial Crisis How should we look at this global financial crisis? Greenspan called this financial crisis originating from the U.S. as a “oncein-a-century credit tsunami.” George Soros commented that it was “the worst financial crisis since the 1930s.” For me, to understand this global financial meltdown, we need to judge it from the perspective of economic globalization. Soros attributed this “worst financial crisis” to “market fundamentalism” which assumes that the financial market mechanism can balance and correct itself. Soros’ words were very educational. When he was interviewed by Caijing Magazine in August 2010, Soros said that what had caused the financial imbalance was a “super bubble.” This imbalance lasted a very long period of time — 28 years — and it spanned 1980 to 2008. He added that the problem was the excessive leverage of the financial sector, as well as that of the real estate sector. The culprit of this global financial crisis was asset securitization and its derivatives, especially the unregulated OTC transactions of derivatives, which were termed by Warren Buffett as “financial weapons of mass destruction.” Andrew Sheng, the former Chairman of the Securities and Futures Commission of Hong Kong and Chief Adviser to the China Banking Regulatory Commission, believed that “it was the four arbitrages in the modern economy that gave rise to “the three greatest inventions” in modern finance, leading to “the greatest problem” in today’s world.

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Through a macro-level analysis, Andrew Sheng attributed this global financial crisis to four types of arbitrages in the contemporary economy. According to him, the four arbitrages3 are: 1. Wage arbitrage. The newly increased market-oriented economies after the Cold War contributed three billion workers to the global market and paved the way for 20-year low inflation. 2. Financial arbitrage. The cheap money policy of the yen gave birth to the global carry trade of the yen and also significantly promoted worldwide leverage operations and derivative transactions; 3. Knowledge arbitrage. Large numbers of financial engineers sprang up; and 4. Regulatory arbitrage. The regulations on the global market were relaxed. It was under such circumstances that the macroscopical trend of globalization was created. Until the end of the 20th century, with the development of financial engineering, to create and pursue profits became the main power of financial innovations. Accordingly, the “three greatest inventions” in modern finance had brought today’s world “the greatest problem.” Those three greatest inventions are: 1. Structured investment vehicle (SIV). An SIV enables the high-risk products invested in by financial institutions to be kept off the balance-sheet, escaping restrictions through regulation (in the U.S., the size of the traditional regulated banking system and the parallel banking system totaled USD20 trillion); 2. ABS. It packages bank loans into securities to be sold again in the market (the U.S. ABS amounted to USD700 billion in 2000 and grew to USD2.4 trillion in 2007, which indicated that banks transferred many of their debts to the securities market); 4 3. CDS. It improves the quality of the underlying assets of ABS by being underwritten by insurance companies (the CDS market soared from USD900 billion in 2000 to USD45.5 trillion in 2007, almost two times the size of the U.S. stock market). I think that “the three greatest inventions” having brought about “the greatest problem” for the modern finance, as presented by Andrew Sheng, was indeed a clever and concise summary of this crisis. What pushed the “three greatest inventions” to the limit were leverage operations by commercial and investment banks, and, as a result, all financial institutions and borrowers were stuck with high leverage. John Mack, the former head of Morgan Stanley, said frankly: “The over-leveraged transaction in Wall Street is really one of our faults. We have borrowed too many debts and taken high risks, and thus we are accountable for this crisis.” Certainly, the financial system also acted as an accomplice in this incident. The United States promulgated in 1999 the Financial Services Modernization Act, which overturned the separation between commercial banking and securities businesses practiced for over half a century and implemented mixed operation

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by integrating commercial banks and investment banks into the transactions of asset securitization products and their derivatives. The last straw that broke the camel’s back was modern high technology. The advance of computers and modern information technology not only enabled remote transactions and instant settlement in the financial field and real economy, but also made the issuance of loans overly rely on computer models by applying a modern credit scoring system and automated underwriting system. Consequently, banks dare issue subprime housing mortgage loans to borrowers with poor credit in order to earn high returns by creating highrisk innovative financial products based on default rates and quantitative models. On the basis of this, various kinds of financial innovations in the capital market and virtual economy developed asset securitization and constantly created different types of financial derivatives. Worse still, investment banks expanded asset securitization products and their derivatives in a huge quantity, resulting in the disconnection of the capital market and virtual economy from the real economy. This led to the collapse of Wall Street and three large investment banks — Merrill Lynch, Lehman Brothers, and Bear Stearns — in this crisis. If we delve into the root of this financial crisis, one of the causes was greed. On May 11, 2009, when Wang Qishan, Vice Premier of the State Council, said during the dinner party of the 80th Anniversary of Bank of China London Branch in the presence of hundreds of bankers that the origin of the financial crisis was that financial professionals were too greedy to remember the basic rules of the financial field: 1. risks or safety; 2. liquidity; 3. profitability. Among these rules, risks ranked first. “When thinking it over, we will know that this crisis broke out after many years of accumulation. If in those years we had borne in mind these three rules, I believe this crisis could have been avoided. But unfortunately, it is easier said than done and the smarter the person is, the more quickly he forgets about these rules. In the face of great temptation, it is human nature to forget ancient wisdom and the three basic rules of finance.” Wang Qishan said that he learned these principles from his friends in London after the start of the Reform and Opening Up era. “My teachers are the friends in Wall Street and the City of London, so I always remember these three rules. When considering financial issues, I put risks at the first place all the time, whether working for a commercial bank, trust company, investment bank, the Central bank, or a local government. I told many entrepreneurs, not necessarily those in the financial field, that you must pay attention to risks and liquidity, and only under these two premises, can you pursue benefits. Now, as we are talking about a people-oriented scientific outlook on development, security is the primary need of humans and the demand for security precedes that for food and clothing from the perspective of the overall development of mankind. That is my understanding. Unfortunately, lots of people forgot these three rules, thus

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triggering this huge disaster.” The blunt words of Wang Qishan silenced naysayers.

Of course, in addition to greed, poor supervision was also another cause.

Veteran business reporter Charlie Gasparino commented: “Greed and poor

regulation stifled the financial system.” It was truly an incisive conclusion to this crisis.

In the memoirs of U.S. Treasury Secretary Henry Paulson — On the Brink, he

remarked: “Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age. It is rife with duplication, gaping holes, and counterproductive competition among regulators.”

In addition, John Mack from Morgan Stanley believed that regulators had

not done a very good job in keeping abreast with the times and failed to grasp

and understand the changes in the market, which added more complexity to the problem. Soros directly criticized the regulators of the U.S. by stating that

“regulators are more flawed than markets. Why are they imperfect? Because they

are bureaucratic and they respond slower than markets. They are also easily subject to political influences.”

Alan Greenspan is to blame for the poor supervision in the financial field.

The underlying reason is that during his 20-year tenure as Chairman of the U.S.

Federal Reserve, Greenspan always advocated an overly lenient system towards financial innovations and firmly opposed the government’s strengthening of

financial supervision on OTC derivatives. According to the statistics of the Bank for International Settlements (BIS), by the end of 2007, the total notional principal

of derivatives traded on the exchange amounted to approximately USD40 trillion while the notional principal of OTC derivatives totaled USD596 trillion, almost 15 times the former. The unregulated OTC derivatives ran rampant, eventually leading to the breakdown of Wall Street and the outbreak of the global financial crisis.

Questions and Answers on the Global Financial Crisis Gary Gorton, a professor of finance at the Wharton School, University of

Pennsylvania, when analyzing the differences between this financial crisis and previous ones, mentioned that this crisis was mainly caused by the bank runs by institutional investors on the repurchase market (repo market) and the existence of a parallel banking system in addition to the regulated traditional banking system, and that the panic of 2007 was due to a run by institutional investors on the repo

market which was not insured by deposit insurance.5 His eight major viewpoints are explained below.

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1. What was the root cause of this financial crisis? The root cause of this global financial crisis was a banking panic which started on August 9, 2007. There have been multiple banking panics in the history of the United States in which a large number of depositors rush en masse to their banks and demand their money back — literally, “runs on banks.” Banking means creating short-term trading or transaction securities backed by longer term assets. The fundamental business of banking creates a vulnerability to panic. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, mainly taking place in repo transactions and repo markets, concerning trillions of dollars. The participants of the repo market were not regular people but firms and institutional investors, so, this panic was not like the previous panics in American history in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms.

2. Why was there a banking panic? As explained, the panic of 2007 was not centered on demand deposits, but on the repo market which is not covered by the U.S. deposit insurance system. As the economy transforms with growth, banking also changes. But, at a deep level the basic form of bank liability has the same structure, whether it is private bank notes, demand deposits, or sale and repurchase agreements. Bank liabilities are designed to be safe; they are short term, redeemable, and backed by collateral. But, they have always been vulnerable to mass withdrawals. During the Free Banking Era before the Civil War, the dominant form of money was privately issued bank notes backed by state bonds. Bank notes were also redeemable on demand and demand deposits were one of the important sources of bank capital. There were banking panics because sometimes the collateral (the state bonds) was of questionable value. During the Civil War, the government took over the money business; national bank notes (greenbacks) were backed by U.S. Treasury bonds and there were no longer private bank notes. But, banking panics continued because of the inherent nature of demand deposits. Until 1933 when the deposit insurance was enacted into law, it basically ended panics due to demand deposits (checking accounts). The time from 1934 to 2007 was a quiet period in the U.S. banking sector. This time the panic was in the sale and repo market. In the last 25 years or so, there was another significant change: a change in the form of quantity of bank liabilities. At root this change had to do with the traditional banking

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system becoming unprofitable in the 1980s. During that decade, traditional banks lost market share to money market mutual funds (which replaced demand deposits) and junk bonds (which took market share from lending), to name the two most important changes. From then on, the U.S. banking industry began large-scale securitization and repurchase businesses.

3. Was the amount of subprime mortgages a cause for the panic? The outstanding amount of subprime bonds was not large enough to cause a systemic financial crisis by itself. In 2006, subprime debt stood at about USD1.2 trillion outstanding, of which roughly 82% was rated AAA and to date has very small amounts of realized losses. In the United States, the total size of the traditional and parallel banking systems is about USD20 trillion. In contrast, the USD1.2 trillion of subprime mortgage loans cannot explain the global financial crisis. In addition, the U.S. subprime mortgages started to deteriorate in January 2007 and the banking panic occurred eight months later in August 2007. That is to say, subprime lending began to deteriorate significantly well before the panic, and thus it was not a true reason for the panic.

4. How did the “parallel banking system” develop? After the 1980s, holding loans on the balance sheets of commercial banks was not profitable. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners will exit the industry by not investing. Here, “exit” means that the regulated banking sector will shrink. One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. The traditional banking sector shrank, and a whole new banking sector developed — the parallel banking system. A major part of it was securitization and the market size was very huge. If comparing the non-mortgage securitization issuance amounts with the amount of all of U.S. corporate debt issuance, we can see that the scale of the former exceeded that of the latter starting in 2004.

5. How to understand the relationship between the traditional banking system and the parallel banking system? The two banking systems are intimately connected, and the parallel banking system is essentially how the traditional, regulated, banking system is funded. It means that without the securitization markets the traditional banking system is not going to function in the modern financial system. The traditional,

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The Capital Market in China: A 60-Year Review Volume 3

regulated banking system makes loans to consumers and corporations, but where do the traditional banks get the money? Portfolios of the loans are sold as bonds, to the various securitization vehicles in the parallel banking system. Like the traditional banks, these vehicles are intermediaries who in turn are financed by pension companies, annuities, mutual funds, and other institutional investors.

6. Who were the investors of the repo market and how large was the market? Some economists believe the so-called “originate–to-distribute” concept which stresses that securitizations should not end up on bank balance sheets. There is no basis for this idea. These asset-backed bonds were needed as collateral for a form of depository banking. Institutional investors have demands for checking accounts. But, for them there are no safe banking accounts because deposit insurance is limited. So, where does an institutional investor go to deposit money? The institutional investor wants to earn interest, have immediate access to the money, and be assured that the deposit is safe. The answer is that the institutional investor goes to the repo market. Suppose the institutional investor is Mr. Smith, he has USD500 million in cash that will be used to buy securities, but not right now. Right now Mr. Smith wants a safe place to earn interest, but such a place where the money will be available in case the opportunity for buying securities arises. Smith goes to Bear Stearns and “deposits” the USD500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset-backed securities that are earning London Interbank Offered Rate (LIBOR) plus 6%. They have a market value of USD500 million. These bonds are provided to Mr. Smith as collateral. Mr. Smith takes physical possession of these bonds. Since the transaction is overnight, Mr. Smith can get his money back the next morning, or he can agree to “roll” the trade. Mr. Smith earns, say, 3%. If Bear Stearns borrows at 3% and lends at 6%, in order to conduct this banking business, Bear Stearns needs collateral (that earns 6% in the example) — just like in the Free Banking Era, banks needed state bonds as collateral. In the last 25 years or so, the money under management in pension funds and institutional investors, and money in corporate treasuries, has grown enormously, creating a demand for the sale and repurchase businesses. How big was the repo market? I roughly guess that it is at least USD12 trillion, the size of the total assets in the regulated banking sector.

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Asset Securitization: A Treasury of Investment Banks

7. What does the panic have to do with repo? There is another aspect to repo that is important: haircuts. In the repo example I gave above, Mr. Smith deposited USD500 million of cash with Bear Stearns and received as collateral USD500 million in bonds, valued at market value. Here, Smith does not care if Bear Stearns becomes insolvent because Smith in that event can unilaterally terminate the transaction and sell the bonds to get the USD500 million. Imagine that Mr. Smith said to Bear: “I will deposit only USD400 million and I want USD500 million (market value) of bonds as collateral.” This would be a 20% haircut. In this case, Mr. Smith is protected against a USD100 million decline in the value of the bonds, should Bear Stearns become insolvent and should Mr. Smith want to sell the bonds. Note that a haircut requires the bank to raise money. In the above example, suppose the haircut was zero to start with, but then it becomes positive, say that it rises to 20%. This is essentially a withdrawal from the bank of USD100 million. Bear turns over USD500 million of bonds to Mr. Smith, but only receives USD400 million. How does Bear Stearns finance the other USD100 million? We will come to this shortly. Prior to the panic, haircuts on all assets were zero. An increase in the haircuts is a withdrawal from the bank. Massive withdrawals are a banking panic. The evidence is that the increase in haircuts for securitized bonds (and other structured bonds) frequently occurred starting in August 2007. We do not know how much was withdrawn because we do not know the actual size of the repo market. But, to get a sense of the magnitude, suppose the repo market was USD12 trillion. If repo haircuts rose from zero to an average of 20%, the banking system would need to come up with USD2 trillion, an impossible task.

8. Where did the losses come from? Faced with the task of raising money to meet the withdrawals, banks had to sell assets. But, there were no investors willing to make sufficiently large new investments, on the order of USD2 trillion. In order to minimize losses, banks chose to sell bonds that they thought would not drop in price a great deal. For example, they sold AAA-rated corporate bonds. These kinds of forced sales are called “fire sales” — sales that must be made to raise money, even if the sale causes the price to fall because so much is offered for sale. Normally, AAA-rated corporate bonds would trade at higher prices (lower spreads) than, say, AA-rated bonds. However, during crises when

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The Capital Market in China: A 60-Year Review Volume 3

multiple banks race to make fire sales of highly rated securities, AAA-rated corporate bonds may fetch less capital than AA-rated corporate bonds. The underlying reason is that in the face of a bank run, banks holding AAA-rated corporate bonds have no choice but to sell these bonds at an extremely low price in order to avoid bankruptcy, which will result in substantial losses. In the above, Professor Gary Gorton analyzed the root causes of this crisis, mainly including securitization and its huge amounts of derivatives, and the parallel banking system. The panic arose as a result of bank runs of institutional investors in the repo market, which is not insured. More importantly, securitization and its derivatives have developed so big as to have trillions of dollars that once massive institutional investors withdraw their deposits, it will lead to not only the fall of the banks but also panic in the whole repo market. Before the crisis, trillions of dollars were traded in the repo market, too big for anyone to save. To sum up, it is because of the four arbitrages and three inventions in the modern economy creating “the greatest problem” and “financial weapons of mass destruction” plus the excessive leverage in the financial system that this crisis is not an ordinary banking cirsis, but a large mistake made by investment banks on the basis of subprime lending, CDO, and CDS. It is reflected in a mass run on banks by firms and institutional investors, instead of individual depositors, in the repo market. As was reported following the bankruptcy of Lehman Brothers, around USD1.6 trillion of trading positions of its partners (equivalent to 14% of the trading positions in London Stock Exchange and 12% of the fixed income in New York Stock Exchange) was frozen, immediately triggering off liquidity shortages in a large number of European financial institutions. Meanwhile, it also caused a state of extreme panic in the market: Everyone may go bankrupt, and who will be the next? It can be disputed whether the U.S. government should or should not allow Lehman Brothers to fall, but in the face of an astronomical figure of USD1.6 trillion, just as exTreasury Secretary Henry Paulson expressed on numerous occasions, “he and the American government have tried their best.” At that time no one would take over the falling company, and to persuade Congress to use the money of taxpayers to rescue Lehman was an impossible task. Considering Soros’s words that the past financial imbalance was a “super bubble” and the past full of a few large crises, I believe that ever since President Franklin Delano Roosevelt introduced government invention in economic adjustment, government intervention, like the girl who opened Pandora’s Box, became an indispensable factor in economic operation. From then on, the eruption of the crisis evolved from four stages of prosperity, recession,

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Asset Securitization: A Treasury of Investment Banks

depression, and recovery to five stages of prosperity, recession, government intervention, depression, and recovery. This government intervention is sometimes reflected in a deficit budget and at others a relaxation in liquidity requirements in the monetary policy. To put it more exactly, it is to use a bubble to replace and rescue another bubble. Therefore, under government intervention, to substitute one bubble for another bubble will probably be a regular way to solve future crises.

To Speed Up Asset Securitization in China China first tried asset securitization in the early 1990s. The earliest successful case was Sanya real estate investment securities of Hainan in 1992. Then the Zhuhai highway fee realized securitization in 1996. China Ocean Shipping (Group) Company (COSCO) completed accounts receivables securitization in 1997 and China International Marine Containers Group also realized USD80 million accounts receivables securitization in 2000. China Huarong Asset Management Company securitized its non-performing assets in 2003 and Industrial and Commercial Bank of China (ICBC) securitized the toxic assets of the Ningbo branch in 2004. In April 2005, the People’s Bank of China and China Banking Regulatory Commission (CBRC) jointly published the Measures for the Pilot Administration of the Securitization of Credit Assets. It indicated that asset securitization had entered into a development stage of standard operation. On December 15, 2005, China Development Bank issued RMB4.18 billion credit asset-backed securities and China Construction Bank launched individual housing mortgage loan securitization goods of RMB3.02 billion. This formally opened the inter-bank bond market and signified the start of the asset securitization pilot in China. The development of China’s asset securitization was always not smooth. According to the report made by Century Weekly, over the three years up to November 2008, there were 19 credit asset-backed securities launched in the interbank bond market and they raised RMB66.8 billion in total. By comparison, the size of the bond market amounted to RMB19 trillion during the same period.6 In the Western countries with mature market economies, asset securitization products usually occupied more than 20% of the bond market. The Central bank had planned to expand the pilot project to include RMB60 billion, but the global financial crisis in 2008 disrupted the expectation. The State Council was cautious about the launch of financial products related to securitization and real estate, so the second round of pilot projects of asset securitization was postponed.

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The Capital Market in China: A 60-Year Review Volume 3

Another problem faced by China’s asset securitization was that the market responded coldly towards the previous released asset securitization products. The two batches of products issued by China Development Bank were not actively traded and showed poor liquidity in the secondary market. In 2007, the scheduled issuance of RMB8-billion ABSs by China Development Bank was aborted due to a failure to meet the minimal subscription amount. Why was the market not enthusiastic about the pilot projects of asset securitization? In addition to the reasons of inadequate information disclosure, poor rating credibility, and insufficient liquidity, according to industry insiders, it was because the maturity was too short and the scale was very small. The maturity period of the first two batches of asset securitization products was generally within three years whereas the international average was between three to ten years or even longer. The size of a single asset securitization product in China usually amounted to just RMB2–3 billion. The industry insiders believed that only with a single product with at least RMB10 billion could liquidity be seen. If a product has a market size smaller than several trillions of renminbi, it can hardly be treated as a major investment product to attract large investors and the issuing institution has no motivation to establish the corresponding internal rating system. The industry insiders added that the restriction on investors entering the asset securitization market was another reason. The composition of asset securitization investors is simple and risks are centered on the banking system. China Insurance Regulatory Commission (CIRC) has not yet permitted the release of asset securitization products issued by national social security funds and insurance firms. After the global financial tsunami, some people simply believed that asset securitization was very dangerous and the management skills of China’s banking industry were not good enough to handle the asset securitization related businesses. Obviously, it is an excessive worry. I agree with Yang Kaisheng, who said “China should not only engage in asset securitization, but also accelerate this process,” for four reasons. First, currently indirect finance still dominates the domestic market and the annual loan increase of more than 10% brings about enormous funding pressure on commercial banks. To divert excess credit assets to the capital market through asset securitization will be an important channel to maintain an optimized CAR. Second, asset securitization offers more financial products and investment tools for investors besides savings and stocks. Third, asset securitization will change the over-concentration of financial risks on banks by dispersing risks.

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Asset Securitization: A Treasury of Investment Banks

Fourth, only when the development of asset securitization and its derivatives is accelerated, can a comprehensive set of fair and impartial institutional structures of the capital market and a relevant talent reserve be built, and experience and lessons be accumulated and learned. It is important to emphasize that the popularity of asset securitization and its derivative products, such as CDO and CDS, in Europe and the United States did not happen overnight. It needs not only commercial banks, investment banks, securities firms, accounting firms, law firms, credit rating agencies, regulatory bodies, institutional investors, and many other professional institutions, but also a large number of accountants, economists, lawyers, actuaries, tax and regulatory personnel, and other professionals. A series of laws, regulations, systems, and experience supporting the capital culture is also necessary. All of these rely on step-by-step evolution and long-term accumulation in market operation. And institutions and professionals who engage in financial innovation also need long-term practices in the market and a constant cash flow in order to support their survival and development and accumulate their professional competence and credibility. At the beginning of the 1990s, when China decided to switch to a socialist market economy, it realized that there was a shortage of hundreds of thousands of lawyers, accountants, and tax personnel. After nearly 20 years of construction and development, the capital market has finally built such a structure and size as we see today. If China wants to develop asset securitization and its derivatives to keep pace with the times, it is necessary to double or triple the size of today’s capital market, financial institutions, and talent pool. This is particularly because asset securitization and its derivatives are highly diversified financial products, unlike savings, state bonds, and stocks which are simple standard products. Not only are assets selected to be collateral diversified, but also the types of ABS products for investors are abundant, be they conservative, risky, or in between, and static or dynamic. It demands heavily professional skills of talents in financial institutions. Here, to borrow the expression used by Xia Xiaojun in “Translator’s Words” in the book Collateralized Debt Obligations: Structures and Analysis, “asset securitization and its derivatives are like a universal converter which converts assets of different natures and from different regions through securitization into investment targets that appeal to international investors with different investment appetites and at the same time raises capital in the market by selling diverse portfolios in order to serve separate purposes.” It should be pointed out that in the last five years, investment banks, rating agencies, and relevant institutions in Western countries continuously searched for business opportunities in the operation of the mathematical model of the default rate,

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which involved almost all high-end mathematical talents. Many of China’s universities responded slowly to this trend, however. They have just set up an advanced mathematics course in the past two years, but to coincide with the global financial tsunami. Even U.S. President Barack Obama said that the financial sector would make up a smaller part of the U.S. economy in the future, and “it just won’t be half of our economy.... We don’t want every single college grad with mathematical aptitude to become a derivatives trader.” President Obama continued to express that some of the job-seekers who would normally go to the financial sector would shift to other areas of the economy, such as engineering. Analyzed further, the U.S. subprime mortgage crisis cannot be attributed to asset securitization itself, for three vital reasons. First of all, new types of securitization products created through financial innovation developed too quickly. Under the conditions of a declining interest rate and rising house prices, a series of relevant institutions and staff were so optimistic and confident that subprime mortgage loans were not appropriately sliced into tranches and often rated too high. They did not take precautions against risks from interest rates and house prices, and also left some gaps in regulation. Besides, when the interest rate rose and the house price dropped, rating agencies did not downgrade the ratings of asset securitization products correspondingly. The facts that multi-layer securities had accumulated excess risks, the hedging strategy of CDS was too optimistic and simple, and the low margin rate of CDS encouraged high sepeculation, contributed to the rise of bubbles from asset securitization and its derivatives. The second important reason is that the high leverage ratio and high correlation of modern financial markets and financial products created new features in the risk emergence and transmission of the modern financial system. The crisis deriving from U.S. subprime debt and its derivatives made it clear that even if it is in America where its financial regulatory system was ahead of other countries and regions, there may be a defect in the arrangement and supervision of high risks and high leverage ratio of certain innovative financial products (such as CDS). Consequently, in the later period of the crisis, the five top-level investment banks in the United States all returned to traditional banks, apart from those being insolvent and merged, and adopted normal risk control measures and proper leverage ratios. For a country like China where its financial development lagged behind, when launching pilot projects and opening innovative financial products with a high-leverage ratio, relevant authorities should be more cautious, try to balance opportunities and risks, and must strictly enforce supervision.

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Asset Securitization: A Treasury of Investment Banks

Lastly, governments should draw a lesson from the U.S. crisis in terms of the changes caused by asset securitization and its derivatives in the financial field, and implement targeted supervision towards institutional investors, repo markets, and the parallel banking system.

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Chapter

Futures Markets

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Pioneers of Financial Futures — Milton Friedman and Leo Melamed How did futures markets develop? The world was on the gold standard for currency until the Second World War. After the war and until the 1970s, the Bretton Woods System was in place under the lead of the United States, where the currency issuance of various countries was pegged to the U.S. dollar while the U.S. dollar was pegged to gold. From the late 1950s onward, overwhelmed by the Korean War and Vietnam War, America was running a large trade deficit for years on end. The balance of international payments deteriorated and foreign countries were also causing the gold reserves to be massively depleted by the exchange of U.S. dollars for gold. In August 1970, when the U.S gold reserve could no longer sustain the increasing overflow of dollars, President Richard Nixon abandoned the commitment to the gold standard by ending the trade of gold at the fixed price of USD35 per ounce and announced the suspension of dollar convertibility to gold. The fixed exchange rate system began to totter. In 1971, Professor Milton Friedman from the University of Chicago expressed the view that the pound sterling was overvalued and that shorting the British currency could be profitable. But banks only offered future cover to financial institutions trading foreign exchanges in the forward market but not to individual investors. And no bank in Chicago dare follow Friedman’s predication to sell the pound short. Meanwhile, Leo Melamed, Chairman of the Chicago Mercantile Exchange (CME), concluded, after long-term observation, that there would be only two fates for the British pound: Either it would be devalued or it would retain its value due to the British government. Melamed discussed his ideas with Friedman who agreed to Melamed’s speculation. At that time, futures markets in Chicago were only engaged in trading commodities, and there was no market in financial futures. The two men predicated that the fixed exchange rate system was going to be disintegrated and Melamed hoped to make use of the symmetry of futures contracts for short and long positions in the Chicago futures market to create a new financial product based on foreign exchanges in the CEM. He planned to experiment with financial futures contracts and establish an exchange market that would be accessible to everyone and that would be the currency futures market. U.S President Nixon closed the gold window as part of the New Economic Policy (NEP) on August 15, 1971. In December of the same year, a group of

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10 countries (G10) signed the Smithsonian Agreement at the Smithsonian Institution in Washington, D.C., and announced a 7.89% devaluation of the dollar in relation to gold and a wider band of ±2.25% for other currencies to move relative to their central rate against the U.S. dollar. The pegged exchange rate system finally wobbled. On December 20, 1971, Melamed officially announced the plan of establishing a futures market in foreign currency, namely the International Monetary Market (IMM). The IMM launched trading in seven futures contracts, including British pounds, Canadian dollars, Deutsche marks, Italian lira, Japanese yen, Mexican pesos, and Swiss francs. Melamed was elected Chairman of the newly established IMM. On May 16, 1972, the IMM officially began operations. It marked the beginning of financial futures innovations and opened a page in the century-long history of the futures industry. In the following years, Melamed and the CME introduced many new financial futures, such as Treasury bill futures and Eurodollars futures, and launched stock index futures in 1982. That is why the financial sector believes that Milton Friedman and Leo Melamed are the pioneers of financial futures. In 1986, University of Chicago Professor Merton Miller, 1990 Nobel laureate in Economics, nominated financial futures as “the most significant innovation in the last 20 years.” The financial futures market was the fastest growing market in the late 20th century. From 1976 to 1986, the annual turnover of financial futures rose from USD37 million to USD216 million. In 1996, the daily volume of foreign exchange futures in only the CME averaged USD12 billion. In 2003, the global trading of futures totaled USD74.9 billion, 25 times the world’s GDP. Financial futures, as a financial derivative, provide stock indices, interest rates, and exchange rates with a kind of financial instrument and mechanism to hedge against and transfer risks, which at the same time enriches the capital culture.

Features and Functions of Futures Markets The international futures market started to develop after the 1970s. At that time, the Bretton Woods system came to an end, the United States abandoned the convertibility of the dollar into gold, and the system of fixed exchange rates was replaced by one of floating exchange rates. As a result, the currencies of each country fluctuated violently, which made averting risks from foreign exchanges, interest rates, and stock prices a top priority. The CME successfully set up the IMM in 1972 and launched trading in seven currency futures: British pounds,

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The Capital Market in China: A 60-Year Review Volume 3

Canadian dollars, Deutsche marks, Italian lira, Japanese yen, Mexican pesos, and Swiss francs. This signified the beginning of the innovative development of financial futures. In 1975, the Chicago Board of Trade (CBOT) created the first interest rate futures contract, one based on Government National Mortgage Association (GNMA) mortgage-backed securities. In January 1976, the CME launched a three-month U.S. Treasury bill future, which later proved to be the most active short-term interest rate futures throughout the 1970s. Although the financial futures markets started relatively later than commodity futures, the turnover of financial futures took up more than 90% of the whole futures market. Financial futures became an important ingredient of not only the futures market but also the financial market. In 2009, global futures and options trading hit 17.7 billion contracts, among which futures and options of stock index and equity accounted for 67%, exceeding the total volume of other financial and commodity futures, including interest rates, foreign exchanges, energy, agricultural products, and metal. According to the survey on 79 derivatives exchanges worldwide made by the U.S. Futures Industry Association (FIA), the global volume of futures and options increased rapidly to reach 22.3 billion contracts, a year-onyear increase of 25.65%. The commodity futures market of China recorded 1.52 billion contracts, representing 50.95% of the global commodity futures and options volume, a growth of 4.32 percentage points compared to the previous year. The stock index futures was first launched by the Kansas City Board of Trade (KCBT) in 1982 and since then, the stock index future was promoted to the whole world and quickly became a leading product in the derivatives markets. In East Asia, the earliest example is the Hong Kong Hang Seng Index (HSI) futures, which was born in May 1986. After that, Japan’s Nikkei 225 index futures, South Korea’s KOSP1200 index futures, and Taiwan’s TAIEX futures were introduced successively. China Financial Futures Exchange (CFFEX) was established in 2006 and it began to trade stock index futures in April 2010. The most positive influence from trading stock index futures is to have changed the existing perception of investors and substituted the strategy of profiting in one direction (either selling or buying) with short-term trading strategies. Financial futures activities place heavy emphasis on standard operation and involve the trading of standard financial or commodity futures contracts according to a set of strict rules in futures markets. The financial futures market is a system combining high complexity and high risks. All players in the market should not only be alert to market opportunities, but also pay attention to regulated operations and risk control. The main features of financial futures transactions are as follows.

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1. Financial futures refer to the futures contracts with financial instruments as the subject matter. The trading object is intangible and virtual financial products, namely securities, and it excludes physical commodities that materially exist. 2. Financial futures are traded with standardized contracts. There are strict standards on the type of currency, transaction amount, delivery date, transaction date, and other contract terms. 3. The delivery period is also standardized. In most cases, the delivery period is three months, six months, nine months, or twelve months, and futures contracts will last no more than two years. Delivery date within each delivery period is determined by the underlying asset. 4. Financial futures adopt an open outcry system to decide the price of contract. Under high transparency and credibility, futures markets are very effective. 5. Futures markets, like securities markets, implement a membership system. Trading members are at the same time members of clearing, who have to pay a margin deposit in order to secure the safety of transactions and reduce credit risks. Additionally, the main functions and roles of financial futures markets are displayed in the following aspects. The first is the price discovery, which means the futures markets can offer price information on a variety of financial instruments. The futures market has very good liquidity, and once there is a shift in market expectation, the futures market will soon respond. In particular, since the price of financial futures reflects people’s forecast and expectation for the changes in market supply and demand and exchange rates and is very sensitive to market fluctuations, it can pass on the information to spot markets as an important reference, and thus affect the spot price to strike a balance. Second, financial futures markets have the function of risk transfer. The introduction of financial futures offers a channel to hedge against risks for the market. The risk transfer function of financial futures is realized through hedging. The fundamental principle of hedging is to buy or sell certain financial instruments in the cash market while at the same time sell or buy the same financial instruments in the futures market in the hopes of offsetting losses in spot goods by gains from the futures. The factors that affect the price fluctuations in the cash and futures markets are the same and the two markets move in the identical direction, so taking equal but opposite positions in the cash and futures markets can compensate losses with profits and hedge against

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The Capital Market in China: A 60-Year Review Volume 3

risks. For example, when there is a rise in exchange rate, investors can enter into an opposite contract to mitigate or eliminate the risk from the future cash market. Take another example, if investors hold stocks which have a direct bearing on stock indices, they can prevent a loss from a future stock price drop by selling a stock index futures contract. And by matching the short position in stock index futures with the long position in stocks, risks from overall positions will be reduced and losses from one position can be offset by gains from the other position. During the hedging, risks are diversified and risks are transferred from those who do not want to bear risks to those who are willing to take risks. Of course, this transfer of risk can be realized only when there are people who would like to assume risks. These people are speculators. Large numbers of speculators activate the financial futures market and expand the scale of futures trading. Third, financial futures markets also function like a lever, creating investment opportunities for speculators. Risks and benefits coexist in the financial futures market. The transactions of financial futures are a kind of margin trading and the percentage of margin is relatively low. Exchanges will decide whether to initiate a margin call or to allow excess margin withdrawal according to the changes of market prices. As a result, financial futures have a high leverage ratio, which means that with a small investment, investors can manage capital several times the size of the margin. Any minor changes in the futures price can translate into a huge gain or loss. This makes it possible to allow hedgers to avoid or transfer price risks while providing speculators with opportunities to make risky investments and gain the corresponding returns. The high leverage feature of the financial futures market encourages speculators to run high risk to make investment and enter into futures contracts in exchange for high returns amid price fluctuations. When trading exchange rate, interest rate, and stock index futures, speculators only have to post a certain amount of margin to control the futures value tens of times. Fourth, the financial futures market offers new trading products and investment opportunities. Interest rate swaps, currency swaps, and equity index futures all can be used as arbitrage tools. For example, when the price of equity index futures deviates significantly from the reasonable price, arbitrage activities around equity index futures will arise. If investors only target the average returns of the stock market or future gains of a certain type of stocks (such as technology stocks) but lack sufficient capital to purchase all these stocks in the spot market, they can still track the market index or technology sector index and share profits by turning to buy stock index futures with a little money. In addition, stock index futures have a short duration (typically three

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Futures Markets

months) and high liquidity, which is beneficial to rapidly changing the asset structure and reasonably allocate resources by investors. Surely, financial common sense tells us that every financial future is in nature a zero-sum game. When some people make a profit, there will definitely be some others who lose money. With stock index futures, if investors sell short when the price is high, they can avoid losses or even make gains. But for the whole market, there must be another group of investors who suffer great losses. Despite that, these financial derivatives play a unique role in discovering value, minimizing risks, creating opportunities, and balancing benefits, which are indeed irreplaceable by other financial instruments. It is no wonder people say that without financial futures, there will be no perfect financial market. Financial futures provide a new measure of risk management in regard of exchange rate, interest rate, and stock investment. By investing in stock index futures, investors are able to not only limit the risk of investment portfolios to a reasonable range, but also grasp investment opportunities and accurately implement investment strategies. Take funds as an example, when the market is experiencing a short-term downturn, funds can choose to exit by buying index futures rather than giving up their long-term holdings of stocks. Similarly, when there is a new direction in investment, funds can grasp the opportunity by purchasing futures and then take time to choose individual stocks. It is precisely because the function of index futures in actively managing risks was gradually accepted by the market that index futures businesses developed very quickly in overseas markets in the last 20 years. Almost all stock markets with a certain scale have listed index futures products with some contracts exceeding the stock market in transaction volume. Robert Merton once said that to not do futures was the biggest venture. That sounds very reasonable. As China’s stock market showed in the previous period, without a derivative product like the financial future, it seemed that investors were encouraged to push up the market and risks were exposed freely. After index futures were launched in 2010, there was a checking force in the market and before the market went up too high, the force would work to balance the price. The “unilateral market” and “short-term bull and long-term bear market” talked about by people in the past few years were reflections of a lack of hedging. Financial futures brought about a new way of risk management, and thus enabled financial institutions which had a very strict requirement for risk control dare put more capital in the market. Throughout the development of foreign stock index futures markets, the ones who used index futures the most were fund managers (such as those of mutual funds, pension funds, and insurance funds). Apart from fund managers, other major market participants

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The Capital Market in China: A 60-Year Review Volume 3

include underwriters, market makers, and stock issuing companies. Certainly, there are also some disadvantages. For a stock whose estimate value is high, it is possible to gain a profit by short selling the stock. This, in turn, will bring a shock to the stock market. Cao Heping from Peking University put forward in 2005 that futures products were more sensitive than other financial instruments to price changes and displayed different price elasticity from physical industries. Due to the feature in price elasticity, when the futures industry develops to a certain scale, it can stabilize the macroeconomy. Some economists even argued that to develop commodities and financial futures markets was likely to help to damp down inflation. It can ease excess liquidity, control inflation, and reduce the pressure coming from the concentration of capital in one or a few areas. The rise of information technology in the 1980s pushed forward changes in futures exchanges worldwide. Starting from the 1990s, there was a surge of exchange restructuring, listing, and mergers in the whole world. For example, in 1998, Deutsche Terminbörse (DTB) and Swiss Options and Financial Futures Exchange (SOFFEX) merged to form a European Exchange which was also publicly traded; By the end of 1999, the publicly listed Singapore Exchange was established with a merger between the Singapore International Monetary Exchange and the Stock Exchange of Singapore; In 2000, the Stock Exchange of Hong Kong (SEHK), Hong Kong Futures Exchange (HKFE), and the Hong Kong Securities Clearing Company (HKSCC) merged under a single holding company called the Hong Kong Exchanges and Clearing Limited (HKEx); The Sydney Futures Exchange (SFE) was listed on the Australian Stock Exchange (ASX) in 2002 and merged with the ASX in 2006; The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) achieved the transformation from a membership system to a listed corporation, respectively, in 2002 and 2005, and the two merged in 2006 to create the world’s largest future exchange. After more than a decade of development, China’s futures market broke the RMB100 trillion mark of turnover in 2009, becoming the second biggest commodity futures market in the world, second only to America’s. The role of the futures markets in serving the real economy has gradually been displayed.

Lessons Learned from the “327 Bond Futures Scandal” China has long delayed the opening of the financial futures markets, because it was feared that the development of financial futures would encourage

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excessive speculation. The 1994 – 1995 “327 bond futures scandal” seriously disrupted financial order and left many financial authorities in a state of shock. In fact, a positive function of the Treasury bond futures market is hedging. It is helpful for institutional investors, especially financial institutions, to maintain the liquidity of short-term assets held by them through hedging. In addition, the Treasury bond futures market also plays a role of value discovery. It can promote the market-oriented reform of Treasury bonds and that of interest rates in related financial markets. During the “327 incident,” the value of inflationlinked subsidy ratio and interest subsidy was discovered. The inflation and fluctuations of interest rates between 1994 and 1995 indicated that there was a need for Treasury bonds to minimize risks in economic life. And the “327 incident” was a result of systematic defect and regulatory misconduct. I published an article in Beijing Economic Daily on March 12, 1995 to analyze this incident shortly after it had happened. M ovies need suspense to increase their appeal to audiences. For Treasury bond futures, the magic of suspense will only add irresistible temptation and market pressure to excessive speculation. Treasury bond futures aim to hedge or to speculate on the price movement of bonds. Originally, there was only one uncertainty for fixed-rate Treasury bonds and that was the fluctuations of the market interest rate. And since the government bonds would receive an inflation-linked subsidy, a sword of Damocles was hanging over their heads and the temptation to overspeculation was further increased. But the bond futures contract coded 327 also involved an interest subsidy. The futures contract was created based on the three-year-term government bonds released in 1992, whose nominal interest rate was scheduled to be 9.5% per year along with an inflation-linked subsidy. One year later, the Central Bank raised the interest rate of three-year deposits to 12.24% in July 1993, creating a two-year interest margin. Whether those bonds would be compensated for by the difference in interest rates at the maturity date became another unknown mystery. Various guesses were made in the market and what behind these rumors were the bets worth tens or hundreds of millions of renminbi. Until February 24, 1995, when new Treasury bonds were scheduled to be launched, the government authorities announced compensation to the bond holders. In this way, a Treasury bond future contains three variables. One more variable means more speculative pressure for the market. This crisis may have been avoided if the government could launch a clear policy at an earlier date during the more than one-year period between July 1993 and February 1995.

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This shows that the “327 bond futures scandal” did not result from a problem of the future itself but a failure in product design and market monitoring. Treasury bond futures are generally only susceptible to fluctuations of interest rate in design, but the “327 bond futures” contain three variables: market interest rates, inflation-linked subsidy ratio, and compensation to interest rates difference (or interest subsidy). Besides, regulatory authorities should have made an earlier announcement about whether there would be an interest subsidy to the 1992 government bonds after the rise of deposit interest rate. And even if the decision of interest subsidy had not yet been made, those authorities could have applied “trading halts” to give the market a buffer time. China’s financial regulators also underestimated the amplification function of futures and under a relatively low margin deposit of Treasury bond futures, excessive speculation was encouraged, which finally caused the “327 incident.” That is why I said in the above article: “As China developed from a planned economy, it was very hard for the country to completely get rid of the influences from the old economic management system. During the transition towards a socialist market economy, the financial department released a series of policies and measures, whose impact was far larger than those of a planned economy. Therefore, relevant financial authorities must take the power of the market into consideration and never underestimate market forces.” “Under a socialist market economy, how to escape from the habitual thinking of the planned economy in management, predict the huge impact of a macro policy on the market, and ensure less uncertainties and more cushions in the Treasury bond market are lessons learned from the ‘327 incident.’ These lessons should also be applied to stock markets, futures markets, foreign exchange markets, real estate markets, and many other markets.”1 The “327 bond futures scandal” in 1995 caused a great pain in the financial circle. Now it has been over 10 years from the “327 incident” and China has transformed itself from a planned economy to a socialist market economy. In April 2010, the stock index futures were first formally launched in China. It should be said that China has gained the ability to master a market economy.

China’s Financial Futures Market Is Underway In 2010, China’s securities market marked its 20th anniversary. There were more than 2,000 companies listed on the Shanghai and Shenzhen stock exchanges with a total market value of RMB26 trillion. This meant that China’s securities market was ranked second in the world, similar to China’s status as the world’s

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second largest economy. In those 20 years, China’s capital market had raised RMB2.5 trillion through equity financing and RMB2.9 trillion through the

issuing of corporate bonds which vigorously supported the sound and rapid

development of the real economy. In 2009, China totally released medium-term notes of RMB695.89 billion, short-term financing bills of RMB447.91 billion,

and corporate bonds of RMB71.29 billion. Together with enterprise bonds, 2 the

total volume of direct debt financing of non-financial companies for the first

time outnumbered RMB1.5 trillion. In the same year, financing through IPO reached RMB202.20 billion and money raised through seasoned equity offering amounted to RMB309.81 billion. The volume of direct equity and debt financing

totaled RMB2 trillion. In 2010, the number of active stock accounts reached 126 million in China, and continued to grow each year. The existing 106 securities companies recorded a total asset of RMB1.8 trillion and a net asset of RMB500

billion. There were 619 funds under the management of 61 fund companies,

which issued 240 million shares with a net asset value of RMB2.2 trillion. The number of securities practitioners amounted to 230,000.

In response to the appeals from all sides, the China Financial Futures

Exchange was established in August 2006 and stock index futures also

started trading in April 2010. This marked an important step forward made by Shanghai’s derivatives market. This was not only a significant advance of Shanghai’s capital market, but also a milestone for the construction of

Shanghai’s international finance center. Due to massive changes of stock index, fluctuations of interest rate, and appreciation pressure on the renminbi, there

was a need to hedge against risks in the market. So, it was very timely and necessary to launch stock index futures as well as other financial derivatives, such as Treasury bond futures, foreign exchange futures, stock index options,

and gold ETFs. Following that, efforts should also be put in perfecting the

benchmark interest rate function of Shanghai interbank offered rate and actively develop multiple derivatives whose prices are determined based on the base

rate. According to the authoritative data and the estimate of experts, at present, China’s national assets are basically composed of: deposit balance of RMB64

trillion, real estate market value of RMB67 trillion, stock market capitalization of RMB26 trillion, insurance funds of RMB4 trillion, wealth investment

products of RMB11 trillion, and margins in the futures markets of RMB110

billion. By comparison, savings, the real estate market, and stock markets are the main investment channels for Chinese citizens while the futures markets are comparatively small in capital size and still have a broad prospect.

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A Dialectical Understanding of Speculation and Investment To develop the financial futures markets, it is necessary to acquire a dialectical understanding of investment and speculation. In China, speculation is often connected with or treated as the crime of speculation and profiteering. In A Dictionary of Modern Economic Law complied by Liu Longheng, the crime of speculation and profiteering is defined as: “Whoever, for the purpose of obtaining illegal profits, violates the state regulations of finance, foreign exchange, gold and silver, and business management, by engaging in illegal business activities and disrupting and undermining the economic order, where the circumstances are especially serious, is considered to commit the crime of speculation and profiteering.” In fact, the Chinese word “touji” (投機, mostly means speculation) also contains positive connotations, and cannot be viewed as a derogatory term. The expressions such as “to seize every opportunity,” “to make a prompt decision,” and “to act as both an opportunity and a challenge,” that people frequently use in their daily lives, actually are very close in meaning with “touji.” In the financial market, “touji” is a synonym for “capturing investment opportunities.” All these connote a positive meaning. In people’s daily interactions, “touji” is often related to being agreeable, for example, to describe “having an agreeable chat.” It conveys a more positive meaning. Zheng Xueqin made a more accurate explanation on “touji” in his article “Speculation and Investment” published in China Securities Journal on February 21, 2008. Speculation and investment, two concepts from Western financial theories, were translated into Chinese by directly borrowing two existing Chinese words. In this sense, when using the Chinese word “touji” to describe trading activities, we should neither be overly swayed by its meanings used in Chinese ancient books, such as “hit a window of opportunity” and “speculate to profit,” nor link the word to the negative meaning of “being opportunistic” or “speculating and profiteering” in modern language usage. That is because the English word “speculating” and its Chinese translation “touji” do not have a continuing relationship in their origin. However, when “touji” is used in stock and futures trading, it corresponds to “speculation” in English. In English, speculation means trying to predict the future based on inconclusive evidence. In the area of finance, it refers to buying or selling

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a security or asset based on the prediction of the price changes in order to make a profit. Here, we can draw the following inferences. First of all, as it is a guess, there will be a risk. Second, the capital used in transactions does not matter itself, because it is just a tool for making profits, and its capacity of appreciation will not be taken into consideration unless such a capacity will affect the asset price. Third, since to make a profit is the only objective, speculation is inclined to use leverage and borrowing to get the maximum rate of return. In this sense, if we refer to “touji” as “trading activities of selling or purchasing a product that you neither need nor will store but solely for the purpose of making profits,” then “touji” is similar to the meaning of speculation in English. Speculative activities are not unique to China. They can be found in every country in the world. They are only different in intensity in each country at a certain period. In the nearly half a century, stocks and real estate have been major targets for speculation in all parts of the world. There are two types of investment opportunities or speculation in financial markets. The first is to make an investment by being discerning in the selection of financial products and able to spot what others cannot. For example, brave speculators dare seize an opportunity to make a bold investment in stocks of new industries that have potential and prospects when most investors dare not venture into the fields. The second is to make an investment by having a pioneering spirit in product and industry selection. Speculators have the courage to decisively buy or sell certain products after a thorough analysis of market trends. For example, they are able to catch chances to buy in a bull market while selling in a bear market. Speculation by taking up investment opportunities should be encouraged in not only financial markets but also any other economic works. To truly achieve speculation, namely capturing investment opportunities is not easy. Here, it is necessary to have a wealth of experience, an in-depth awareness of market changes, rational predictions and judgments on future trends, some investment skills, the courage to take the inevitable risks, and, lastly, ability to make a prompt decision after carrying out a comprehensive analysis of the above factors. This kind of speculation, in fact, resembles the art of command in a war to look for an opportunity to wipe up the enemy. In the financial market, speculation and investment are both profit-seeking activities via the purchasing of financial products or securities. The speculation in securities transactions is different by nature from the speculation meant in speculating and profiteering. Speculation in the securities markets refers

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The Capital Market in China: A 60-Year Review Volume 3

to the legal activity of profiting on the price difference by reselling securities based on the predication of market movements. Especially after the financial futures markets were opened, financial futures were allowed to be traded on margin, which gave them a relatively high leverage ratio. It not only turned the possibility of avoiding or transferring price risks by hedgers into a reality, but also provided conditions and opportunities for speculators to gain a risk premium through leverage or risky investment. By placing a certain amount of margin, speculators can control the trading volume multiple times when dealing with exchange rates, interest rates, and stock index futures. The high leverage ratio thus encourages speculators to run a risk and enter into futures contracts in exchange for high returns amid price fluctuations. In a stock market, whether the purchase of a stock is an investment or speculation is very hard to tell. There are a bunch of studies on securities investment in Western countries and most of them are dedicated to discussing the boundary between investment and speculation. Some argued for using the holding period of a stock to distinguish between short-term speculation and long-term investment. Some believed the motives of profit-making activities should be used to make such a distinction: Investment is concerned about longterm benefits from business development while speculation focuses on gains from price fluctuations and stocks transfer. Others thought we should judge based on the amount of risks: The one with a large risk is speculation whereas that with a small risk is investment. In fact, there is no strict distinction between stock investment and speculation. Under certain circumstances, investment and speculation will transform into each other. For example, an investor may sell a stock which was meant for long-term investment shortly after he bought the stock due to drastic market changes. Similarly, some speculators who originally intended to engage in short-term trading, have no choice but hold their stocks for a longer time when the market was gloomy. This actually turns speculation into long-term investment. So it is really hard to draw a dividing line between the two activities. In real economic lives, each country often categorizes speculation into two kinds on the basis of the nature of speculative activities: justifiable speculation and illegal speculation. Justifiable speculation refers to the speculative activities that are carried out under the permit of laws and regulations. It features openness, legitimacy, and competition, and it is also called “legal speculation.” For example, leverage trading in financial futures markets as mentioned above is legal speculation. Illegal speculation is the speculative activities forbade by state laws and policies and characterized as being unlawful, monopolized, and fraudulent. Therefore, each nation in the world encourages justifiable

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speculation, suppresses illegal speculation, and condemns excessive speculation in the management of securities markets. In financial markets, investment and speculation are both trading activities concerning the selling and buying of financial products, but they are also different in certain ways. First, attitudes towards risks. Investors wish to avoid risk, so they generally purchase financial products which can generate a stable expected return and where their principals are relatively safe. Speculators dare to purchase high-risk securities in exchange for high returns during sharp price fluctuations. So, they can also be called risk takers. Second, holding periods of financial products. Investors are often longterm holders who receive periodic dividends or capital gains. Speculators prefer quick purchases and quick sales in order to gain a price difference in transactions. Third, modes of doing business. Investors usually engage in spot trading and physical delivery. By contrast, speculators mostly do credit trading, buy and sell short, or conduct no physical delivery. Fourth, analytical methods. Investors emphasize the analysis and evaluation of the intrinsic value of financial instruments. Speculators are only concerned about price fluctuations rather than the intrinsic value of financial instruments. It is not surprising that there is speculation in the financial market. The key is we should update our concepts and develop a dialectical view towards speculative activities in the financial market. 1. Speculation can activate markets. There are always price ups and downs in the securities markets. If all buy when prices go up and all sell when prices go down, there will be no transaction that can be made. The securities market will turn into a stagnant or dead market that has only demand but no trading. Similarly, if everyone purchases the safest securities and dares not touch new securities, there will be neither the issuance of new securities nor primary markets. If in the secondary market, no one dare run a risk to sell when prices rise or buy when prices fall, the secondary market will not continue to exist. So, it may be an exaggeration to say that speculation can create a market as believed by some people in the West, but justifiable speculation indeed activates markets. 2. Speculation maintains liquidity and continuity in stock markets. One function of equity financing is to turn short-term capital into long-term funding by the constant transfer of a stock among different short-term

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The Capital Market in China: A 60-Year Review Volume 3

capital holders. However, an affluent investor may not be able to purchase a certain amount of securities whenever he wishes and a securities issuer will not necessarily manage to finance enough capital in the securities market anytime he needs. At this point, speculators fill in the gap of transactions by reselling securities. This, therefore, ensures a constant flow of a moderate amount of securities in the market and maintains the continuity of market transactions. Meanwhile, owing to speculators, normal investment and hedging transactions become possible. 3. Justifiable speculation ensures a reasonable and balanced market price. In an open, fair, and legitimate competition, wise speculators who buy low and sell high will survive in the end. It helps to maintain the market price at a stable level, make the price accurately reflect the supply and demand in the market, and ensures the price of the securities of the same kind in different markets or at different times to be within a reasonable range. 4. Legal speculation disperses various kinds of risks in securities markets and brings financial futures markets and hedging into existence. Financial markets involve the trading activities of securities based on constantly changing stock prices, exchange rates, and interest rates within a certain period of time. Both investors and fund raisers wish to maintain the stock price, interest rate, exchange rate, and stock index within a certain range at the maturity of securities in order to avoid a significant loss caused by violent fluctuations. For this reason, the trading of financial futures and options has come into existence, and it is actually another kind of speculative transactions. It can not only secure the value of an underlying asset by transferring risks to the market, but also form the price of futures or options through specifying the expected future prices (of exchange rate, interest rate, stock index, etc.) by two parties in a contract. This kind of speculative activity maintains the existence of futures and options exchanges and enables investors to realize hedging and risk aversion. The fact that speculation comes along with investment is not subject to man’s will. Speculation requires risk taking, so does investment. In fact, there is no investment without risks and risks will bring about speculation. Securities investment involves at least two types of risks. One is inflationary risks. It is difficult for securities investors to avoid the loss caused by a price rise, even though sometimes the loss is only a small fraction. The other is credit risks, namely, investment may incur a loss of principal or a financial reward. In the international securities market, there are also interest rate risk, exchange rate risk, and price risk. In addition, risks from political changes, disasters, and

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economic downturns will also affect investment. In this way, any investment, whether a securities investment or an industrial investment, will contain certain risks, so it is inevitable for investment to involve a bit of speculation. Even if such a risk is as small as 1/1,000 or 1/10,000, there will still be a 1/1,000 or 1/10,000 chance of speculation, and the investment is by no means 100% risk free or speculation free. Of course, it should be noted that we must also be aware of the negative impact of justifiable speculation. First, excessive speculation should be prevented. To completely rely on good luck or chances and take reckless moves are considered to be gambling. And gambling is neither an investment nor speculation. It has nothing in common with speculation which aims to capture investment opportunities as we talked about above. Second, it is important to be careful of the contagion of speculation. Even justifiable speculation is contagious. It will easily encourage the masses to push their luck, thereby starting a wave of excessive speculation through panic buying or panic selling, either of which will create a threat to the stability of the economy and society. More importantly, illegal speculation must be clearly forbidden by law. For example, naked short selling which will influence the market price and successive trading of a certain security by buying high and selling low for the purpose of speculation ought to be prohibited. Since speculation rises along with investment in the securities market, will the development of the securities market promote frauds and illegal speculation and thus make the socialist economic construction lose its way? The prevention of frauds and illegal speculation is a regulatory issue. Even in the securities markets and financial futures markets of developed countries, frauds and illegal speculation frequently take place. These countries constantly learn from the fraudulent and illegal speculative cases that have happened in order to strengthen market supervision, protect the public interest, and prevent the occurrence of similar cases in advance. The credit system of mature markets advances economic development by a couple of centuries. Although there are deceptions and frauds made through taking advantage of credit in societies with a market economy, the market economy is built based on a credit system. Without credit, the economy even cannot survive for one more minute. Accordingly, capitalist societies of developed countries are committed to promoting and guaranteeing the orderly operation and development of the credit system through all sorts of scientific methods, legislation, and moral standards. As socialist countries claim to put people’s interest in the first place, they ought to intensify their financial management through laws and regulations from the very beginning. But even the most comprehensive

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The Capital Market in China: A 60-Year Review Volume 3

scientific management can only reduce, instead of completely eliminate, frauds and illegal speculation. Therefore, it is important that any government which is responsible to its people has to take every effective measure to ensure that the financial market is built based on a scientific system and legislation and that it operates in an orderly manner if the country wants to develop its securities market and financial futures market. In fact, frauds and speculation will take place in not only securities markets and financial futures markets, but also any business that is built on credit whether it is related to commerce, banking, clearing, insurance, or securities. If without strict management, fraudulent and speculative activities are very likely to arise. It is clear that credit provides a few capital managers with control over others’ capital but without themselves being controlled by the private capital. So, it is possible for those people to run a risk by using others’ capital. The few people, thus, are able to occupy social property and are pure risk takers in nature. This feature of credit applies to both capitalistic societies and socialist societies. It also works in the same way for all business managers no matter if their companies have issued stocks or not. In enterprises of a socialist country (even if they are unlisted companies), the managers may abuse their power for personal gains, appropriate public property, or participate in frauds and illegal speculation by using public property. All these problems stem from the nature of the credit system. Socialist countries should treat those malpractice cases seriously and try to get rid of them. However, there is no reward without a risk and regulators should not close all companies and abolish all transactions just for fear of official profiteering or official speculation. Similarly, credit and financial markets should not be abandoned in order to avoid frauds. It must be made clear that socialist reform is a kind of self-improvement under the premise of a socialist system and to develop securities markets in a socialist country is for the purpose of building socialism rather than capitalism.

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16

Chapter

The Investment Banking Mentality and Capital Operation at Investment Banks

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Banking Redistribution and Ten Financing Assumptions by Liu Lixin Before we go into investment banks and their mentality, let us first review the history of what happened during the early Reform and Opening Up era. In 1979, China had just been transformed into a “large public finances but small banking industry” system and this system continued for 30 years after the founding of New China. However, China had no idea of how to get banks extensively involved in the economy, let alone investment banks. As soon as enterprises were granted greater operational autonomy and were allowed to keep more of their profits, the proportion of fiscal revenue in national income decreased from 40% to 31%. This drew attention to an important issue: There was a large demand for investment, but state finances did not have enough money. It was in 1980 that the Central government promoted economic unification. Lateral economic ties were built between different provinces, government departments, enterprises, and ownership systems. The Shandong Longkou government entrusted China Construction Bank (CCB) to undertake equity financing for the construction of power plants; Gansu Province set up its first investment company; the Shanghai government established a cement plant in Zhejiang Province by using cement as compensation to Zhejiang; the nation’s first leasing company, China Oriental Leasing Company, was founded with the injection of Japanese capital. New businesses successively sprang up and this reflected a demand for lateral capital financing. In a meeting of the Development Research Center of the State Council in 1981, Ma Hong chaired a discussion on how to resolve the financial predicament and raise capital for urgent infrastructure construction. During the meeting, Liu Lixin, Vice President of CCB, put forth a new solution. He said: “Do we have money? There are two different views. Some believe we do not have money, and are under a financial deficit, if banks increase money supply, commodity prices will go up. Others think that although the state finances are poor, institutional reforms have motivated all parties, hence local governments, enterprises, and citizens have money in their hands. If the measure is right, it is possible to collect some funds for necessary construction. I agree with the second view. We can finance urgent construction projects by applying different approaches to different investors and take banking redistribution as a supplement to fiscal redistribution.” This turned out to be a brilliant solution. Liu Lixin’s proposal was confirmed by Premier Zhao Ziyang. Zhao almost completely repeated Liu’s speech in the meeting of the Central Politburo of the Communist Party of China (CPC). Later, Workers’

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The Investment Banking Mentality and Capital Operation at Investment Banks

Daily reported in detail on Liu Lixin’s ten fundraising assumptions and his idea of making banks’ redistribution a supplement to fiscal redistribution. This proposal was a powerful impetus to lateral economic unification and capital financing between different regions. Banking redistribution may not be an effective supplement to fiscal redistribution, but it set into motion the liberation of mind in financial management and reform at the early stage of the Reform and Opening Up era. Since then, the financial sector has gotten rid of many longstanding, narrow perceptions, such as earmarking a fund for only a specific purpose or limiting credit funds to shortterm purposes. The four specialized banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and CCB) competed to make long-term investment loans on the basis of deposits. It gradually became a common phenomenon that financial funds were used to sustain government operation while economic construction relied on bank loans. Thus, China developed from a “large public finances but small banking industry” system to the banking-dominated indirect finance system which lasted for more than 20 years. As a result, a large group of state-owned enterprises were built through bank financing. Among them, a considerable part was made up of large- and medium-sized enterprises, which became the backbone of China’s economy and played a significant role in the country’s economic development. Unfortunately, under the reign of indirect finance for more than 20 years, China developed another abnormal economic pattern — an excessive, large banking system but an extremely small capital market. It became an obstacle in contemporary economic and financial development. The reason why I mentioned Liu Lixin and his proposal of using banking redistribution as a supplement of fiscal redistribution is because, for one thing, as a senior member of CCB and a pioneer in opening up the investment field, Liu Lixin has made enormous contributions to financial reforms and investment theories. For another, his idea of making banking redistribution a supplement to fiscal redistribution is definitely an excellent example of applying the investment banking mentality ’to solving fiscal difficulties by replacing the 30-year “large public finances but small banking industry” system with economic construction relying on bank loans.

What Are Investment Banks and Their Business Scope? Investment banks exist independently as non-bank financial institutions, the opposite of commercial banks. There are many kinds of non-bank financial

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The Capital Market in China: A 60-Year Review Volume 3

institutions, including not only insurance companies, investment trust companies, leasing companies, and finance companies, but also investment banks, securities firms, and financing and investment consultant companies. The latter group is, in practice, collectively referred to as the investment banking sector. Investment banking originated from the accepting houses of bills of exchange in foreign trade in mid-18th-century England. So, in the U.K. and most European countries, investment banks are also known as “merchant banks.” In the United States, the term “investment bank” is more frequently used. Although named as banks, investment banks, in fact, do not engage in general monetary services. Japan learned from America the separate management between banks and securities after the World War II and classified investment banks, according to their business nature, as “securities firms” which specialize in securities underwriting and trading. Examples include Nomura Securities Co., Ltd. and Yamaichi Securities Co., Ltd. Institutions involved in corporate mergers, restructuring, and asset management are under the category of “investment advisory companies,” such as Nomura Asset Management Co., Ltd. and Daiwa Asset Management Co., Ltd. The investment banking industry has its own unique service coverage. Generally speaking, commercial banks provide general monetary services such as accepting deposits, making business loans, offering remittances, and facilitating settlements. But investment banks do not offer such kinds of services. The main lines of business of investment banks include: 1. Corporate capital financing mainly through dealing with securities and related businesses including securities issuance, underwriting, and trading, which is the conventional service of investment banks; 2. Intellectual and financial services in regard to asset restructuring and realization, as well as corporate mergers and reorganization; 3. Fund management, direct investment, and asset management; 4. Company advisory. The latter three businesses were developed later on. Therefore, it can be said that investment banks engage in capital- and asset-related businesses in the capital market. Early investment banks mostly participated in securities transactions in the capital market. So, investment banks, in the narrowest sense, are limited to the institutions which raise capital by underwriting securities in the primary market and act as client’s’ agents or dealers when trading securities in the secondary market. Back then, vital matters, such as business mergers and capital expansion were more often than not achieved by depending on a capitalist’s operating strategies, schemes, and skills in capital operation. What brought about such a historic opportunity for the investment banking industry was the rise of the Euro-dollar market in the second half of the 1960s.

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The Investment Banking Mentality and Capital Operation at Investment Banks

At that time, European countries had recovered from the trauma of World War II and faced a strong demand for dollars in industrialization. On the one hand, the United States started to collect an interest equalization tax (IET) in 1964 and the tax was levied on domestic investors in the purchase of foreign securities. Since the United States strengthened its control over dollars, foreign fundraisers had to leave the country and collect dollars in the European market. In this way, a large amount of surplus dollars flowed to Europe. Shortly after that, plenty of oil dollars also joined this trend. This was a major reason for the rapid growth of the Euro-dollar market. The co-existence of huge capital demand and sufficient dollars supply provided investment bankers with a chance to use their wisdom and talents, which in turn promoted the rapid expansion of the Euro-dollar market. Due to the collapse of the Bretton Woods system in 1970, a great variety of low-cost financing securities and financial innovations appeared in the Eurodollar market between the 1970s and 1980s. Apart from traditional fixed-interest bonds and floating-rate bonds in the European market, new securities such as convertible bonds, multiple currency bonds, European commercial papers, option bonds, and securities with a subscription right to various financial instruments, came out. Later, swap transactions (such as currency swaps and interest rate swaps) were created by taking advantage of violent fluctuations of exchange rates. The talents of investment bankers were given full play. In 1960, the volume of pure intermediate trade in the Euro-dollar market was as small as USD4.5 billion. However, the bonds issued in the Euro-dollar market reached USD80 billion in 1984, similar to the issue amount of the U.S. dollar bonds. In particular, during this period, “offshore finance” was developed in Hong Kong, Bahrain, Singapore, the Bahamas, and the Cayman Islands and that constituted an international financial market, parallel to the financial market of each country. Consequently, the Euro-dollar market became a huge duty-free store and wholesale market which strongly integrated international finance in an indirect way. Another historic opportunity in the development of the investment banking industry was the fourth and fifth merger waves in the 1980s and 1990s and mergers and acquisitions, management buyouts, and leveraged buyouts between enterprise groups arose. Investment banks realized commodification, marketization, and industrialization of their intellectual services relating to corporate mergers, reorganization, and capital operation. Since then, investment banks went beyond the business scope of securities and removed the role of securities brokers from themselves by setting up specialized brokerage firms. Meanwhile, they transformed into professional planners and organizers of corporate mergers and restructuring and carved out a new area in company advisory and corporate mergers.

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The Capital Market in China: A 60-Year Review Volume 3

Strictly speaking, investment banks have nothing to do with either general monetary business or the securities trading business. Now, investment banks in fact have developed into a knowledge industry of investment advisors or financial consultants specialized in business mergers, acquisitions, and reorganizations. Therefore, some scholars argued for the need to distinguish between the investment banking and the securities industries and only focus on the studies of the securities trading activities which would affect the capital market by excluding research on retail business.1 I believe the biggest difference of investment banks from commercial banks lies in the arrangement of resources in addition to lines of business. Commercial banks create credit and allocate resources. Investment banks create markets and optimize the allocation and reorganization of resources. Moreover, the two are different in their attitudes towards enterprises. Commercial banks undertake business credit based on what an enterprise originally is and take a negative attitude towards the enterprise without doing anything to change it. In contrast, investment banks adopt a positive, dynamic, and innovative approach towards enterprises and even reshape them by undertaking mergers, expansion and reorganization businesses, on which basis enterprise assets of different quality and risk will be priced. China’s securities business was, at first, undertaken by banks. The public bonds for economic construction in the 1950s, the government bonds released since the 1980s, and a large number of corporate bonds were all issued and underwritten by banks. As trust investment companies were founded in the 1980s, stocks and bonds businesses were completed through them. It was not until the late 1980s that securities firms were finally established. Their business scope roughly corresponded to that of Japanese ones and did not truly assume the business of investment banking. In 1990, China’s stock markets began pilot trials; however, investment banks did not develop rapidly afterwards. There were two concerns in China’s economic management: The first was a fear about the excessive expansion of credit and investment; and the second was the fear of excessive speculation in securities trading. In real economic life, trust investment companies repeatedly used shortterm loans in long-term investment and securities firms contributed to excessive speculation through speculating on stocks, which increased the government’s concern in developing the investment banking industry. It was precisely for this reason that I proposed to justify investment banks in the mid-1990s by stating that investment banks were not banks in nature but investment and financing consultant firms or an investment and financing advisory industry. Such a distinction was necessary in order to differentiate investment banking from the monetary business of banks and general securities trading. In fact, my concern was not necessary. After

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the founding of the Sino-foreign China International Capital Corporation Limited (CICC) in 1995, China owned its first investment bank. It signified an important step of China’s financial reform in developing the investment banking industry. And when the CICC led large Chinese business groups in overseas listings in 1997, to develop investment banks became a logical step and was not a problem any longer. In the following, I will talk about the necessity of building investment banks and the theoretical basis of this idea. In the area of finance, investment banking fulfills society’s needs for direct financing and is associated with the intermediary service of capital supply and demand in the capital market. The existence of investment banks reflects the socialization of production in economic life. 1. As a country’s economy grows, individual income and national savings increase. When people become richer and national savings tend to be increasingly dispersed, it is necessary to have a mechanism that translates savings into investment in the economic field, in addition to fiscal redistribution and banks’ indirect finance. As direct finance and capital markets arise besides indirect finance, securities firms and investment banks have to act as intermediaries between the supply and demand sides of capital. 2. The essence of capital markets is an exchange market where assets are traded for capital. Here, the assets refer to property, property rights, or securities of a company. Under a market economy, investment and financing activities are, in nature, the trading of capital. The price of capital transactions is subject to not only the quality of assets but also the amount of risk the assets have as well as capital supply and demand in the market. Overall, the general principle is to decide the price according to quality and make returns correspond to risks. Therefore, to maintain a fair, open, and just transaction of capital, it is necessary to have investment banks which provide special services (such as to price stocks or act as sponsors for a listing company) for such a kind of trade, especially in determining the trading price in the capital market. 3. Enterprises under a market economy will present a declining average rate of profits due to the changes of resources, technology, markets, and the variations in the lifecycle of the enterprises, products, and technologies. This is a common rule. So, there is a need for a market-oriented method to maximize and reorganize existing resource allocation. Asset reorganization, and mergers and acquisitions between advantageous companies and disadvantageous companies, industrial consolidation, and adjustments of industrial structure become necessary. Investment banks are rightly

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4.

5.

6.

7.

professional institutions which offer the services for corporate mergers and asset reorganization. It is the nature of industrial capital to pursue efficiency and expansion. During business and capital expansion, a mechanism which can continuously accumulate, centralize, and reorganize capital should be established through the market, and investment banks should play a role of financial advisors and carry out capital operation. In a market economy, capital owners and capital users are separated. Those who suffer from capital shortage want to raise enough long-term capital through the most convenient methods and at the lowest price; and those who have surplus capital also wish to lend out their money in the easiest and relatively safest way and with proper gains. The cooperation between the supply and demand sides requires investment banks as intermediaries to find an appropriate form of trade through various financial services and financial innovations. The capital market is like high technology in the market economy. When commercial banks play a leading and monopolist role in the competition of the indirect market with their standard and regulated financial products and services, there is a need for investment banks and investment bankers to provide intellectual services for the enterprises and business groups of different trades in the marketing of direct finance through financial innovations. Due to the information asymmetry between investors and fundraisers, it becomes necessary for investment banks to act as a bridge between the two parties. Investment banks have advantages in information and credibility accumulated through long-term involvement in the business and they are the ideal intermediaries for the two sides of investment. In the traditional business of financial intermediation, the interests of investment banks are essentially the same as financing enterprises: Only when an investment bank acts as the intermediary, can an enterprise be successfully listed; and only when the enterprise succeeds in listing, will the investment bank make money. The conflict of interest between investment banks and listing enterprises only reflects the selection of underwriting teams and stock pricing.

In this way, investment bankers and the investment banking industry have made a contribution to the development of the world’s finances and economy through playing a traditional role as intermediaries.

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The Mentality of Investment Banks Investment banks and their capital operation are products of modern economy and finance. During a very long period after the 1970s, it was investment bankers and the investment banking industry that created miracles in capital formation and made a great contribution in optimizing resource allocation during economic development. Now, of course, investment banking is no longer a new term in the economic field. But in the early 1980s, when China was just transforming from a planned economy to a socialist market economy, investment banking was indeed an unfamiliar thing. At that time, “investment banking” was understood from the perspective of industrial investment, and that was why CCB termed a subsidiary bank, which handled loans granted by the World Bank, as a “China Investment Bank.” In the international interactions of CCB, foreign sides always focused on the word “construction” in the name of CCB and related the bank to the building industry, while CCB boasted of itself as an “investment bank.” Moreover, Zhao Ziyang required the development of CCB into an investment bank like the World Bank. In 1986, when making contacts with foreign banks, CCB heard from them about “merchant banks.” Our interpreter, however, rendered the term as “commercial banks” due to a lack of financial knowledge. Until much later, we came to realize that the “merchant bank” mentioned by the U.K. and Canada was in fact the investment bank. Shortly after that, Hiroshi Takeuchi, a director of the Long-Term Credit Bank of Japan (LTCB), told me that the LTCB had a department called “merchant banking.” During that time, I also represented CCB to negotiate investment cooperation with Japan’s Nomura Securities. By this chance, I specially invited Hiroshi Takeuchi of the Nomura Research Institute (NRI) to give us a lecture on the situation of merchant banks in the international market. When I was working for China Investment Consulting Company (CICOC) in 1988, I had a chance to communicate with the World Bank about the reform orientation of CICOC. Richard Stein from the World Bank said that during China’s economic reform, there would be a dramatic increase in the demand for merchant banks and he suggested that we should make early preparations. The merchant banks mentioned by Stein were actually investment banks. In later discussions, the expert from the World Bank advised us to set up a joint venture investment bank by cooperating with a famous foreign investment bank and recommended 100 large enterprises to be listed overseas through shareholding reform. This idea was, in fact, close to the mode of CICC. But we were not

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confident as we lacked the necessary knowledge about investment banking. To that end, Xia Bin, Li Xujun, and I met Liu Hongru who was then the Vice President of the Central Bank to hold an in-depth discussion. Liu consented to this proposal and believed it was the best way to utilize foreign capital. We even talked with Lu Xueyong, President of the People’s Bank of China’s Beijing branch, about the equity participation in Beijing Municipal Securities Company. At that time, the capitalization of the Beijing Municipal Securities Company was around RMB10 million. On that basis, we planned to transform the company into “Beijing Securities” by injecting RMB20 million from the Beijing municipal government and the CICC and wished the new company would serve as a springboard for cooperation with foreign investment banks. However, things were not always smooth in China. Due to the clean-up and rectification movement towards Chinese companies, this idea was not put into practice. Unexpectedly, the predication of a dramatic increase in the service demand for merchant banks by the World Bank was delayed for more than 10 years owing to the rectification and clean-up movement and the reluctance on the part of the government to give up its role in resource allocation during industrial consolidation and business mergers. In 1990, I got a chance to visit America and Canada for the purpose of investigating the business of investment banking and corporate mergers and acquisitions. This was an extremely rare opportunity to study investment banking and probably the first time that China’s domestic banks could investigate Western investment banking operations. During this chance, I got access to the mentality of investment banking; before that, my shallow understanding in this regard was gained from the experiences during China’s Reform and Opening Up. Since then, I have become interested in the thinking of investment banks and collected some materials and articles on this topic. Originally, I thought that since investment banks originated in the West, there would be some concrete studies about capital operation. However, Western books on investment banks were often ambiguous and vaguely written. I asked some professionals in the investment banking industry about this question and their answer was very straightforward: “That may be because it is not appropriate to let out the secret in the practical operation of Wall Street.” Another more realistic explanation was that investment bankers in Wall Street were too busy to write a book while professors were too proud to make money, so those books were only skin-deep. I experienced the old society. Before China’s liberation, I once lived in Shanghai where financial awareness was the most keen in all of old China, and worked for the Bank of Communications (BOCOM). It set up a Trust Department and entrusted the department with the business of industrial investment. The

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department operated very flexibly under two names: One was China Pacific Insurance Company and the other was No.31 Securities Broker. After the founding of New China, I personally experienced the construction of CCB on the basis of the old BOCOM, practiced the most rigid financial management of the planned economy in the Ministry of Finance, and got involved in the transition of CCB from a specialized bank to a commercial bank. The government advocated that we expand our thoughts after the Reform and Opening Up era, and in the face of a series of flexible and invigorating measures, what impressed me most in the financial field was value discovery. As far as I am concerned, the mentality of investment banking is about monetization, realization, flexibility, and invigoration. In fact, when looking at traditional Chinese thinking, the wisdom behind overall planning in military deployment, game theory in playing Chinese chess, and strategic alliances in the Warring States era is completely the essential thinking of investment banks. Later, in my interaction with investment bankers, I deeply felt that the most creative strategy investment banks had was to leverage policy loopholes. The originality of the strategy lies in that it does not follow the common practice but does not violate laws or regulations. It invigorates the financial market through flexible means, discovers value under the permission of multiple laws and regulations, and creates value by taking advantage of policy loopholes. So, what is at the heart of investment banking is value discovery. In the 1990s, when investigating investment banking and business mergers in the United States and Canada, I asked an investment banker from Morgan Stanley: “Why is it the investment bank rather than the commercial bank which has worked miracles in corporate mergers as the latter has more financial contacts with commercial banks?” He responded to me very straightforwardly: “It is because commercial banks are familiar with the financial staff in companies whereas investment banks establish connections with decision-makers, such as directors and CEOs. And it is the decision-makers who have the final say over business mergers and acquisitions.” During my later investigation, I became further aware of the difference in attitude of the two types of banks. Commercial banks undertake granting a business credit based on the existing condition of the enterprise and take a negative attitude towards the enterprise without doing anything to change it. In contrast, investment banks take a positive, dynamic, and innovative approach towards enterprises, and even reshape them through business mergers, expansions, and reorganization. On the basis of that, they will discover value and price the enterprises’ assets according to quality and risks. Of course, the most critical part is value discovery, i.e., whether you are able to find investment opportunities or not.

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In 1995, China launched its first investment bank — China International Capital Corporation, or CICC, a joint venture by CCB and Morgan Stanley International Incorporated. The cooperation dates back to 1993. At that time, John J. Mack, President of Morgan Stanley Group, invited Edwin R. Lim, World Bank Country Director for China, to join Morgan Stanley and entrusted Lim to negotiate with the Chinese side about jointly establishing an investment bank. Lim visited the Central Bank which later appointed Zhu Rongji, Vice Premier and Governor of the Central Bank, to negotiate this matter with the CCB. Consequently, CICC was set up. The Vice President of CCB, Wang Qishan, was appointed as Chairman and Lam as President. I was invited as Senior Consultant. The name of CICC also reflects the thinking of investment banks. Serving as the World Bank’s first Chief of Mission to China for many years, Lim was a China hand. He knew that China avoided saying “capital,” so he determined that the Chinese name of CICC should be “中國國際金融 公司” (literally, China International Finance Corporation). In this way, the name not only manifested the real practice of investment banks, which was capital operation in the international market, but also conformed to China’s avoidance of the word “capital.” That was why I said the Chinese name of CICC both reflected the mentality of investment banks and contained Chinese characteristics. CICC was established in September 1995. As the company’s consultant, the first task for me was to get large state-owned banks out of the bad loans of overindebted state-owned enterprises. Fang Fenglei, Bi Mingjian, and I conducted research in Shanghai and picked out Shanghai Xinghuo Pulp and Paper Mill from the list of bankrupt companies to try out the debt-for-equity swap. Back then, banks were not allowed to hold shares, so we had to take a detour. We asked CCB to transfer its claim of debt of the paper mill to CICC and made CICC a shareholder of the paper mill through a debt-for-equity swap. Here, taking a detour is equally important as leveraging policy loopholes as a strategy of investment banking. To be honest, I did intend to solve the non-performing loans of banks and save over-indebted state-owned enterprises by advocating Xinghuo’s practices. This idea was approved by President of CCB Wang Qishan, State Economy and Trade Committee, Shanghai Municipal Government, and the Central Bank. The President of CICC even praised this plan by saying metaphorically: “We have dug a gold mine.” But surprisingly, the only objection was from senior government officials. In spite of that, until today, I still believe that Xinghuo’’s way of debt-for-equity swaps is indeed a creative strategy of investment banking. Later, in the attempt to reform and bail out state-owned enterprises, although the senior government officials encouraged business

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mergers and standardized bankruptcy procedures, a fundamental problem was that the government could not afford to replenish capital in a large number of distressed companies and therefore was unable to completely reverse the overindebtedness. Until 1998, since the three-year deadline to help out distressed state-owned companies as committed by the government was approaching, the government had no choice but to implement the debt-for-equity swap in the second half of 1999. Four newly-established financial asset management companies transformed loans into shares of stock in the companies which defaulted on loans from state-owned commercial banks, thus fundamentally relieving the enterprises of excessive debts and the banks of bad loans. This debt-for-equity swap basically borrowed some of Xinghuo’’s experience and core principles. Although we criticized it for lacking creative intellectual services and active financial innovations tailored for different projects like those provided by investment bankers, it was almost impossible to completely solve the over-indebtedness of enterprises and non-performing loans of banks within just three years if the government did not make the debt-for-equity swap into an administrative policy. In 2001, Premier Zhu Rongji declared success in the three-year bailout plan for state-owned enterprises in the Report on the Work of the Government. Despite bureaucratic habits of ingratiating with power and the rent-seeking behavior of government officials during this project, it was really a significant achievement. From a series of flexible and invigorating measures in the Reform and Opening Up era to the present exploitation of policy loopholes, there were many creations which were achieved by following the thinking of investment banks. Here, I believe, the core point of the investment banking strategies is the discovery of value and the making of innovations. What is at the center of innovation is to be able to size up the situation, grasp market opportunities, optimize resource allocation and reorganization, and create and capture markets. It is also imperative to adopt a positive, dynamic, and innovative attitude towards enterprises and even reform enterprises through business mergers, expansion, and restructuring. In addition, the courage to challenge inappropriate laws and regulations, the dedication to reforming political and legal systems, and the efforts to rationalize economic relations, create new financial instruments and means, and promote the development of productive forces are also essential. After the mid-1990s, I have not continued research on the mentality of investment banks for a long time. During the decade-long equity division in China’s stock market, what had been frequently seen was to buy non-tradable state-owned shares through negotiated transfer and then acquire huge capital

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through issuing additional shares at the market price. Here, it was not a smart invention but an unfair capital operation. Still, many people were eager to make quick money and the distorted system of the China Securities Regulatory Commission (SCRC) was impotent to monitor the unjust money operation. This is by no means a reflection of the thinking of investment banks. After entering the new century, especially in recent years, China’s reform got bogged down. Each government department stuck to the old routine for the purpose of safeguarding existing interests and thus the practices of exploiting the loopholes in existing laws and regulations by these departments frequently occurred. Let me give you the most typical examples. In the bond market, the Central Bank allowed enterprises to issue short-term financing bills and medium-term notes in addition to bonds and negotiable instruments. China’s bond market lagged behind and the two main reasons were: First, the Negotiable Instruments Law prohibited enterprises from issuing promissory notes and only allowed them to issue banker ’s acceptances; and second, the non-financial sector kept the management right of enterprise bonds under control while the National Development and Reform Commission (NDRC) insisted on approval authority over enterprise bonds issued to finance capital construction. The Central Bank bypassed those two obstacles and opened up short-term financing bills and medium-term notes. So, the bond market was injected with new vitality by gaining two kinds of new bonds and commercial banks extricated themselves from the worry of excessively concentrated risks from acceptance bills. Similarly, the CSRC invented corporate bonds apart from enterprise bonds in order to bypass the examination of the NDRC. Another example was financial leasing. In the 1980s, when I represented CCB to cooperate with a Japanese company in forming International Union Leasing, I noticed that the tax was very high in aircraft leasing. Unexpectedly, this problem continued for 20 years and the taxation department was still unwilling to lower the tax. In 2010, CBRC led several relevant banks to approve the setting up of “project companies” in bonded zones of China by ICBC Financial Leasing Co., Ltd. (ICBCFL), CCB Financial Leasing Corporation Limited (CCBFL), and Minsheng Financial Leasing Co., Ltd. (MSFL). Through these project companies, the original one-off payment of taxes and dues in aircraft import can be amortized into a series of payments to be made during the lease term, indirectly solving the high tax problem. The project company was a unique innovation by CBRC and the three commercial banks in an attempt to break the restriction of high tax in developing a leasing business by bypassing the taxation department. What the two cases did reveal was that the power conflicts between different departments gave rise to the above unusual bypassing practices. In

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Western countries, it is investment banks that help enterprises to leverage policy loopholes whereas in China, it is government departments who exploit the loopholes in the administration of other departments. Although it was an expedient out of a unwilling choice, the “innovative” practice of bypassing the NDRC and taxation department led by CSRC and CBRC was not only a financial innovation making use of the strategies of investment banks, but also a special way unique to China in solving the power conflicts between different departments and breaking the stalemate of reform. But in any case, productive relations must conform to the development of productive forces and the superstructure must comply with the economic base. This is a universal law of the development of human society. If the development of productive forces breaks through the restriction of existing relations of production and the superstructure is incompatible with the economic base, how to change the superstructure becomes the key. There are only three ways out: First, to give in and compromise. This is actually to stick to the present condition. Second, to confront it and break it down which may result in an unusable mess. Unless absolutely necessary, it is not a wise choice. Third, to find an alternative. It means to follow the thinking of investment banks — to think out an expedient, exploit policy loopholes, and bypass government authorities, in order to reshape the superstructure to suit the existing economic base. Most of the above stories happened 20 years ago. The reason why I recalled those histories and admitted the past limitations in understanding is to explain that there will be a gradual process in economic transition as well as in people’s updating and accumulation of knowledge. And back to the topic of the mentality of investment banks, the core is whether one can discover value and investment opportunities, and find out new ways to optimize resource allocation.

Capital Operation: Unique Financial Services Western countries often refer to investment bankers as “financial engineers.” It is because what investment banks provide are highly intellectual professional services that are necessary for capital operation in order to enhance a company’s efficiency and market competitiveness. Investment bankers know best how to optimize resource allocation to maximize benefits. Investment bankers are different from general bankers in that ordinary bankers sell financial instruments and financial services. Investment bankers, however, offer a package of flexible financial services customized to a particular

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enterprise and financial innovations under specific conditions. This is what people call “packaging.” Financial engineers differ from general engineers because the former do not commit to studying and discovering the value of a product or a technique but are skilled in researching and comparing the opportunity costs and marginal revenue of a certain capital operation method in order to discover its value and maximize the value through “packaging” various operation methods on the basis of their unique highly intellectual financial services (including the financial services and innovations that are available in modern society). In this regard, what investment bankers promote is not the capital operation in a general sense but companies which undergo business restructuring and special capital operation and can manifest the value of the capital managed by applying various intellectual services. Investment bankers know best how to optimize resource allocation to maximize benefits. Investment banks, from the very beginning, were designed for capital operation. They aim to increase the efficiency in enterprise and capital operation, namely carrying out external expansion of enterprises through financial innovations. If an enterprise uses its own capital or internal accumulation to invest, it is just an investment activity, namely capital utilization, rather than financial behavior. But when an enterprise transforms the assets with future income into securities (either stocks or bonds) to finance and be traded in the market, it is a financial activity. Meanwhile, as an enterprise raises capital in the capital market and undertakes business mergers or asset swaps to realize business and capital expansion, it becomes the capital operation in the capital market. So, capital operation is a kind of economic activity related to market financing and business expansion. The object of operation is not products or techniques but capital. But the capital operation of an enterprise must be based on the product management of the enterprise. Neither side can be underestimated and product management should always be the base. The capital operation of a company under a market economy includes five aspects: capital allocation, capital financing, capital utilization, capital concentration, and capital circulation. The target of capital operation is to rationalize and optimize capital allocation, simplify and reduce the cost of capital financing, make capital utilization more sufficient and efficient, increase the liquidity of capital deposits, and enlarge the scale of capital concentration. The capital operation in the stock market refers to how investment banks capitalize the assets with the future income of a company. Investment banks can either amplify the function of capital and gain the actual control over a

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company’s capital by holding shares, or increase the efficiency of an enterprise and its capital and realize capital expansion through business mergers, asset restructurings or swaps, or capital injection (including stock allotment and seasoned equity offering). Under the condition of full stock circulation, this kind of capital operation, though gambling, is the basis of the same price for the same share, and thus is seldom unfair. Sometimes, takeovers and reverse takeovers may cause huge ups and downs of stock prices and the cost is significant. It is important for capital operation to take advantage of capital markets and equity transactions. The capital market is a place where assets with future income are exchanged for capital. Asset (stocks and bonds) securitization is its basic way of operating. The law of capital movement in the capital market is the balance between risks and returns. The transactions of equity are essentially the trading of corporate control. During this trade, investment bankers and financial intermediaries have to price the assets of an enterprise, measure the risks or growth potential of the enterprise, and manifest the value of both the capital and the enterprise through a variety of intellectual services. This is the so-called “packaging.” Yet, this “packaging” must be based on real data and prospect analysis rather than exaggeration or deception. Here, the “packaging” refers to a kind of artistic creation and is by no means fabrication and fraudulence. Some intermediary institutions deliberately “package” poor quality stocks into high-yield “quality” stocks through accounting fraud to cheat investors in order to gain the position and interests of lead underwriters. This is deception and has nothing in common with what we call real “packaging.” There are also some securities firms which want to compete to be lead underwriters, but solely rely on a formulaic prospectus. They follow each requirement in the prospectus mechanically in every project. It is at most imitation and by no means “packaging” or innovation. The capital operation of investment bankers should be a real work of art rather than a forged piece of art. If investment bankers want to become well-deserved financial engineers, they have to make sure their creations can withstand the test of the market and time and they are truly responsible to investors. There are too many small enterprises in China. Therefore, it is necessary to carry out external expansion and industrial consolidation by taking advantageous enterprises as the backbone and industrial structural adjustments as the base. In 1997, the Report at the 15th National Congress of the CPC by Jiang Zemin put forward: “By using capital as the linkage and relying on the market forces, we shall establish highly competitive large enterprise groups with transregional, inter-trade, cross-ownership and trans-national operations.” 2 The economic development, industrialization, and quality improvement of economic

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agents in a country have to rely on large enterprises and enterprise groups. So, for large enterprise and business groups with international competitiveness, especially state-owned large enterprise groups that are large in scale, leaders in respective industries, and related to the lifelines of the national economy, the question of how to operate capital by depending on the market and enable themselves to grow stronger and larger has significant bearing to the reform and development of the state-owned economy. It should be said that for this reason, investment banks and capital operation have a broad space for development. The development of industries must take capital as the linkage and this is the law of socialized production in modern economic development. During business expansion of enterprises, how to connect and control production technologies, the supply of raw material, parts, and semi-finished products, and production and management personnel? Certainly, there may be various ways to achieve the results, but the most important and vital approach is to connect and control by using capital as the linkage. Capital is both a connector and a controller. It is able to bring technologies, products, the supply of raw material and parts, distribution channels, and staff and operation management under control. The expansion of large business groups especially international groups in the world is all realized through capital expansion. Their business operation also starts from capital operation. To use capital as the linkage, it is essential to take the basic functions of capital as levers and improve the efficiency of business and capital operation. As was said, the fundamental functions of capital are: 1. to establish an enterprise and ensure its continual operation; 2. to generate a high return (it is a more expensive scarce resource than loan interest); 3. to develop corresponding debt-paying ability; 4. to represent ownership — the control over a company is reflected by how much capital one has contributed. On the basis of those functions, the capital operation of enterprises realizes capital expansion through creating, splitting, or merging another enterprise under different circumstances. It may aim to enhance the return on capital and achieve the maximization of profits through controlling the enterprises and using low-cost borrowed capital (such as loans or bonds). It can also determine the control mode of the enterprises (direct or indirect holding), the degree of control (equity participation or taking majority stakes, and engaged in personnel management or compensation management), and whether voting by hands or feet. There is a learning curve for us to understand capital operation. Prior to 1978, Chinese people avoided saying capital, and of course, never talked about capital operation. The Third Plenary Session of the 11th CPC Central Committee in 1978 declared the transition from the planned economy to the socialist market economy

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and people gradually broke through the shackles of their way of thinking. They came up with the idea of achieving industrial consolidation through business mergers, but did not know how to solve the problem of restricted property rights flow. There was no real progress as the government only encouraged enterprise mergers but steered clear of property rights flow and asset restructuring. In September 1995, the CPC Central Committee adopted the Proposal on the Ninth Five-Year Plan on National Economy and Social Development and Long-Range Objectives to the Year 2010. It confirmed the policy of liquidizing and restructuring stock assets and proposed to “promote rational flow and optimized reorganization of existing assets through market competition,” and “realize strategic restructuring of state-owned enterprises through liquidizing and reorganizing stock assets.” The proposal paid unprecedented attention to stock assets. Since then, the economic sector brought forward the issue of capital operation. But even at that time, there were many people who only advocated asset management and asset operation but still considered “capital operation” taboo words. Until the 15th National Party Congress of the CPC in 1997 removed the clouds over capital in a socialist society and brought up the ideas of “using capital as the linkage,” “amplifying the function of capital,” and “enhancing the operational efficiency of enterprises and capital,” capital operation became a hot topic in the capital market. For me, I started to develop a positive attitude towards capital operation when I was asked by Zhao Bingxian to write a forward for his book On Capital Operation. I wrote a 7,000-word article which carefully reviewed different views towards capital in the 40 years of New China and the article probed into the operation of capital. The Chinese edition of the Financial Times published this article under the title “Capital Operation: A New Topic for Us” in May 1997. Subsequently, on the eve of the National Day of the same year, under the request of Wu Jinglian, I wrote “The Reform of State-Owned Enterprises and Capital Operation” for the Reform magazine. In 1997, the media started to focus on the topic of capital operation. An article written by Ai Fei in Economic Daily published on June 12, 1997, stated that the transition from strengthening state-owned enterprises to strengthening the stateowned economy was the first leap in cognition while the thoughts on capital operation were the second. Zhan Guoshu published an article on September 8 and suggested that the first leap in cognition happened when enterprises transformed from product producers to commodity producers and the second leap in cognition was their transition from commodity producers to capital operators. Regardless, during the 40 years of economic life in New China, from the avoidance of saying “capital” to the acknowledging of capital in socialist societies and capital operation with capital as the linkage, there was undoubtedly a leap in understanding. In

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that period, there were two kinds of fever in Beijing: capital operation fever in the business circle and investment banking fever in the financial circle. This reflected the fact that enterprises have huge demands for capital operation services, and investment bankers are eager to grasp this opportunity.

Initial Attempt by Chinese Enterprises at Capital Operation during Overseas Listing The first step of a company’s capital operation is to get listed. Once the company is listed, it is naturally qualified to take up direct finance, control social capital, and undertake capital operation. In the 1990s, China had just opened its economy and Chinese enterprises had no idea of the benefits of capital operation due to a lack of exposure to the capital market. The pioneers were companies which realized back-door listing in Hong Kong, such as CITIC Pacific and Shougang Group. These companies had accumulated sufficient capital in China’s Reform and Opening Up era and longed to enter into the global market from Hong Kong to enhance market visibility. They purchased a public company in Hong Kong and then directly injected capital in the shell company to achieve indirect listing in the Hong Kong Stock Exchange. By doing so, those private companies could avoid the disagreement between domestic accounting, auditing, legal practices, and international practices as well as the regulatory and financial requirements associated with an IPO. Early back-door listing implied the strategy of registering companies overseas by investment banks. Through back-door listing, a company can manage a large sum of money without selling assets, paying interest, or applying for a mortgage. This tangible benefit brought much joy to those pioneer enterprises in a closed economy. Reviewing the practices of China’s enterprises in capital operation, we can find that there was an evolution from spontaneity to consciousness.

Overseas back-door listing The first case of overseas back-door listing was the establishment of CITIC Hong Kong (Holdings) Limited by CITIC Group in 1985. In 1986, CITIC Hong Kong purchased Tylfull Company Ltd. The acquisition was completed through Tylfull issuing HKD270 million in shares to CITIC Hong Kong who would hold a 64.7 % stake in the former. It fixed the cost of mergers by avoiding the negative impact of stock market swings. This was considered the first attempt of Chinese companies in overseas capital operation. After purchasing Tylfull, CITIC Hong

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Kong successively acquired Dragonair, Companhia de Telecomunicações de Macau S.A.R.L. (CTM), and Dah Chong Hong Holdings Limited (DCH), and injected these stakes in Tylfull. In 1991, Tylfull changed its name to CITIC Pacific Ltd. From 1990 to 1992, Tylfull or CITIC Pacific had raised more than HKD8 billion through issuing new shares to pre-existing shareholders or to third parties. When CITIC Hong Kong purchased Tylfull in 1986, the latter had a net asset value of only HKD350 million. This figure grew to HKD6.12 billion in 1991 and was further expanded to HKD26.64 billion in 1995 with the assets under management reaching HKD39.30 billion. The listing of Shougang Group in Hong Kong was another example. In July 1992, the State Council granted Shougang Group the rights of foreign investment, equity financing, and foreign trade. At that time, Tung Wing Steel Holdings Limited held by Lee Ming Tee encountered difficulties in operation. It was said that among the 1 million tons of Hong Kong’s steel imports in 1990, one third was contributed by Tung Wing, one of the largest steel suppliers in Hong Kong. China Shougang International Trade & Engineering Corp. under Shougang Group spent USD22 million to acquire a controlling stake in Tung Wing by partnering with Cheung Kong (Holdings) Ltd. and CEF Holdings Ltd. Therefore, Shougang Group was able to indirectly get listed in the Hong Kong Stock Exchange after establishing a Shougang Holding Ltd. in Hong Kong to help the group manage its overseas investment and stock controlling. Then, Tung Wing raised capital by issuing new shares in the stock market and injected that money in Shougang’s subsidiaries (such as steel wire plants and strip steel mills), which expanded Tung Wing’s assets. In February and April 1993, Tung Wing, cooperating with Cheung Kong and CEF Holdings, acquired Eastern Century Holdings Limited and Santai Manufacturing Limited at the prices of HKD164 million and HKD314 million, respectively, by using its stocks as collateral. Following that, in June 1993, Tung Wing collected HKD1.88 billion through equity financing to gain the controlling interest of Santai and changed its name into Shougang Concord Technology Holdings Limited. Then, the investment alliance contributed HKD384 million to purchase a 50.32% stake in Kader Investment Company Limited which was later renamed into Shougang Concord Grand (Group) Limited. Starting from acquiring Tung Wing when the market value of Shougang Holding was HKD300 million, within less than two years, Shougang Holding increased its value to HKD6.36 billion. Then, through a series of stock offerings and mergers, its market capitalization reached as high as HKD12 billion. This capital operation mode of snowballing assets was known as the “Tung Wing development mode.” That is to say, by taking advantage of Shougagng Group’s influence, to first acquire a listed company, and then raise

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money through stock offering before leveraging the acquired company’s assets to pursue new acquisitions. The back-door listing of CITIC Pacific became a role model for many other enterprises which planned to undertake cross-border operation. Subsequently, there were some departments, cities, and enterprise groups which developed a variation of the back-door listing. That variation involved transforming an overseas subsidiary of a business group into a shell company instead of buying a shell company in order to realize the overseas listing of these parent companies (business groups). The first mover trying this new listing method was Hai Hong Holdings Company Limited under China Merchants Group (CMG). It was initially created as a paint maker to support the shipping business of CMG and was responsible for manufacturing marine paint in Hong Kong. Later, under the lead of Yuan Geng, the head of CMG, Hai Hong built technical cooperation with Hempel Marine Paints A/S (Denmark) and quickly occupied half of the Hong Kong marine paint market. In 1981, Hai Hong set up a factory in the Shenzhen Shekou Industrial Zone and continuously developed new products such as building emulsion paints, interior and exterior wall coatings, and road-marking paints, after absorbing the Danish technologies. Starting from 1989, Hai Hong diversified its business by branching out into building coatings, road markings, protective coatings for heavy industry, and container paints and even entered into the anticorrosive paints market by designing and producing heavy-duty anti-corrosion coatings used in wide areas including bridges, port machinery, power plants, railcars, boarding bridges, oil and petrochemical storage tanks and pipes, and marine drilling platforms. Hempel-Hai Hong enjoyed a high reputation in the worldwide electrical (hydro, thermal, wind, and nuclear power) anticorrosion market. In 1991, Hai Hong transferred its technologies of wall coatings to Australia which signified that China’s building coating technologies were among the world’s best. In July 1992, CMG injected the capital from Hai Hong’s factory in Shekou into Hai Hong Holdings (Hong Kong) and got the latter listed in the Hong Kong Stock Exchange as Hong Kong’s first red chip company. Raising HKD90 million through its IPO, it was oversubscribed by more than 370 times, creating a new record in Hong Kong’s stock market. In 1997, Hai Hong Holdings (Hong Kong) was renamed China Merchants Holdings (International) Company Limited (CMHI). The gross turnover of CMHI soared to RMB1.3 billion in 2004 from RMB100 million when the company first went public. The practice of CMHI going public in Hong Kong was widely talked about among the business circle. As a result, many enterprises followed suit,

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for example, China Overseas Land & Investment Ltd. under China State Construction Engineering Corporation (CSCEC) was listed in Hong Kong in August 1992; China Travel International Investment Hong Kong Limited under China Travel Service conducted its IPO in October 1992; Denway Motors Limited under Guangzhou Automobile Group Co., Ltd. went public in February in Hong Kong in 1993; Hong Kong Stone Electronic Technology Limited (later known as Stone Group Holdings Limited) under Stone Group Corporation (Beijing) became a publicly-traded company in 1993; and Legend (Hong Kong branch) under Beijing Legend Group (now renamed Lenovo) floated shares on the Hong Kong Stock Exchange in 1993. Together with the back-door listing of CITIC Pacific and Shougang Tung Wing, a red chip wave surged in China. Red chip companies later were expanded to more than 50 as many local enterprises or business groups were eager to emulate those forerunners. Here, I would like to explain why those companies are called red chips. In Hong Kong’s stock market, people usually call the most valuable stocks as “blue chips,” which is a practice derived from American poker where blue poker betting discs are the ones with the highest value. And at that time, the international world also referred to China as “Red China.” Correspondingly, Hong Kong investors named stocks of mainland China companies incorporated outside mainland China and listed in Hong Kong as “red chips.” During that period, apart from issuing renminbi-denominated A shares, China’s stock market also issued B shares that are traded in foreign currencies and some large- and medium-sized Chinese enterprises, such as Sinopec Shanghai Petrochemical Company Limited (SPC), Tsingtao Brewery, and Maanshan Iron & Steel Company Limited, were allowed to go public in Hong Kong with their stocks called H shares. The reason why Hong Kong is a preferred listing place for many Chinese companies was mainly because Hong Kong is subject to the international standards in operation philosophy, governing structure, and accounting system, and offers a rigorous regulatory environment, besides the reason of leveraging overseas capital through equity financing. By contrast, the Hong Kong financial circle favors red chips more than B and H shares. That is because red chips are incorporated in Hong Kong and their management teams are also based there. So when compared to other Chinese companies, they have better access to market information, are more sensitive to market changes, and can deliver more timely services. Similar to B and H shares, red chips are also particular to China and benefit from China’s Reform and Opening up era and subsequent high-speed economic growth. The only difference is that red chips are less prone to administrative intervention and restrictions. For example, in material purchases, product distribution, and

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price controls, B and H shares are subject to the government’s macroeconomic regulation or direct control whereas red chip companies are more flexible in management and receive fewer restrictions. Additionally, red chips enjoy complete freedom in financing and can seize favorable opportunities to raise funds in the best methods while B-share and H-share companies are more likely to lose the optimum financing chance due to lots of administrative restrictions. Lastly, red chips have high transparency and are the same as Hong Kong companies in terms of information disclosure, business development, and operational philosophy. However, at the early stage, red chips, similar to overseas listed H shares, only centered on enterprises themselves and operated capital in a disperse and spontaneous way without taking advantage of governments’ functions. Until May 1996 when Shanghai Industrial Holdings Limited got listed, red chips were transformed into “window companies,” and were involved in the capital operation where governments had injected money, and thus became popular among investors.

Controversy over acquisitions by China Strategic Holdings Limited In 1992, China Strategic Holdings Limited headed by Oei Hong Leong purchased 55% and 51% stakes in two rubber plants located in Taiyuan and Hangzhou, respectively, through investments of USD20.25 million, and the company then registered China Tire Holdings Limited in Bermuda. China Tire Holdings Limited was listed in New York and raised USD103.7 million by issuing American depositary receipts (ADRs). Shortly after that, it merged three tire plants in Chongqing, Dalian, and Yinchuan by holding 51% to 52% shares in each. In the brewery industry, Oei Hong Leong brought Beijing Beer Factory, Hangzhou Beer Factory and another two beer factories and “repackaged” them as “China Beer Holdings Ltd,” which was also registered in Bermuda. It was later put onto the Toronto Stock Exchange in Canada. And in less than 2 years, the new company was sold to the Asahi Beer Corporation of Japan and it went on to become the “Beijing Asahi Beer Corporation.” From April 1992 to August 1993, China Strategic Holdings managed to acquire more than 200 companies within just four months and people referred to this series of events as the “China Strategic Storm.” Apart from some half-way terminated contracts due to government intervention, China Strategic Holdings in fact merged 196 companies. After purchasing those Chinese enterprises, China Strategic Holdings recorded an interim turnover of HKD1.79 billion (HKD1.03

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billion when listed) and a pretax profit of HKD203 million (HKD116 million when listed) in 1994. The success of China Strategic Holdings in capital operation stirred turmoil in China. Some criticized its practice as “creating something from nothing” and speculating on Chinese state-owned enterprises by purchasing at a low price before selling at a high price. Some questioned its contribution to China’s economic reform and argued its capital operation caused the drain of state assets. For a time, China Strategic Holdings became the center of the debate over China’s state-owned enterprise reform. Looking back, I think the success of China Strategic Holdings is firstly owing to the fact that it had the right timing. Deng Xiaoping’s southern tour speech and the prevalence of the “China miracle” in the international capital market in 1992 created favorable opportunities to invest in China. Second, China Strategic Holdings chose the right industries and enterprises. The industries it invested in had positive market prospects, large demands, and significant profits and the acquired enterprises were middle-sized stateowned companies with fixed assets being less than RMB100 million but having a considerable scale and profit potential, whose approval rights were in the hands of municipal governments. Third, there were loopholes in China’s laws and regulations concerning Sino-foreign joint ventures. For example, China allowed foreign investment to be made by instalments and a foreign company can easily obtain corporate control by prepaying 15%–20% of the total investment. China Strategic Holdings took advantage of this policy by listing the acquired companies in overseas markets before leveraging the raised capital to make the instalment payments and purchase other companies. In addition, China Strategic Holdings also benefited from China’s favorable policies to joint ventures in taxation and exchange rates. Fourth, China Strategic Holdings was very successful in capital operation by listing acquired Chinese enterprises abroad. At that time, China had just started to transform from being a planned economy to a socialist market economy. Before that, people longed for a product economy, and until the Reform and Opening Up era, they accepted the planned commodity economy and finally recognized the socialist market economy in the 14th National Congress of the CPC in 1990. Under the planned economy for over 30 years, China’s stateowned enterprises always manufactured and distributed their products according to the state’s plan. During the first decade of China’s Reform and Opening Up era, enterprises were only regarded as “relatively independent product makers” and never truly assumed the role as the main market players.

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They neither had the legal personality nor exercised the power of legal persons and lacked basic knowledge and experience of equity transactions, let alone the trading of corporate rights. Meanwhile, in fundraising, Chinese enterprises were only accustomed to attracting foreign investment and establishing joint ventures and not until much later, did they learn to borrow money from banks and issue stocks in securities markets. It is no wonder that in the face of Oei Hong Leong’s fundraising of several billions of dollars in the stock market, people would think he violated state interests and caused the loss of state assets. Surprisingly, the listing of Hai Hong, China Travel International, Stone Electronic Technology, and Legend in Hong Kong was not questioned by Chinese people. There must be some irrational emotion in the controversy of China Strategic Holdings. Last, the capital operation of China Strategic Holdings through establishing joint ventures and overseas listings not only strengthened the acquired companies in terms of capital and equipment, but also brought a huge shock to the longclosed Chinese state-owned enterprises with respect to management philosophy, governance model, leadership arrangement, and personnel placement. Overall, China Strategic Holdings completely renewed the management system concerning not only production and distribution but also personnel, capital, and materials. It will act as a role model and incentive in the reform of state-owned enterprises. Besides, some people were oversensitive to the flow of state assets and mistook it each time as the drain of state assets, but they were not aware that to leave state assets unused was also a kind of waste.

Window companies and capital operation of government funds In the early 1990s, many cites in China were in great need of construction funds. Some foreign investment banks noticed the favorable investment policies of the Chinese government and looked for investment opportunities in China. Meanwhile, some overseas back-door listed companies also sought business opportunities in China by relying on offshore funds. People called these companies pseudo-foreign companies. Some of those cities attempted to undertake new construction projects by raising money from transferring the right of management of existing infrastructure assets, namely, selling old roads in order to build new ones. At that time, Shanghai transferred the management right of a tunnel and two bridges to CITIC Pacific through the transfer-operate-transfer (TOT) method in exchange for capital for new infrastructure construction. This action inspired the officials of Shanghai’s industrial sector to build a “CITIC Pacific” of their own. This resulted in the listing of Shanghai Industrial Holding Limited (SIHL) in the Hong Kong stock market.

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When SIHL went public in 1996, the prices of “China concepts stocks” languished in the Hong Kong stock market. At the time, Peregrine Investments Holdings and Morgan Stanley were the financial consultants and principal underwriters for SIHL. After analysis, they concluded that in the past, red chip stocks mainly comprised enterprises of industrial production, which were highly susceptible to government regulation and control. In contrast, SIHL engaged in the manufacturing of consumer products with its constituent companies being Nanyang Tobacco, Wing Fat Printing, Shanghai Jahwa and Sunve Pharmaceuticals. Their products were less impacted by the government’s macroeconomic policies. Therefore, when listed, SIHL could emphasize its special value in location (Shanghai) and products (consumer goods) by saying that China is a large country with more than one billion people and which has a huge market for consumer goods, and Shanghai is an international metropolis that is open to the world. This strategy indeed contributed to the successful listing of SIHL and the revitalization of China concepts stocks. As a result, SIHL’s IPO was oversubscribed by 160 times and it attracted HKD30 billion. Later, in a meeting of SIHL, the leaders of the Shanghai Municipal Government promised, “SIHL will be built into a window company of the Shanghai government in Hong Kong. More capital will be constantly raised through its stock offering, and high-quality enterprises and assets will be injected into SIHL.” In fact, the real intention of the government was to use high-quality enterprises and assets to attract more capital through this window company. In the subsequent stock placements of SIHL, the Shanghai government fulfilled its promise by acquiring interests in Bright Dairy, Shanghai Orient Shopping Center, Shanghai Yan’an Road Elevated Road, Shanghai Huizhong Automotive, and North-South Elevated Expressway in order to maintain the high profits and high growth of SIHL. The successful practices of SIHL in raising funds through stock offerings and continuous acquisitions of high-quality enterprises and assets in Shanghai displayed high profitability, and were thus greatly sought after by Hong Kong investors. In 1997, when Beijing Enterprises Holdings Limited (BEHL) launched its IPO in Hong Kong, its financial consultants and principal underwriters were also Peregrine Investments Holdings and Morgan Stanley. At first, BEHL borrowed the mode of SIHL and promoted its stocks by highlighting the position of Beijing and the production of consumer goods. It was said that through buying shares of BEHL investors could gain an interest in almost every business they needed in Beijing, from Capital Airport Expressway, Beijing Jianguo Hotel, Beijing International Switching System Corporation Limited (a telecommunications equipment provider), Beijing Badaling Tourism

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Co., Ltd., Wangfujing Department Store, to McDonald’s, Sanyuan Food, and Yanjing Brewery. BEHL held shares in all of these companies. This showed that investment banks indeed provided many good ideas in promoting the selling points of BEHL. Since SIHL as a window company was welcomed by investors in the stock market, investment banks immediately adjusted their strategies and introduced the concept of a “window company” in the roadshow of BEHL. Therefore, the value of being such a company had been revealed: High-quality enterprises or assets would be constantly injected. This change in strategy reflected the flexibility of investment banks in capital operation. Consequently, BEHL’s IPO locked up HKD210 billion by being oversubscribed 1,200 times and BEHL suddenly became a popular stock in the Hong Kong market. The Beijing Municipal Government also kept its promise by continuously injecting highquality assets and maintained the growth of profits of the window company. The successful listing of SIHL and BEHL triggered the boom of red chip stocks in many cities of China and these companies also learned from the two window companies about post-IPO capital operation, namely, stock placement and high-quality asset injection. From then on, red chip stocks were no longer limited to the spontaneous listing of and fundraising by an independent company but included the planned capital operation activities by local governments through the setting up of a window company to raise capital and inject high-quality assets. This was a large breakthrough during this period. It should be said that the red chip stock was a major breakthrough for China’s state-owned companies in capital operation. After all, the key of the state-owned economy was in its controlling power and competitiveness. The success of red chip stocks like SIHL and BEHL was owing to the full play of the controlling power and competitiveness of the state-owned economy. The planning and decision-making role of local governments in the capital operation of red chip stocks was realized through them acting as large shareholders instead of exerting administrative power. State-owned capital is contributed to by the state and therefore should be planned, operated, and utilized by governments. As long as governments participate in the operation and planning of a company as shareholders, it is totally lawful and complies with the “rules of the game.” In fact, any holding group under a market economy operates its capital in the same way. For red chips and all listed companies, what matters in capital operation is not whether governments participate or not but how governments play their role. Companies should consider: Whether governments act as shareholders or administrators; whether governments inject assets based on arbitrary decisions or careful choices; whether governments simply aim to reduce their burdens or focus on business

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returns and profit growth (this is an important indicator to measure the growth potential of a company); and whether the capital is operated in accordance with market rules, mechanisms, and orders or by relying on mandatory administrative intervention of governments. Experience has shown that if red chips want to make some contributions in capital operation, they should focus on financial operation and regard providing high-quality enterprises to the market as a constant goal rather than counting on speculations in the secondary market.

The listing of China Telecom in Hong Kong opened a new era in the overseas listing of large Chinese enterprises When local governments were busy with the capital operation of red chip companies, China’s Central Government decided to reform the monopolistic telecommunications industry by separating government functions from enterprise management. China’s telecommunications industry is an enormous industry, including 33 telecommunications bureaus at the provincial level and 2,385 telecommunication systems at the municipal (prefectural) or county levels. At that time, postal and telecommunications services were under unified management of the Ministry of Posts and Telecommunications of China. While starting the separate management of the two types of services and undertaking a reform in industrial consolidation, the ministry was also preparing the overseas listing of a telecommunications company. According to the plan of investment banks, a company named China Telecom (Hong Kong) Limited would be first incorporated in Hong Kong before a fully-owned subsidiary, China Telecom Hong Kong (BVI) Limited, was registered in the British Virgin Islands. This arrangement was the result of learning from the listing experience of red chips. The subsidiary owned 100% interest in Guangdong Mobile Communications Co. Ltd. and 99.63% interest in Zhejiang Mobile Communications Co. Ltd. During that time, under the unified management of postal and telecommunications services, provincial companies were responsible for the operation strategies and network building of the mobile phone business while municipal and county level posts and telecommunications bureaus were in charge of actual operations, maintenance, and billing. There were some slight differences in the specific division of labor in those two provinces. The largest obstacle in business restructuring before listing was the system conversion in accordance with the international standard. The past administrative and closed management mechanism must be transformed into an open, transparent, and standard management system in line with international practices. China

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Telecom (Hong Kong) faced a series of difficulties in its reorganization in the aspects of telecommunications network interconnection, accounting standards, financial and accounting systems, and corporate structure, and also encountered many challenges in reform practices. On October 23, 1997, China Telecom (Hong Kong) (subsequently renamed China Mobile [Hong Kong]) was listed in both Hong Kong and New York and successfully raised USD4.22 billion by taking advantage of its RMB19 billion capital base. Shortly before that, China Southern Airlines raised USD700 million through its IPO in Hong Kong, which was already a huge volume IPO, but the capital collected by China Telecom (Hong Kong) was six times larger than that gathered by China Southern Airlines. During the IPO of China Telecom (Hong Kong), CICC and Goldman Sachs acted as sponsors and underwriters. The successful listing of China Telecom in Hong Kong was attributed to two major successes in capital operation. First was the success in issue pricing. When China Telecom (Hong Kong) was listed in 1997, the offering price was first set at HKD7.75–10 per share on September 26. During roadshows, investors showed confidence in the company’s stocks. On October 12, after careful research, investment banks and China Telecom decided to raise the issue price to HKD10–12 per share. Unfortunately, the impact from the Southeast Asian financial crisis on Hong Kong was increasingly dramatic, the Hang Seng Index dropped from its peak of 16,000 points to 14,000 points in mid-October and how to price the stock became an acute issue. On October 16, China Telecom finally set the offer price at HKD11.8 per share. When China Telecom (Hong Kong) made its IPO on October 23, the Hang Seng Index fell to 10,426 points. On that day, Hong Kong share prices fell across the board and China Telecom (Hong Kong) also dropped below the offer price, but its price soon stably returned to above HKD12 and remained rock solid even during the East Asian financial crisis. This indicated that investment banks had done a good job in evaluating the company’s profitearning capacity and potential risks. The second success is the overall listing. In preparation for the listing of China Telecom (Hong Kong), some suggested that Guangdong and Zhejiang mobile telecommunications should be listed separately. But CICC believed that to list China Telecom as a whole was better than separate listings for the sake of highlighting the family brand. Admittedly, the telecommunications market itself was very attractive, but the overall listing of China Telecom (Hong Kong) displayed the charming brand value of an industry in China and thus the Hong Kong market hailed this stock as a “red chip giant.” This event initiated the overall listing of industry-based holding companies in China and marked a new

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era in the overall listing of China’s large enterprise groups in overseas markets. Following that, China Unicom, China National Petroleum, China Petroleum and Chemical Corporation (Sinopec Corp.), China National Offshore Oil, the Bank of China (BOC), CCB, and BOCOM successively floated abroad, and ICBC was dual-listed in both the Shanghai and Hong Kong markets. Now, it has become an important channel to utilize international capital and also created a new mechanism for Chinese enterprises to be geared to international standards in terms of management and governance structure.

Offshore spin-off listing of Chinese companies In 1999, Hong Kong opened its growth enterprise market (GEM), attracting many of the Mainland’s small- and medium-sized enterprises to go public in Hong Kong. It offered a new channel for capital operation. In 2000, Tong Ren Tang, one of the oldest traditional Chinese medicine companies in the Mainland, set up a holding company (Tong Ren Tang Technologies Co. Ltd.) which was successfully listed in the Hong Kong GEM and became the first offshore spin-off listing of a Mainland enterprise. The uniqueness of Tong Ren Tong’s mode lies in that it not only improves the competitive edge of Tong Ren Tong in the international pharmaceutical market but also offers a stable way for the listed company to spread risks while entering into the high-tech industry. Additionally, Tong Ren Tang Technologies raised a huge amount of capital through spinning off the stock premium of the listed parent company whose stock price would also appreciate at the same time. Meanwhile, according to the provisions of GEM, the newly-established company is able to establish an incentive mechanism in the distribution system in order to enable its senior management staff and the core technical experts to obtain shares in the company in the form of performance shares or stock warrants. In the original equity of Tong Ren Tang Technologies Co. Ltd., this incentive scheme accounted for approximately 1.91%. This brought about a huge shock to the egalitarian remuneration system of the Mainland’s state-owned holding companies. In the above, we have outlined the back-door listing of Chinese enterprises, the overseas listing of local window companies, and the overall listing of large Mainland enterprises in Hong Kong, and it can be summed up as the process of capital operation by Chinese enterprises in the overseas stock market. The stock market of Hong Kong is a full-circulation market, and the above-mentioned Chinese enterprises magnified the function of capital through share holding, got the actual control of corporate capital, and raised capital through planning IPO and secondary offerings. This type of capital operation, though gambling,

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is based on the principle of the same price for the same share and expands capital by improving the efficiency of companies and capital through normal means, and therefore the capital operation is fair, just, and open. It is strictly different from what we will discuss later — unfair capital operation under equity division.

Early China’s Stock Market Left No Room For the Capital Operation of Investment Banks Beginners in stock markets always wonder why a stock worth RMB1 can be sold at a price of RMB10-20; why a net asset worth RMB1 can be sold tenfold or twentyfold; how a stock price is determined. In the above, we have briefly mentioned that in stock markets of mature market economies, the stock value is collectively decided by the future earnings of assets and the value discovery function of the market. An important role of investment banks is to reflect, in an appropriate way, the price expectation of the market formed based on the value discovery function via their special financial services. However, in China, during the 15 years from the stock market pilot project in 1990 and the equity division reform in 2005, what people frequently saw was the market manipulation and speculation by brokerage firms and large capital groups instead of the intellectual services provided by investment banks and investment bankers. In the first 15 years of China’s stock market, there was a strange phenomenon: The primary market was booming while the secondary market was struggling. The root cause was that new shares were priced too low. Why were new shares underpriced and why can these shares not be priced reasonably as in mature capitalist markets? The key did not lie in the method of pricing but in the fact that China lacked a mature investment environment like that in the Western countries. The capital market is a place where assets are exchanged for capital and in this market, listed companies are sellers while investors are buyers. The two trading parties are separate and the asset value of listed companies is priced based on the quality and risks of assets. In a mature capital market, it is investment banks who are responsible for the pricing (in China, it is securities companies). The duty of investment bankers is to discover the value of a particular asset and reflect the value through their intellectual services. In general, investment bankers work as sponsors and underwriters in IPOs. The question is how to set a reasonable offer price. Issuers hope that the

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price of their stocks can be as high as possible in order to raise more money. Underwriters think the same way in that the higher the offer price is, the more fees they can receive. But if the price is fixed too high, there will be a chance that the stocks cannot be sold. If brokerage firms (or investment banks) enter into a firm-commitment contract with issuers, they will assume the risk of an enormous sum of money being tied up when the price goes down. If they sign a best-efforts or stand-by underwriting contract, they should bear the risk of failed selling, which will impair the reputation of the underwriting investment banks. So, it can be seen that the pricing of new shares concerns the two sides of the market (namely, buyers and sellers) and cannot be determined solely based on the wishes of sellers and brokerage firms. In this way, it is necessary to take full consideration of the opinions of buyers. Among buyers, an important participant is institutional investors, including investment funds, pension funds, business groups, insurance companies, securities firms, banks, etc. In the mature stock markets of Western countries, there is a significant part of securities underwriting of investment banks — road shows. When visiting some large investment banks in Western countries, we frequently heard: “Our investment banks do not have money in hand, but we know where to get it and we can help you to find ‘cheap’ money.” These few words are very critical because this means investment banks have a long list of institutional investors, or to be exact, a network of institutional investors. The road shows are held by investment banks to give issuers a chance to introduce new stocks to potential buyers. During this process, institutional investors can have a full understanding of the listed companies and the management skills of their managers while issuers can also take this chance to seek out advice in respect to share prices and subscriptionrelated issues. Institutional investors serve four functions for listed companies. 1. When institutional investors participate in road shows and express their intent to subscribe, listed companies can identify opinions and reactions from potential buyers. 2. Holding shares by institutional investors implies support for newly-listed companies and their stock prices. 3. Institutional investors can play an exemplary role for public investors in purchasing shares. 4. Institutional investors usually undertake long-term investment and thus will stabilize the stock market. As the price determination involves such a complicated process, the price difference between the primary market and the secondary market will not be significant in Western countries. However, the capital gains in China can be several times as many as the purchasing price. This is a challenge for the intellectual services provided by investment banks in stock pricing.

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China’s stock market was an incomplete capital market during the early stages. First of all, the qualifications of investors were strictly controlled. There was a fundamental flaw in the system design of China’s stock market. Financial authorities only planned to raise funds in securities markets but failed to make full preparation for dealing with investors’ capital collected from various channels. In 1993, when the stock market pilot project was in full swing, capital raised from various sources swarmed into the market. The supervisory body thought that the stock market was highly speculative and too risky, so they strengthened the regulation and supervision towards the capital flowing into the stock market. As a result, illegal inter-bank lending was cleaned up in 1993; pension funds and insurance funds were no longer allowed to enter the stock market in 1994; bond repurchase funds were kept away from the stock market in 1995; and state-owned enterprises and listed companies were prohibited from investing in stocks and bank funds were forbidden from flowing into the stock market against regulations during the bull market between 1996–1997. Additionally, securities companies were only allowed to participate in the stock market by using their own capital and could not engage in margin trading or short selling. And investment funds were not opened until much later. However, the problem was that when closing the doors of illegal trading, the supervisory authorities did not open new channels for legal fundraising in the stock market. The market was almost completely made up by individual investors but it lacked institutional investors, so it was built based on an unstable capital base comprised of 40 million individual investors. Under such a condition, even though securities firms were able to fix a reasonable price for new shares, there was no standard institutional investor to review and endorse listed companies and their stock prices in road shows. If new shares cannot be sold out at the set price, it is impossible to demand that brokerage firms sign a firm-commitment contract every time. After several rounds of pricing experiments after 1993, especially after the stock market slump and the fear for market expansion between 1994 and 1995, the securities brokers decided to sell new shares at a price-earnings ratio (P/E ratio) of 13–15 and allow millions of individual investors to directly subscribe to the shares through filling securities deposit forms or online purchasing. It was in fact equivalent to using a low offering price in the primary market to lure investors to profits by selling at a higher price in the secondary market. This is a non-normative expedient aiming to expand the stock market based on the condition of a lack of institutional investors in China’s stock market. An extremely low offering price of new shares brought about two major drawbacks:

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First, there was asymmetry in risks and returns between the primary and secondary markets. The P/E ratio of stocks in the secondary market was generally around 30 to 40 times earnings while in the primary market, the ratio was only 13 to 15. Generally speaking, once the subscribed new shares are traded in the secondary market, investors will receive capital gains of several times the purchasing price. Some people made statistics especially on this matter in 1998 and the result showed that the capital used for subscribing new shares could record an annual rate of return of 70% in 1996 and 50% in 1997. In 1998, there were a large number of new large cap shares of state-owned enterprises in the stock market, whose annual rate of return was still above 30%. In short, the primary market generated sure-fire returns and contained no risks, while the secondary market saw frequent price rises and falls and accumulated high risks. Second, capital gathered from the public was overly concentrated in the primary market. New shares usually have high earnings and the subscription rate was around 200 times but the average demand-to-offer ratio was only 0.5%. Additionally, the full amount of the subscription price must be paid in new shares subscription. According to the situation in 1998, there would be two new shares issued every week, which could raise about RMB1 billion, but over RMB200 billion would be tied up. At that time, the market value of the secondary market was around RMB600 billion and the average daily transaction volume in the market was only RMB10 billion. The capital concentration in the primary market was caused by the fact that investors would sell old shares in the secondary market before new shares were offered in order to free up their capital. After subscription, their capital would be locked in the primary market for four days and four days later, unsuccessful subscribers would get their money back into the secondary market. Some investors even stayed away from the secondary market and devoted all their funds into the primary market. They became specialized new share buyers. It was because too much capital was accumulated in the primary market that the secondary market suffered a deficiency of capital. The booming primary market caused the inactivity in the secondary market. The shortage of institutional investors in the stock market system encouraged the low offering price of new shares, and, more importantly, fostered excessive speculation. As a result, securities firms did not make efforts to standardize stock pricing but were dedicated to decorative or even deceptive packaging and therefore they did not make money through providing intellectual services as their counterparts in Western countries but sought profits through speculation and manipulation in the secondary market. In addition, since there were no

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institutional investors for public investors to follow, the latter made blind investments, which increased the risk of investment. So, at that time, some people said that the vicious purchasing of new shares in China’s stock market was a kind of excessive speculation stemming from the systematic defect. This was no exaggeration. As new securities were issued at a low price and corporate mergers and asset reorganization were conducted under the government’s planning through the transfer of state-owned assets and equity replacement, so it was said that China needed only brokerage firms rather than investment banks. Under such a condition, before 2005, regulatory authorities stipulated that the underwriting fee charged by securities firms should not be above 1.5%–3.0% of the raised capital and for the fundraising amount over RMB400 million, the fee should be less than RMB10 million. This was the lowest underwriting fee in the world. It seemed to imply that in the regulations China did not need the high intellectual services of investment banks. In 1999, the financial environment of China’s stock market changed. First, legitimate financing channels for brokers were clarified and banks were able to invest in the stock market through lawful means. Second, holding shares for six months by state-owned enterprises and listed companies were no longer considered speculation. Third, insurance funds were allowed to enter into the stock market through investment fund companies. These were the three major breakthroughs in laws with the purpose of creating financial channels for the stock market. Meanwhile, brokerage firms were able to undertake business consolidation and increase share capital, securities investment funds were expanded (in 1999, there were 19 securities investment funds from 10 fund companies with a total sum of RMB47 billion), and state-owned enterprises and listed companies could act as institutional investors to hold new shares. The direct result of those policies was a sharp increase in the subscription amount of new shares. On September 23, 1999, Shanghai Pudong Development Bank (SPD Bank) launched its IPO and locked up RMB226 billion. During that week, the money frozen in the new share subscription amounted to more than RMB400 billion, breaking the weekly record of RMB250 billion. Certainly, compared to the frozen capital of new share offering in the great bull market between 2006 and 2007, this number was insignificant. In 2006, capital locked up in IPOs was: RMB780 billion for ICBC, RMB839 billion for China Life, RMB1.16 trillion for Industrial Bank (IB), RMB1.1 trillion for Ping An Insurance, RMB1.43 trillion for China CITIC Bank, RMB1.46 trillion for BOCOM, RMB2.66 trillion for China Shenhua, and RMB3.3 trillion for China National Petroleum Corporation (CNPC).

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At the same time, more and more listed companies developed towards large cap blue chips and were open to private stock companies and technology stocks, and the stock issue method turned to be a market-oriented one. Since 1999, IPOs were no longer issued at a price of 13–15 times earnings and they adopted an improved stock issue method for larger cap shares with a total capitalization over RMB400 million. Starting from Beijing Shougang Company Limited, listed companies introduced share ownership by institutional investors and legal persons and held road shows to introduce their companies and shares under the lead of securities firms. For one thing, through direct communication between investors and listed companies, the entrepreneurs were able to display their managerial and administrative expertise while the investors could know whether these managers were trustworthy or not. For another, this communication provided a chance for buyers and sellers to negotiate the offering price. Additionally, by combining legal person allotment and online issue, institutional investors and legal persons could be attracted. As they engaged in long-term investment, their participation would stabilize the stock market. This made a good start in changing the stock issue method, but due to the delayed equity division reform and especially the enforced implementation of circulating state-owned shares at the market price in 2001, a bear market continued for five years and all new stock offerings was suspended, let alone the development of investment banks.

Unfair Capital Operation in the A-Share Market under Equity Division The international stock market is a full-circulation market where same shares are traded at the same price. However, in China’s stock market, starting from its pilot project in 1990 to 2005, there was a price difference between tradable shares and non-tradable shares in the same state-owned enterprise. The fundamental cause was a fear of the loss of state-owned assets in circulation. But the real problem was not the restricted circulation of state-owned shares. Without the trading of those shares, the capital operation of equity transfer, asset reorganization, asset swap, and corporate mergers would not happen, and the worst impact would only be the deterioration of resources allocation and the loss of faith by holders of state shares in state capital operation and business efficiency improvement. It would only create losses to large shareholders and would not damage the interests of medium and small investors, so it was not unfair. The unfairness during this period was caused by the fact that though

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state shares were forbidden from being circulated, they were allowed to be transferred via negotiation outside exchanges. It brought about all sorts of the pursuit of profits through speculative means and stimulated fundraising activities and unfair capital operation in the stock market. The unfairness had four major features: First, two parallel markets of different prices for the same share were created. One was a public tradable share market where stocks were traded at the market price. The other was a private market for non-tradable shares. In this market, non-tradable state shares can only be transferred through negotiation at a price a little higher or lower than the net asset value and their prices were much lower than the price of their counterparts in the public market. Second, the two markets with a price difference for the same share implemented the same financing system as the full-circulation market, thus creating a system defect. People were encouraged to pursue low-price transfer of state-owned shares and assumed the position of major shareholders in order to manipulate stock offerings. This was the so-called “money hunting trap.” Additionally, in the year 2000, the requirements for secondary offerings were lowered and the volume of new shares issue was generally three times the size of stock allotment, which promoted excessive secondary offerings. Large shareholders of state shares can choose to give up their preemptive right to purchase new shares in allotment, which further encouraged the issuance of new shares. Third, the unfair capital operation in China’s stock operation was reflected in the backdoor listing through negotiated transfer of non-tradable shares at a low price. And it was also reflected in the deceptive packaging (mostly, in the aspect of asset replacement) of listed companies which were going to undertake the allotment and issue of share capital in order to increase the proportion of new share offerings. This packaging was achieved through either local tax relief and rebate by local governments, or the appropriation of subsidiary funds, or the sharing of a portion of earnings after the purchase of partial assets of the listed companies by its large shareholders at a high price, or the granting of assets or the right to earnings by those large shareholders. All these actions serve the same purposes: to create high profits, raise stock prices, and control more social funds. Additionally, large shareholders used the listed companies as their own “cash machines” and occupied the companies’ capital at will. Fourth, there was excessive speculation through insider trading and the market-making by large capital groups. For one thing, negotiated transfer

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and asset reorganization of state-owned shares were planned and operated by governmental departments and involved a lot of people, so it was difficult to ensure confidentiality and avoid insider transactions. And the reason why many securities companies participated in asset reorganization was not for reorganization fees but for speculation in the secondary market. Similarly, many listed companies would deliberately disperse reorganization news for the purpose of bidding up their stock prices and accumulating more social capital. These operations all aimed to take away the money of small investors. For another, asset reorganizations through negotiated transfer created opportunities in the system for large capital groups to manipulate stock prices in the secondary market. So, the prices of asset restructuring-related concept stocks and even underperforming stocks frequently fluctuated and their P/E ratios were as high as several hundred times earnings. Those features indicated that since there were two parallel markets, anyone who could acquire low-cost non-tradable shares through negotiated transfer would become controlling shareholders. They would be able to control the whole company, undertake asset reorganization, obtain the right to dispose the funds raised through secondary offerings, and operate the social capital of high market value with a low-cost controlling stake. Meanwhile, as insider trading was inevitable, it enabled large capital groups to manipulate the stock prices through market making. Profiting through seasoned equity offerings and unfair capital operation by taking advantage of the two parallel markets stimulated the unreasonable rise of tradable share prices and stock indexes and the accumulation of bubbles. They were abnormal dynamic bubbles which would exert larger destructive power on the market. In theory, it was a punishment for violating the laws of the market economy and the cost that should be paid by certain rigid understanding. This reflected the incompatibility between some reforms in relations of production and superstructure and the development demand of productive forces. In addition, I would like to discuss the loopholes in the regulations of the non-tradable share transfer market. The regulatory institution opened the negotiated transfer of state-owned shares and legal person shares in the restricted circulation market for several reasons. First, the regulatory authorities tried to be flexible in dealing with non-tradable state-owned shares by facilitating the transfer of these shares. Second, the policy was announced as a response to the government’s intention of relieving state-owned enterprises of heavy debts and supporting industrial restructuring in the capital market. Third, the authorities wished through negotiated transfer of state-owned shares to accelerate the elimination of

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insufficient companies and give full play to the resource allocation function of the stock market. Consequently, the Securities Law passed by the National People’s Congress of China confirmed the legitimacy of negotiated transfer of state-owned shares. It, however, created a loophole in the law for investors to manipulate the seasoned equity offerings and unfair capital operation in the tradable market through negotiated acquisition. Later, the regulatory institution noticed the problems existing in the negotiated transfer and acquisition of state-owned shares and issued several orders to regulate the transfer by focusing on substantial restructuring, tender offers, and requirements on the selection of transferees in order to help listed companies to find proper and reliable transferees who could assume control person liabilities and the fiduciary duty of controlling shareholders and thus ensuring the long-term stable operation of the companies. A series of documents including Administrative Measures for the Takeover of Listed Companies promulgated by the authorities specified new trading rules and financing methods concerning negotiated transfers, management buyouts (MBOs), share swaps, and targeted offering. Their aims were to standardize takeover activities and promote the marketization of mergers and acquisitions. But if the unfair capital operation in the negotiated transfer market of non-tradable shares, which was against the laws of the market, was not outlawed, no matter how many regulations targeting the technical or detailed problems of mergers and reorganizations were implemented, it was merely regulated unfair capital operation. To continue doing the same would not only not cure the problem of unfair capital operation but also create the risks of manipulating the market of tradable shares by using the negotiated transfer of non-tradable shares. The solution is very clear. If China wants to eliminate equity division and eradicate the unfair capital operation in the stock market, the fundamental way out is full circulation. Here, as to the question of whether same shares can be traded at the same price, the key lies in circulation. But if state shares want to be circulated again, there is a cost to pay. We know that the value of circulation was unveiled by the value discovery function of the market. In a market of full circulation, the stocks of a listed company can appreciate above the net asset value, because the market finds in the circulation the value of expected future earnings generated by net assets. Under the equity division in China’s stock market, the price difference between tradable and non-tradable shares was caused by restricted circulation. If non-tradable shares cannot be circulated in the market, their market value will not be discovered and revealed and that was why private negotiated transfers were created. This transfer price was fixed around the net asset value

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and always below the market price. In contrast, tradable shares were priced above the net asset value and appreciated day by day. For one thing, the market found out the value of expected earnings of net assets in circulation; for another, as non-tradable shares of a large number were prohibited from being sold in the market, tradable shares gained a scarcity value. So, it was not surprising that the price of tradable shares went up. Admittedly, the price rise of some stocks was the result of unfair capital operation by insiders and speculation groups in manipulating the market through negotiated transfer. Therefore, whenever there was news about the circulation issues of state-owned shares, social investors would underweight their tradable shares, which would cause the depreciation of tradable shares. In 2001, the decision on the transfer of state shareholding at the market price brought about a market slump for five years. This became a typical case of the reduction of government shares. The prohibition of state shares circulation not only made their value undiscovered, but also encouraged the appreciation of tradable shares. It was a great irony to the advocates who were strictly against the circulation of state shares in the fear of the drainage of state assets. That was why during the equity division reform, many theorists believed that in order to protect the interests of medium and small investors, if stateowned shares which accounted for two thirds of the stock market were going to be circulated again, compensation to social investors must be made. The solution was very simple: One was to ask state stockholders to buy in all tradable shares from social investors at the market price before pricing and listing these shares again in the market; and the other way was to compensate social investors by making up the difference between net asset value and market price of tradable shares. This was the cost that must be paid in order to avoid starting all over again. However, as to the opinion that stock prices were unfairly priced, I cannot agree. People holding this view thought that to sell the state share worth RMB1 at a premium in stock offerings was a kind of unfairness. The truth was that the offering price of a company’s stocks was determined based on the present earnings and expected returns of the company. During the company’s IPO, social investors voluntarily paid a premium to hold stakes in that company and shared the benefits of net asset appreciation with pre-existing shareholders. This did not damage the interests of small and medium investors. The premium was a kind of founders’ profits, investment returns that entrepreneurs deserved for assuming the risk of failure. This was like interest and profits, and it should be protected by law.

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Unfair Capital Operation by Large Capital Groups and Market Manipulation through Excessive Speculation Following state-owned capital, social capital also acquired majority stakes in a listed company by taking advantage of the low-cost transfer of non-circulating shares in order to control a large sum of funds raised at a high price through seasoned equity offerings. Typical cases included acquisition of Chang Zheng Machine Tool Group by Chengdu Top Sci-Tech Company, takeover of Hunan Wuyiwen Industry Co., Ltd. by Powerise Information Technology Co., Ltd., and a series of negotiated mergers and asset reorganizations by Xinjiang Delong Group towards Xinjiang Tunhe Co., Ltd., Torch Automobile Group Co., Ltd., and Hejin Holding Co., Ltd. Those takeovers were also unfair, but if not involving market making or manipulation, they did not break laws. What state-owned companies can do, private companies also can. We cannot hold bias and criticize social capital since it has adjusted the structure of ownership and invigorated listed companies. What should not be allowed was speculation, namely, large capita groups make profits by using the information about negotiated transfer and the subsequent business restructuring to manipulate the secondary market. Reports like “major funding providers control the market” and “market makers unload stocks” by the securities media were reflections of unfair capital operation. At the end of 2000, some stock commentators estimated that the market control rate of at least 30% market makers was above 50% and around 50% market makers have a market control rate of over 30%, which denoted serious speculation in the market. A system defect in the stock offering can be covered up by the insensitivity and inability of the operators of state-owned companies. And the profit-seeking activities of private capital would amplify the defect a thousand times. The most widespread speculative practice by large capital groups was to manipulate the market by integrating market making with the negotiated transfer of non-tradable shares and unfair capital operation. The most typical example was the operation of China Venture Capital (Group) Co., Ltd. (formerly known as Shenzhen Kondarl [Group] Trading Co., Ltd.) by Lü Liang. According to the report by Caijing Magazine in February 2001, Zhu Huanliang, a market maker in Shenzhen, who controlled 80% of the circulating shares of Kondarl Trading Co., Ltd., consulted another experienced market manipulator, Lü Liang, about withdrawing the capital from these stocks in 1998. Lü Liang agreed to purchase 50% circulating stocks from Zhu on the condition that Zhu had to help Lü to acquire parts of the state-owned shares in Kondarl in order to realize the control and restructuring of

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the company. Later, Lü Liang soaked up capital from different sources to acquire 34.61% state-owned shares of Kondarl with RMB175 million in April and May 1999. Together with 55 million shares purchased from Zhu Huanliang with over RMB600 million, Lü Liang transformed Kondarl from a poultry breeder and supplier into an agricultural and high-tech company in the name of reforming state-owned enterprises and renamed the company into China Venture Capital (Group) Co., Ltd. Due to the operation by Lü Liang, the stock price of Kondarl rose from RMB36 to RMB40–45, which lasted for four months. Although Lü Liang’s manipulation of the market failed at the end, it was clear that all his speculative activities stemmed from the system defect of negotiated transfer of non-tradable shares and without the unfair transfer, his control and restructuring over the company would be impossible. The case of Kondarl indicated that speculators not only manipulated the stock price by making use of the information on non-circulating shares transfer and business reorganization but also manipulated the market by connecting market making to negotiated transfer and unfair capital operation. This was a kind of “creation.” Speculators not only created bubbles but also “soaps.” The negotiated transfer of non-circulating shares provided conditions for these speculators to create both bubbles and “soaps,” which pushed unfair capital operation in market making to its peak.

Unique Financial Services of Investment Banks Offered High Added Value to the Market How do investment banks provide high value-added with their unique financial services for enterprises in capital operation? As we know, when listed companies undertake IPOs, seasoned equity offerings, or financing for mergers and acquisitions, due to the information asymmetry between equity investors and the firms, investment banks can act as sponsors and underwriters in stock offerings for they have advantages in information and credibility formed through longterm engagement in the capital market. They are ideal intermediaries for the two parties. In the following, I will focus on several major capital operation activities of investment banks.

Intellectual financial services provided in equity financing As noted before, the value of a company lies in its assets’ capability to create profits in the future. For this reason, not any company or corporate asset can

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be exchanged for capital through stock issue. Investment banks, as sponsors and underwriters in stock issue, should first identify whether a company can win investors’ favor or not and whether a company’s assets can generate future income by using their long-term experience in the capital market. Then, investment banks will reform the company’s assets through several steps. First, by performing assets restructuring, namely detaching the subsidiaries which have no or low profitability. For example, to separate the auxiliary businesses and social functions (such as, catering, entertainment, commerce and trade, hospitals, vocational schools, and property management) from all-round enterprises, in order to maintain the main business and the affiliated companies which have the best ability to create future income; Second, to carry out a shareholding reform, that is, to transform the company into a joint-stock company. But not anyone or any company can be shareholders and well-known investors and enterprises are preferential choices (for example, Li Ka-shing and his Cheung Kong Holdings). Third, reputable accounting firms are necessary to give an accounting judgment on the value of assets under reorganization. Fourth, renowned law firms will provide a legal proof for the ownership of the company’s equity. Fifth, investment banks and investment bankers will conduct due diligence, estimate the profit-making capacity of the listed company’s assets and related risks, and perform stock pricing, promotion, and sponsoring services. These are financial services provided by investment banks when acting as sponsors and underwriters in equity financing through an IPO in the primary market. They are in fact special high intellectual financial services offered by investment banks for listed companies in the selection, development, and pricing of the assets with future profit-making capacity. For enterprises, stocks are abstract things which signify the value of the enterprises’ business and capital. So, investment banks have to identify what can represent the nature of a company by using their acute insights in order to price the company’s assets based on their quality and risks. It is usually said that the stock pricing by investment banks is a perfect blend of science and art. To call it science, because investment bankers will present scientific basis for preliminary stock pricing after conducting quantitative research and scientific analysis via numerical models established based on financial data of a company’s past performance and taking into consideration the development trend of macro economy, the supply and demand of capital and interest rates in the market, stock prices, and profitmaking capacity of similar enterprises, changes in exchange rates, and expectation of investors’ demand. Meanwhile, investment bankers will also conduct a comprehensive risk assessment, including risks from inflation (rising prices and currency devaluation will undermine the purchasing power of the investment and expected earnings), credit (whether a company is able to redeem its bonds upon

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maturity based on its financial strength and debt repayment capacity), operation (the chance of business failure), competition (damage incurred as a result of fierce product, technology, or market competition), market (losses from sharp ups and downs in the stock market), financing (fluctuations in exchange rates, interest rates, and financial markets), etc. The reason why stock pricing is considered an art is due to the fact that in pricing, there are some factors that cannot be quantified but reflect the nature of the company, similar to inspirations and feelings, which should also be expressed concretely. Whether such a stock pricing is appropriate or not usually determines and has an important bearing on the market image and status of an issuer and the market standing and future development of an investment bank itself. I will illustrate this point with a few examples of the above-mentioned red chips. In 1996, when SIHL went public in Hong Kong, the prices of “China concepts stocks” were depressed owing to Mainland China’s macro regulation and control. To differentiate SIHL from other China concepts stocks, investment banks highlighted SIHL’s unique value in its location (Shanghai) and the production of consumer goods. The innovation in the stock promotion was reflected in the connotation of the two highlights, that is, the assets quality of SIHL was far higher than those of general China concepts stocks while the risk of SIHL was far lower than that of general China concepts stocks. As a result, on May 30, 1996, SIHL raised HKD1.4 billion at a price of HKD7.28 per share and its listing was a success with its stock price rising by 25% in the first day. Subsequently, SIHL fulfilled its promise as a window company of Shanghai by undertaking seasoned equity financing and asset injection in November 1996 and April 1997. Within just 11 months, the price of SIHL stocks soared to HKD45 from HKD7.28, an increase of six times. The company which had a net asset value of just HKD700 million at the start grew to a listed company whose market capitalization amounted to over HKD37 billion within less than one year. This enabled the Hong Kong market to discover the new investment value of SIHL as a window company. Take BEHL as another example. When BEHL was listed in 1997, investment banks promoted its stocks by switching to emphasizing its status as a window company rather than focusing on its consumer goods products by taking advantage of SIHL’s success as a window company. It implied that BEHL, the same as SIHL, was also a window company, and although its assets quality and risks were different from those of SIHL, BEHL’s stocks were also profitable. Not surprisingly, this promotional idea was attractive to investors and BEHL was 1,200 times oversubscribed by locking up HKD210 billion. It suddenly became a popular stock in the Hong Kong’s stock market.

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Another example is the listing of China Telecom (Hong Kong). If the company chose a separate listing of Guangdong and Zhejiang mobile telecommunications, not only will the financing cost be higher but the stock price will be lower. The overall listing of China Telecom (Hong Kong) as an industry-oriented holding company by CICC displayed the advantage of centralized financing and revealed greater investment value than window companies like SIHL and BEHL. In the face of a severe impact from the Southeast Asian financial crisis on the Hong Kong stock market, the stocks of China Telecom (Hong Kong) were still priced as high as HKD11.8 per share. As a result, among the dropping prices of all major stocks in the Hong Kong stock exchange, the stocks of China Telecom (Hong Kong) alone showed stable growth. Investment banks’ innovation in the stock pricing of China Telecom (Hong Kong) not only firmly established the position of China Telecom (Hong Kong) as a red chip giant, but also exposed the investment value in the overall listing of China’s industry-oriented companies to investors in Hong Kong. More importantly, by acting as the sponsor and underwriter in this IPO, CICC established its brand value and upgraded its status and position among international investment banks. From here, we can see clearly the contribution made by investment banks through their high value added financial services in stock pricing. In the above, we talked about the financial services offered by investment banks who acted as sponsors and underwriters in the IPO. Similarly, after a company is listed, it also needs investment banks to serve as sponsors and underwriters in seasoned equity offerings. Compared with those provided in IPOs, services from investment banks are comparatively simpler. The capital operation in this stage features the selection of assets or new projects for capital injection after investigations. For example, when SIHL went public, the government officials committed to constantly raising capital through equity offerings and injecting high-quality assets into the window company SIHL. Subsequently, the Shanghai municipal government fulfilled its promise and helped SIHL raise HKD7.8 billion by injecting in SIHL partial equity of Shanghai Orient Shopping Center, Bright Dairy, Shanghai Yan’an Road Elevated Road, Shanghai Huizhong Automotive, and North-South Elevated Expressway. Here, whether the capital injection can maintain the high profits and growth of SIHL depends on the financial services of investment banks as sponsors and underwriters in capital operation and the success is inseparable from the proper judgments and the decisions of investment banks on the profit-making capacity of assets. It can be said that each time the process of stock issue, pricing, or underwriting involves a series of intellectual services of investment banks. It needs to be mentioned that the stock issue and underwriting services

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of investment banks in the primary market is closely related to the securities trading in the secondary market. Securities markets are able to convert scattered short-term capital into a huge sum of centralized long-term capital through stock holding and trading by investors. A premise for this is a fully liquid secondary market where securities can be freely traded and long-term securities can be readily cashed in. To turn short-term funds into long-term ones must be based on the condition that the long-term funds can be easily exchanged for cash. This is another law of capital movement in the securities market. The successful pricing of securities in the primary market must be backed up by sufficient liquidity of the securities in the secondary market. It is crucial for investment banks to undertake proprietary trading and act as securities brokers and market makers in order to sustain the trading price of securities. It is owing to the high liquidity of the secondary market that investors are confident about the stock issue and sale in the primary market.

High value-added services during business mergers and asset reorganizations If the stock pricing by investment banks based on the assets’ quality and risks of a company in the primary market is an art, then business mergers and acquisitions and assets restructuring conducted by investment banks in the capital market are a perfect mixture of artistic processes. The high value-added services provided by investment banks in business mergers and acquisitions and assets reorganization are mainly manifested in the huge benefits obtained through enterprise mergers. These benefits are as follows. 1. Synergy effect in corporate mergers and restructuring As mentioned previously, corporate mergers have a synergy effect of 1+1>2. The aim of the intellectual services provided by investment banks is to discover the synergy effect after mergers and acquisitions of targeted enterprises through analysis and research. For instance, investment banks have to decide whether a company after business takeovers can achieve optimum economic scale in production and management and benefit from economies of scale; whether the acquiring company can gain financial benefits by increasing its debt-paying ability and reducing the cost of debts; and whether the mergers of two similar enterprises can stop the strength offsetting in business competition in order to benefit from rising market competitiveness and a larger market share.

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2. Creative benefits in MBO By converting managers into owners of a company, MBO raises the value of management and human capital, turns economical and reasonable assets stripping and restructuring into a reality, optimizes resources allocation through relating agency cost reduction to profit maximization of shareholders, further improves the growth of enterprises and capital. The most difficult step in MBO is financing. But since American investment banks initiated leveraged buyouts in the 1970s, especially when they used subprime mortgage loans as a financing means for leveraged buyouts in the 1980s, MBOs became much easier. Therefore, the real value of intellectual services offered by investment bankers in corporate acquisitions and reorganizations, leveraged buyouts, and financial innovations lies in high value added. The essence of corporate mergers and business restructuring is the transfer of corporate control. Experience in China and Western stock markets has shown that only with control transfer, can there be real optimized resources allocation, assets and industrial restructuring, and the synergy effect. In fact, any capital market cannot be called a mature capital market if there is no transfer and trading of corporate control. In company acquisitions and restructuring, investment bankers should commit themselves to the smooth transfer of corporate control apart from providing a series of services like planning, negotiation, and financing. Many of the mergers and acquisitions of listed companies in China’s stock markets are the allocation of state equity led by governments and the personnel changes in the management are similar to the transfer or promotion of government officials. However, mergers between companies with different ownership systems will usually cause equity disputes. This in reality reflects the fight for corporate control. In the late 1990s, disputes arising over corporate control of many listed companies in China’s stock markets constantly aroused the awareness of ownership rights among both medium and small shareholders and stirred up their strong desire to change the dictatorship by major shareholders of stateowned shares and legal person shares. In addition, those disputes reminded investors that the reason why many listed companies performed poorly and could not get rid of the impact from the old system was closely related to the unreasonably large proportion of state-owned and legal person shares in the equity structure. Thus, only when we promote the transfer and trading of controlling stakes, can the capital market of China be more efficient and vigorous.

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To adjust the layout of state-owned economy and ownership structure, the first key is to properly arrange the withdrawal of state capital and the participation of private capital. Here, it is important to prevent the loss of stateowned assets and also encourage the involvement of non-state capital to enter in the state-owned sector and contribute to economic development as the stateowned shares to be transferred were very large in number. However, at present, the Chinese government has put too much energy on the former without giving sufficient attention to the latter issue. The disputes over the controlling stakes in listed companies during this period revealed a contest for corporate control between private shareholders and state-owned shareholders. This clearly showed that the enthusiasm of private capital in investing in state-owned enterprises was under a test. Certainly, the dispute over corporate rights is a very complex issue in relation to proprietary interests and although there are two sides to every question, we still can conclude some facts from these complicated disputes. First, state capital is usually compelled to exit those listed companies, either because state-owned equity is used as a pledge which will be acquired by a private company later, or for the reason that some loss-making state-owned companies have no choice but to seek help from private capital. Second, representatives of shareholders in private companies sometimes go against rules and regulations in business operation and financial transactions due to their lack of managerial experience in corporate governance, thus creating occasions for scandal and doubts in corporate rights disputes. T h i rd , l o c a l s t a t e - o w n e d s h a re h o l d e r s , t h o u g h t a k i n g a b a c k s e a t , still maintain their connections with local powers. In spite of all sorts of weaknesses, those shareholders, representing the old system, are able to gain the initiative by using their social connections. Fourth, one trick used by state-owned shareholders in the disputes was the excuse of preventing the loss of state assets. Under such an excuse, even public security organs can be utilized to prohibit the transfer of corporate control to non-state shareholders. Worse still, some state-owned companies will seek help from private capital when they are in a tight corner, but will force the private capital to withdraw once they are out of trouble. In all fairness, when considering this from the perspective of private capital, we will doubt why private capital enters into state-owned companies if it cannot gain corporate control and achieve profit maximization and how it will be protected by laws and public opinions if it fails to gain corporate control. Additionally, to prevent the drainage of state-owned assets is a pretentious excuse. The fact is that the state-owned controlling stake in many listed

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companies was lost due to the poor management of state-owned shareholders. It is unfair to force out the private capital which has helped the state-owned enterprises turn losses into profits. If they allege that state-owned assets should be prevented from draining, how can we tolerate the loss of the interests of private capital? Therefore, I believe that the priority of current adjustments in state economy layout and ownership structure is to protect the enthusiasm of private capital in participating in state-dominated sectors and ensure the development of private capital free from the discrimination and disruption from the old system. There was a sign in the equity disputes over the past few years that although a new party representing promising emerging forces had come into being, it was often in an inferior position. This reveals that it is necessary to not only adopt market-oriented principles, but also formulate new regulations, and strengthen management and supervision in the transfer of corporate control during business mergers and reorganizations. The equity disputes also show that the new forces usually cannot achieve the final success by solely relying on their own power. It implies that the transfer or circulation of corporate control is a large project, which cannot be handled and controlled by entrepreneurs themselves, and therefore requires the capital operation of investment banks and investment bankers, which creates many opportunities for the investment banking industry.

Intellectual services in financing arrangements The high value-added services offered by investment banks include not only the formulation of acquisition plans for acquirers, but also the implementation of these plans and various relevant financing activities. As we have mentioned in Chapter 12 about corporate mergers and acquisitions, investment banks pushed the leverage buyout in the 1980s to a new high by leveraging bridge loans and subprime mortgage loans. It shows the significance of appropriate financing arrangements to business mergers and acquisitions. He Jinsheng published an article in Beijing Economic Information in 1994 to introduce the financing activities during the acquisition of Hong Kong Telecom by CITIC (Hong Kong). This case fully manifested the wisdom of investment banks. In 1990, CITIC (Hong Kong) purchased 20% stakes of Hong Kong Telecom from its controlling shareholder Cable & Wireless Worldwide PLC with an

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intention to acquire Hong Kong Telecom. During this takeover, Barclays Bank PLC was acting as the lead financial adviser. The acquisition required a total of over HKD10 billion, among which HKD2 billion was contributed to by CITIC (Hong Kong) and the rest was from equity and debt financing. According to the financing plan of Barclays, funds were raised through: 1. making a ten-year syndicated loan of HKD5.4 billion with 14% stakes in Hong Kong Telecom as collateral (its interests would be paid by the dividends from its holdings of Hong Kong Telecom); 2. issuing five-year zero coupon bonds of USD224 million (HKD1.75 billion); and 3. releasing five-year covered warrants of its stakes in Hong Kong Telecom worth HKD1 billion. This plan was smart because by issuing covered warrants, CITIC (Hong Kong) could borrow less money from the syndicated loan market, thus lowering the ratio of debt to total acquisition cost (HKD10 billion) from 80% to 70%. And among its debt of HKD7 million, zero coupon bonds of HKD1.75 (USD224 million) were sold to investors at a price below par and CITIC (Hong Kong) did not need to pay regular interest. So, the company could focus on the interest payment of the syndicated loan. Moreover, Hong Kong Telecom belonged to high-growth stocks in the area of public utility and would pay out stable dividends. Although the loan interest was two times higher than the stock dividend, the value of 20% stakes of Hong Kong Telecom exceeded HKD10 billion which was two times larger than the syndicated loan. This deal was a real bargain as CITIC (Hong Kong) could acquire 20% stakes of Hong Kong Telecom with HKD2 billion of the own capital. This was a typical case of leveraged buyout. Those financing arrangements by investment banks were only a tip of the iceberg. In addition to that, investment banks will also provide intellectual services for acquired companies during their anti-mergers actions.

Why Did Five Major Investment Banks on Wall Street Collapse during this Financial Crisis? In the financial crisis of 2008, five major Wall Street banks collapsed. On April 16, 2010, the U.S. Securities and Exchange Commission (SEC) charged Goldman Sachs for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages named “synthetic CDO.” It caused a stir in the investment banking industry. On April 26, 2010, Century Weekly published an article written by Huang Ming.3 The article, named “The Root of the Interest Conflict between Investment Banks and Their Clients,” specially focused on the changes in investment banks

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in the past 30 years and pointed out the causes of the conflict of interest. According to Professor Huang Ming, the conflict of interest between investment banks and their clients had deteriorated in the last 30 years. Prior to the 1980s, the major business of investment banks had remained more or less the same: acting as the bridge between investors and fundraisers. In the capital market, the information asymmetry between the two sides would cause market paralysis in the worst case scenario. So, investment banks became ideal intermediaries by virtue of their advantage in information and credibility formed in their long-term engagement in the market. Through performing this traditional role as intermediaries, investment banks have made indelible contributions to the development of the world economy. It is worth noting that the most renowned brands in the investment banking industry were run by a family or partners who tended to hold on to shares for a long time and would forsake short-term interest in order to maintain long-term brand value and reputation. In the traditional business of financial intermediation, the interests of investment banks are essentially the same as those of financing enterprises: Only when those enterprises are successfully listed, the investment banks can make profits. The conflict of interest is not serious between investment banks and listed enterprises, which is only reflected in the selection of underwriting teams and stock pricing. Therefore, the bad reputation of Goldman Sachs in the derivatives market would not affect its judgments in traditional investment banking businesses such as underwriting. But starting from the 1980s, the interest conflict started worsening owing to two factors. At first, top investment banks transformed from partnerships into listed companies and long-term shareholders were gradually replaced by short-term shareholders and professional managers who focused on short-term bonuses. This led to a weakened force for safeguarding the internal long-term reputation in the investment banks and increased the possibility of hurting the interests of clients for the sake of short-term profits. Meanwhile, innovations of financial derivatives and the expansion of proprietary trading offered plenty of temptations for investment banks. Businesses concerned with derivative products from the very beginning contained a severe conflict of interest and investment banks and their clients were at opposite ends of the financial contracts. From the perspective of clients, it was better to invest in the simplest derivative products in that they would achieve their aim of hedging or speculating at the expense of a small commission fee. But investment banks usually preferred to introduce high-risk and complex products. Excess innovations and sales of complicated derivative

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products by investment banks increased the risks in the market, which was also an important cause of this financial crisis. In the derivative markets of different regions around the world, investment banks faced similar short-term temptations and pecuniary attractions. But owing to the restrictive and deterrent forces from market supervision and legal charges in European and American markets, there were seldom cases of physical enterprises and individuals falling victim to complex derivative products in recent years. On the contrary, the regulations of over-the-counter derivatives in many countries and regions of Asia were more relaxed than in the U.S. and the direct result of loose supervision was the damage to clients’ interests. The originality of Huang Ming in this article was reflected in the following words: The charge against the financial derivative of Goldman Sachs was not surprising. Based on my research and analysis on the Asian derivatives market in recent years, the activities of international investment banks in the complex derivatives market of the U.S. were nothing compared with their behaviors in the Asian derivatives market. At the end of 2004, China Aviation Oil (Singapore) Corporation Ltd. lost RMB4 billion in its trade with Goldman on complex derivative products. Hired as an expert advisor after this incident by China Aviation Oil, I concluded that the problems exposed in the transaction between the two parties were more serious than those exposed in the cooperation between Goldman and American local companies after detailed analysis on the contract and communication between China Aviation Oil and Goldman. In the complex derivatives market of Asia, investment banks which make profits at the expense of their clients’ interests are more than just Goldman Sachs. But with preeminent brand influence and derivatives innovation capability, Goldman will exert greater destructive power. How should the regulatory body in Asian countries and regions respond in the face of the severe conflict of interest in the international derivative market? Although a supervision reform is under consideration, the effectiveness of the reform is still questionable. Therefore, Chinese enterprises and investors have to understand such a conflict of interests with investment banks and bolster resistance to temptations from complex derivative products. At the same time, investment banks should also be required to modify their behaviors in selling derivative products. Certainly, the most effective way is to improve the Chinese government’s awareness towards the significance of those problems. To ameliorate the regulatory environment will be a win-win solution in the end and also the trend of the post-financial crisis era.

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Time-Space Compression Leads to the Urban Era: Capital Accumulation and the Urban Economy

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Wenzhou Longgang Town, the First Town of Farmers Longgang Town in Wenzhou City is a well-known name in China. Longgang Town is a modern town that was developed by farmers themselves through smart leveraging of the rapid growth of the market economy in Wenzhou after the start of the Reform and Opening Up era. As an economic heavyweight in southern Zhejiang Province, the town has worked and is still working miracles in China. The rise of Longgang Town is a wonder in the course of China’s reform path towards being a market-oriented economy.

The first leap forward: Local farmers self-funded “China’s first town of farmers” Located in southeast Zhejiang Province, Longgang Town faces the East China Sea and is situated at the south riverbank near the estuary of the Aojiang river. Before the policy of Reform and Opening Up was implemented in this area, what its geographical advantage could bring to Longgang Town was the sea water inflow caused by tropical storm surges between August and October. Consequently, not a single grain of crops could be reaped. So, there was a popular ballad among the local people: “A farmer ’s small plot of land, often flooded by sea water unplanned; / Rice crops grow with no spikes most times, the farmer will only cultivate two dimes.” The Reform and Opening Up policy in 1979 boosted the economy in Wenzhou City where the market was comparatively active. At that moment, the household handicrafts industry was thriving in Wenzhou and it later spread to many towns in the Cangnan area of Wenzhou, such as Jinxiang Town, Qianku Town, and Yishan Town. For instance, as the college entrance examination system had been resumed in 1977, there was a large demand for school badges. Jinxiang people grasped this opportunity and gradually built family workshops for the manufacturing of aluminium scutcheons, hard plastic sheets, and other goods. Just within the Cangnan area, there were already 6,500 households with an annual income over RMB10,000, among which more than 90% lived near the Longgang port. The development of the economy requires space expansion and city formation. In June 1981, Zhejiang Province divided the old Pingyang County into Pingyang County and Cangnan County. In April of the following year, Cangnan County saw a business opportunity in the favorable geographic location of Fangyanxia

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Village (located in southeast Zhejiang and northeast Fujian) and decided to establish a port town as the collection and distribution hub of Zhejiang and Fujian provinces. As a result, Longgang Town was built on the site of Fangyanxia Village and, according to the initial plan, the local population size would be 12,000 in the short term and 19,000 in the long term. At the beginning, there were only five small finishing villages in Longgang Town with a population of over 6,000 and the funds for town construction added up to just RMB8,000. As the first Secretary of the Longgang Town Committee of the Communist Party of China (CPC), Chen Dingmo gasped at the sight of the vast wasteland and a small group of little cottages. It was only a new town with a preliminary structure but short of residents. Then, the Central Committee of the CPC and the State Council issued the No.1 Central Document of 1984 which “allows farmers to settle in towns on the condition of self-providing their own food grain.” This policy made a breakthrough in the strictly segregated household registration system between rural and urban areas. The market economy in Wenzhou was known for being very active after the Cultural Revolution. At that time, Guangming Daily carried a report about “Building a city for Shandong Weifang people by the people,” which offered an inspiration to Chen Dingmo. With the vision to develop the wasteland into a modern port town, Chen Dingmo proposed the idea of paid land use, income from which would be applied to town construction. He set up a welcome office for migrant farmers and posted a notice which said, “Farmers are welcomed to settle down in Longgang Town on the only condition that they can arrange their own grain. In case migrants plan to build their own homesteads, different amounts of construction fees will be charged according to the house location. Different rates of municipal infrastructure fees will also be collected based on different locations, ranging from RMB2,000 to RMB5,000 per house.” It was said that anyone who was willing to take out RMB30,000 could construct a new house and acquire urban citizenship in Longgang Town. Within just 10 days, there were more than 2,700 specialized households flooding into Longgang Town with the people gaining permanent resident status. At the same time, the town succeeded in collecting RMB10 million, which would basically solve the capital demand for initial infrastructure construction. It was recorded that shortly after Chen Dingmo put up the poster, Longgang Town became a construction site with an unprecedented scale. Over 3,000 buildings were being erected by 37 construction teams from all over the country. And there were more than 10,000 people onsite every day including over 4,000 carpenters and plasterers, 2,000 odd-job men, and thousands of house owners.

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By the end of 1986, the total area of the newly-built houses in Longgang reached 1.02 million square meters. A new town built up by farmers had finally been established. Some people concluded later that Chen Dingmo had introduced three major reforms in Longgang Town: 1. household registration reform, that is to allow farmers to be registered as urban residents only if they can arrange their own grain; 2. paid land use reform which solved the capital demand for building public facilities through selling land and charging costs for infrastructure development; 3. private economy reform, namely, to encourage small businesses in the town. For example, when Longgang Town was just formed, the local government had no money at hand, so it fostered the establishment of privatelyrun nurseries, kindergartens, and cleaning companies. Besides, having just transferred from being farmers to being urban dwellers, Longgang residents had a thirst for knowledge, and as a result, a great variety of learning classes were set up by private capital. The most popular one was free make-up courses by beauty salons for female customers with a view to developing customers and promoting cosmetics. Within a short time, the story of Longgang Town had spread far and wide. In 1986, I was the General Manager of China Investment Consulting Company (CICOC), and some postgraduates from Renmin University of China and Dongbei University of Finance and Economics worked there as interns. I arranged for them to conduct a special investigation in Longgang Town and their report was very impressive. Among all the stories about Longgang Town, two were most widely told. One was about the land sale by Chen Dingmo, which violated the country’s law and offended top local officials. Yuan Fanglie, Municipal Party Secretary of Wenzhou, specially convened a meeting for Chen Dingmo to report his work. Under the old system, a Township Party Secretary was responsible for both towns and subordinate villages. Chen Dingmo reported that in the town, the primary task was to sell land for the purpose of building more houses while in the villages, the priority was to reclaim land for agricultural production. After detailed questioning of the accurate acreage of sold lands and reclaimed lands, Yuan Fanglie made a conclusion that the size of newly reclaimed lands was larger than that of sold lands. Accordingly, Chen’s bold policies were recognized by government officials. This may be the earliest case where an increase in land use for urban construction was linked to the decrease in that for rural construction. Another widely known story was that in 1985 when Premier Zhao Ziyang paid an inspection visit to Wenzhou, Yuan Fanglie intended to take this opportunity to win some investment for the Jinhua-Wenzhou Railway project which aimed to

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solve the transportation difficulty between Hangzhou and Wenzhou. However, the Premier was not interested in this project and directly asked to hear the report about Longgang Town. So, Yuan Fanglie accompanied Zhao Ziyang to travel to Longgang via a ferry and they listened to the work report by Chen Dingmo. Chen explained the whole story about selling homesteads and collecting the municipal infrastructure fee in detail. Zhao Ziyang listened carefully and commented with acknowledgment, “You are like a real estate developer.” Hearing those words, both Yuan and Chen were finally relieved. Within less than three years since the establishment of Longgang Town, tens of thousands of farmers moved into the town which they had built themselves. In 1990, the local population had grown to 48,000, far above the number stated in the long-term plan. Longgang Town was praised as an example of farmers financing urban construction and the “First Town of Farmers in China.” It was the first leap forward.

The second leap forward: From a farmers’ town to an industrial town The well-known brand of the “First Town of Farmers in China” drove up the economic growth in Longgang. In 1994, Longgang Town recorded a GDP of RMB920 million and fiscal revenue of RMB83.01 million to become the most powerful town in terms of overall economic strength in Wenzhou. In 1995, its population surged to over 160,000. In 1996, 11 state ministries and commissions implemented a comprehensive reform of small cities and towns in Longgang, and although not upgraded into a city, Longgang set up the first townlevel coffer of Zhejiang Province and enjoyed partial rights of a county-level government in economic management. Thereafter, the printing demonstration industrial park, small-scale packaging and printing industrial park, plastic woven industrial park, and eastern city comprehensive industrial park were constructed in Longgang Town, and they attracted around 208 enterprises to set up their factories. The town was also labelled by some national trade associations as “China’s printing town” and “China’s gift town.”

The next step: Where will the town head? In the mid-1990s, the population size, economic volume, town scale, and social comprehensive indicators of Longgang Town reached the standard of a county-level city. During the comprehensive reform of small cities and towns by the state government, local people strongly called for upgrading the town into a city. Unfortunately, this urgent request could not break away from the constraints of the vested interests of the local government under the tax-sharing

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system, and Cangnan County was unwilling to let go the goose that had laid the golden eggs. The comprehensive reform in Longgang ended up in failure. This led to the migration of local residents and the sharp decline of local house prices. Longgang Town found itself in a predicament. The town fell four places from No.1 to No.5 with respect to the comprehensive strength in Wenzhou City. It should be said that this revealed a conflict between the existing administrative system and urban economic development. Wan Chongdian, the richest man of Longgang, said with regret, “Farmers can create a town in Longgang, but we can never decide the government system of Longgang.” In 2007, the area of Longgang expanded to 83 km2 with a total population (including both registered and mobile population) of approximately 400,000, equivalent to a medium-sized city. Its economic aggregate exceeded the sum of the wealth of Dongtou County, Taishun County, and Wencheng County in Wenzhou. As Longgang remained a town, there was no public security bureau, industrial and commercial bureau, land resources bureau, and tax bureau. It was very difficult for a town-level government to govern such a large area. Another contradictory fact was that the Wenzhou government positioned Longggang Town as the heart of Aojiang River Basin in its plans. And according to the tenyear plan of Longgang Town, its population was expected to grow to 700,000 in 2020. How ridiculous it is to have a “town” with that many people! Imagine if Deng Xiaoping had not converted Shenzhen Town under the administration of Baoan County into a city and that today Shenzhen was a “town” with 12 million people. Longgang Town needs to follow a similar path to become such a city.

Industrialization and Urbanization Added Crucial Significance to Urban Economy When speaking of capital formation mechanism, we cannot overlook cities. They are a product of pre-capitalism, but as capitalism propelled mass production, cities underwent significant changes and development. In fact, it was industrialization that created cities and advanced urbanization. In the era of Karl Marx, capitalism had just started, and neither industries nor cities were developed to today’s levels. Therefore, Marx understood cities based on their contributions to the rise and growth of industrial capitalism and did not regard cities as his research focus.

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The urban economy has grown independent from the industrial economy under modern production Under mass production, the advances and changes in cities have displayed four features: 1. Industrialization created cities and boosted urbanization. Since then, industrialization produced supplies while urbanization generated demands, and industrialization was closely related to urbanization. Industrial capital set up industrial enterprises which attracted a large quantity of farmers to be away from the countryside and agricultural work and become industrial labor. This led to the growing number of workers and the middle class. Meanwhile, the expansion of those enterprises deprived rural areas and agriculture of a vast expanse of land and new cities were formed as a result. The urban infrastructure construction accelerated population flow, which benefited the concentration of production factors such as labor and capital, thus creating economies of agglomeration. The further growth of urbanization in turn put forward a higher demand for industrialization. 2. Urbanization underlined the effect of spatial elements (location, movement, and mode of existence) on economic development. Urbanization practice suggested that the economy (saving) not only consisted of the saving of labor time but also the economization and optimization of working space in order to realize a reasonable arrangement of economic elements. Urbanization required a perfect combination of value balance, objects (commodity) balance, and space balance. In optimizing the space structure, urban economy focused on the research of the neighboring benefits, layout benefits, and network benefits among economic elements and the aggregation economies of urban regions. Benefits from spatial patterns can exert more profound and extensive significance than the economic benefits of each sector in a city. 3. Apart from stressing the function of linking production with operation, cities put more emphasis on the role of household consumption demand in urban development, especially when economic growth has raised labor income. With the expansion of the upper-middle-income group and the middle class, an olive-shaped society has been formed. Uppermiddle income families had demands for more varied and high-quality living and consumption conditions in the aspects of accommodation, catering, transportation, shopping, healthcare options, cultural and

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artistic activities, education and training services, dwelling environment, and tourism. They, for the first time, asked for satisfactory consumption of the means of development (knowledge, education, and training necessary for improving the quality of labor) and the means of enjoyment (such as pastimes), as their subsistence consumption had been fulfilled. Urban residents required not only a wide range of consumer industries and consumption facilities but also relevant policies and programs promulgated by municipal administrative authorities to guarantee such a rich life. Practice also proved that when the population concentration reached a certain level, it would give rise to the need for the tertiary industry. This would provide a wide space for the development of the modern service industry such as postal operations, telecommunications, banking, and hospitals. 4. The development of cities formed the capital of urban infrastructure which existed side by side with production capital. Cities should have clear policies and urban planning and offer public goods, investment, welfare, and facilities within the scope of the public economy. Municipalities have to optimize the allocation of public economic resources and enhance the efficiency of public economy through city planning in the aspects of land development and utilization, and the construction of infrastructure, cultural facilities, public amenities, public health infrastructure, residential building, and communities. The city planning should meet residents’ needs in living, consumption, and culture, and turn cities into not only a place where production and life are linked to each other, but also a cultural high ground, a cradle of science and technology, and a breeding ground and gathering place for talents. It should also endow cities with distinctive characteristics, unique charms, and distinguishing competitiveness, and therefore drive forward the development of the urban economy. It is just because urban economics is a study of how to govern a city and completely different from business economics that some people sometimes refer to it as “mayor economics.” Overall, cities have developed into a form of an economy distinct from the industrial economy. In the development of cities, governments were integrated into the economy and had become an inner factor for economic growth. The urban infrastructure capital including land that was in the hands of governments not only played a special role in the capital formation mechanism, but also grew to be the urban economy independent from the industrial economy.

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Henri Lefebvre and David Harvey’s theory on time-space compression In the modern mode of production, as cities are the optimum spatial organization for mechanization, technology innovations, and economies of scale, industrial societies rely more and more on cities. Henri Lefebvre, an urban study theorist and neo-Marxist philosopher, once called this reliance “urbanism.” He believed that urbanism was starting to control industrial production and organizations and in the past industries were the creators of cities but now they are being created by cities. Lefebvre even proposed the concept of “urban revolution” and argued that the urban revolution, the same as the industrial revolution which signified a historical shift from an agricultural to manufacturing world, had crucial social significance and influence. Accordingly, human history could be divided into three overlapping and connected ages: agricultural age, industrial age, and urban age. He predicted that if capitalism spread to the whole world, it would change productivity and create a series of new sectors of production, exploitation, and domination, such as leisure activities, everyday life, knowledge, art, and urbanization. The globalized production which resulted from consumerism would definitely lead to the general suppression of differences and individuality, which would further transform into the social basis of people’s everyday lives, hence people were alienated by urban spaces. Those extreme opinions of Lefebvre were criticized and opposed by many people. Later, Lefebvre also gave up the idea of urban revolution and replaced the notion of cities with the notion of space. He just admitted the dialectical role of cities in productive relations and reproduction and stopped giving urbanism any unique theoretical attributes, but adopted a more inclusive concept of modernity to act as a substitute for past discussions of urbanization. It now appears that with the advances of mass production and urban economy, industrial societies increasingly rely on cities. This reliance is manifested in not only the fact that “cities became the optimum spatial organization for mechanization, technology change, and economies of scale, but also the positive influence of urban development on the economy. Cities will pose more demands for industrial societies, and therefore the concepts of “urban revolution” and “urban age” should not be easily denied. Another renowned social theorist was David Harvey, a neo-Marxist. He developed his theories on cities based on the division of labor between production space and living space. In his work The Urbanization of Capital, he specially focused on the suburbanization of America after 1945 and explained how capitalism created a physical landscape of roads, houses, factories, schools, shops, and so forth in its own image for the purpose of space expansion and

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capital accumulation. Then, from the perspective of capital accumulation, he pointed out the contradictions among production capital, urban infrastructure capital, and capital for scientific education and health care. But as financial institutions and government intervention had played their parts, the capital circulation of the above three aspects was formed. Harvey’s theory about urban infrastructure capital was an inspiration to us about capital’s unique role in the capital formation mechanism. In the past, people paid more attention to the production capital of capitalists but neglected the function of governmental and urban infrastructure capital in the modern mode of production. Originally, in the traditional capital formation theory, only capital and the labor force were counted in, so there were just competitions of the business groups of capitalists and the labor force in the market. At this time, governments were merely regarded as administrators who should not participate in the competitions. Therefore, in the classical economic growth model, governments were only deemed as an external factor. In fact, governments of capitalism dare not step beyond the line. If it is true that in the past, industrial capital of Western capitalist countries made investments spontaneously and separately under competitions and an anarchy of production while governments stuck to the traditional theory by attempting and accomplishing nothing, and cities were expanded as a result of spontaneous capital accumulation, accompanied by the advent of residential communities, public facilities, medical services, education, governmental services for a large amount of the labor force, then it can be said that in the modern mode of production, once governments are in charge of urban planning, they will gain an advantageous position in leading urban development and economic growth and intentionally use urban infrastructure capital (including the capital for scientific education and health care) to guide the industrial capital flow. Here, urban infrastructure capital has developed into the urban economy, independent from the industrial economy. And now, governments have been converted into an internal factor of economic growth. A d d i t i o n a l l y, D a v i d H a r v e y a l s o r a i s e d a c o n c e p t o f “ t i m e - s p a c e compression.” It is true that transportation assumes considerable economic significance in the process of industrialization and urbanization. Initially, vessels and carriages contributed to the formation of ports and market towns, and then the rise of steamers, railways, highways, airports, and expressways brought about huge economic benefits to transportation-developed cities. Harvey enumerated the changes of time-space compression generated by the advance of modern transportation technologies: In 1500–1840, the average speed of carriages and sailboats was 10 mph; in 1850–1930, the average speeds

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of steam locomotives and steam ships were 65 mph and 36 mph, respectively; in the 1950s, the speed of propeller-driven aircraft was 300–400 mph; and in the 1960s, the speed of jetliners was 500–700 mph. This led to the tremendous restructuring of spatial relations and representation. Harvey believed that the general trend of those time-space compression changes was towards the acceleration of turnover time in production and the condensing of spatial distance. The invention of highways, canals, railroads, steamships, telegraphs, radios, cars, containers transportation, air cargo, televisions, and electronic communications has altered the space-time relationship, and thus a changing cityscape. As early as the 19th century, the U.S. had built the transcontinental railway network, which boosted the economy of cities along the railways. The U.S has a vast territory and is also the world’s largest economic and technological superpower, so it is suitable for constructing railroads, especially highspeed ones. However, in the 1950s, Americans alleged that railways were outdated, so they were busy dismantling tracks while building new roads. This led the country to the development of expressways and civil aviation and postponed the arrival of high-speed railroads for half a century. Certainly, there were reasons behind ’this practice. During World WarⅡ, the crisscrossing expressways of Germany astonished Americans. Later research revealed that the developed road traffic system had been an important factor for Germany’s recovery after World WarⅠ as a defeated country and then its later development again as a superpower in Europe. The U.S. after World WarⅡ had a large number of demobilized soldiers and their employment became a crucial issue for the government. After taking the suggestion of many economic experts, the U.S. government decisively adopted the development strategy of Germany and mobilized millions of ex-soldiers to build expressways in order to ease the unemployment pressure. Meanwhile, the U.S. automobile manufacturing industry had developed a huge production capacity, which also required the expansion of road traffic to boost the demand for cars. It was owing to the largescale construction of expressways that within less than 10 years, the country had completed its interstate highway system. Cars were speeding on interstate freeways and traffic was running smoothly. Heavy trucks could deliver goods door-to-door in a fast and punctual way, far better than trains of rail transport. American residents got used to driving for either business or personal pleasure and did not rely on trains any longer. Consequently, both the government and the public believed that railways were outdated, leading to the conversion of lots of railways into highways. After the opening of the highway network, the States became a “kingdom of automobiles.” Although it paved the way for the

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national economic growth though vitalizing many cities along the highways and accelerating the development of automobiles and a series of related industries, it also brought about huge negative impacts on energy conservation and environment protection. In the 1960s when Americans advocated the theory of “railways being outdated,” Japan had completed its Tokyo–Osaka Shinkansen. Later, France opened the Paris–Lyon high-speed railway. The success of high-speed railways in the two countries completely overturned the theory. But due to the narrow territories of the two countries, the power of the high-speed railway did not come fully into play. Subsequently, Italia, Germany, Britain, the Soviet Union, Spain, and many other countries set off a boom of railway construction. So, now it has pushed the U.S. to reconsider its transport development strategy. In recent years, China also emphasized the construction of metropolitan areas and urban agglomerations based on high-speed railways and urban mass transit systems, especially the “four vertical and four horizontal railways” along Beijing–Guangzhou Railway and Beijing–Shanghai Railway. This not only expanded Bohai Economic Rim, Yangtze River Delta, Pearl River Delta, but also contributed to the formation of a group of urban agglomerations, including the Central Plains Economic Zone, city clusters in the middle reaches of the Yangtze River, open economic zone of Xiamen-Zhangzhou-Quanzhou Triangle, urban agglomeration of Shangdong Peninsula, urban agglomeration of the Central and Southern Liaoning, West Taiwan Strait City Belt, Sichuan-Chongqing urban agglomeration, and Guanzhong urban agglomeration. It revealed the special significance of time-space compression in creating cities. In 2010, Shanghai World Expo decided that its theme was to be “Better City, Better Life.” It reminds us that for cites which strive to get rid of high energy consumption, pollution, and emission rates and extensive growth, it is more important to avoid repeating the same mistakes in the future. It is necessary to overcome all difficulties and provide more comprehensive and thoughtful services in the areas of social life, economics and finance, healthcare, culture, education, environmental protection, tourism, consumption, and the modern service industry in order to guarantee people an affluent, comfortable, harmonious, and high-quality life. To change China’s rash industrialization policy and to stimulate urbanization, the top priority is to push forward in a large scale the revolution of new technologies such as green energy, green transport, and green building by taking the opportunities arising from the construction boom of urban agglomerations and metropolitan areas and new rounds of timespace compression. I think that it is not wise to doubt the theories of “urban revolution” and “urban age” and people have all the reasons to believe the

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advent of both the “urban revolution” and “urban age” and expect possible subsequent changes in the economic development mode.

China’s local governments employed land and urban infrastructure capital to lead urban economic growth China is a special case in which urban economic growth is driven by local governments. During China’s Reform and Opening Up era, capital was in a desperate shortage. Unlike Western governments, China’s local governments were not subject to the traditional ideology of the Western market economy which said “governments can only play a role of managing instead of participating in the economy.” In China, local governments not only govern cities but are also responsible for local economic development. Under the state-owned economy, governments assume two roles as managers and investors. Besides, during China’s reform towards a market economy, as private capital was not strong enough, local governments had to attract outside investment, first from Hong Kong and Taiwan, and then from Western countries. In this way, competition for capital took place first among four special economic zones (Shenzhen, Zhuhai, Shantou, and Xiamen), then among 14 coastal cities of the open economy, next between Yangtze River Delta and Pearl River Delta, after that among different provinces. Finally, as the famous economist Steven Ng-Sheong Cheung put it, after the value-added tax reform in China, since the local government could share a portion of the taxes, even county-level governments were motivated to join the competition. To be more exact, it should be called “urban competition.” The key problem was not competition itself, but what was used as capital by local governments to compete with each other. Local governments had no money on hand, and the only thing they had control over was land in cities where the public ownership played a dominant role. Therefore, when the Shenzhen Special Economic Zone was opened, the Shenzhen government first decided to undertake compensated transfer of land use rights as Hong Kong had done. This practice later spread to many other cities. Land controlled by governments would undergo “three connections and one levelling” (which means a construction site is connected to water and electric power supplies and roads, and that the ground is leveled before a project is begun) or even “seven connections and one levelling” (which expands to also include utilities connections to drainage, heating, telecommunications network, and natural gas or coal gas), in order to facilitate the construction of secondary developers. Later, local governments even leveraged old factory buildings and living quarters

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of local state-owned enterprises to attract foreign investment. Preparation works of “three connections and one levelling” and “seven connections and one levelling” constitute the aforementioned urban infrastructure capital of governments. In today’s China, local governments still control the land use rights. Having land and urban infrastructure capital at their command, they can lead the formation of capital. We know that Western countries spontaneously occupy the market through competition by relying on industrial capital. By contrast, Chinese governments count on land and urban infrastructure capital which is used to provide supporting facilities on the land to lead the investment of external capital. Steven Ng-Sheong Cheung thought that the Chinese government offered investors “a negative land price” in his book The Economic System of China. He wrote that local governments take “land to be the capital contributed by the landlord, [and] the possibility of using a negative land price means the landlord is offering infinite opportunities for adjustment, under which the equi-marginal condition required for efficiency can always be attained as long as the uniform sharing is within a reasonable range…. The xian (county-level governments) may not only give improved land to the investor free of charge, they may even build the facilities gratis, or allow the investor a rebate over a number of years out of the value-added tax the xian is entitled to.” Thus, Steven concluded that local governments used what he called “a negative land price” to attract overseas capital in order to build up industries, promote urban economic growth, enlarge local revenue collection, and speed up the rise of China. It took the economist Steven Ng-Sheong Cheung 28 years to arrive at a “general theory,” from his initial study of China’s development in 1979, and his theory of “Xian competition” in 2003, to his manuscript of The Economic System of China in 2007. This general theory boils down to “contracts restraining competition” which centers on “a negative land price.” However, local governments are very familiar with this practice and what they have frequently said when inviting investment — “seeking presence rather than ownership” — reflects the role of “a negative price.” It should be particularly pointed out that the reason why China’s local governments are very skillful at this practice is a result of the nature of the urban infrastructure capital of the urban economy, just as it is the nature of industrial capital to pursue scale expansion and profit maximization in the industrial economy. Local governments in China are engrossed in the urban economy. That is because China has implemented a market-oriented reform on the basis of a government-dominated state-owned economy. Local governments are

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responsible for the prosperity and economic growth of cities, but they only have control over lands and urban infrastructure capital. So, they develop the nature of urban infrastructure capital to the fullest for the purpose of building up industries, increasing employment, satisfying employers’ and residents’ demands in living and consumption, or adjusting the economy. However, things were different in Western countries. Industrial capital of Western capitalist countries made investments spontaneously and separately under competition and amid the anarchy of production, while governments stuck to the traditional theory of zero government intervention. Under the condition of a traditional market economy, industrial capital developed exceedingly owing to its nature of pursuing scale expansion of profit maximization and thus it caused the latest financial crisis and brought about a disaster to the whole world. Finally, governments had to intervene to save the economy. Some people said sarcastically that the U.S. was being transformed from capitalism towards socialism and China and the U.S. were implementing practically the same system. Although it was a joke, it reflected a truth that as long as a government works for the social welfare of people, be it a capitalist government or not, it will show a certain tinge of socialism.

The special role and function of governments in urban development As already stated, governments have been intensively involved in the economy and become an internal factor of economic growth in the modern mode of production. Urban infrastructure capital including land controlled by governments plays a unique role in the capital formation mechanism and has developed into an urban economy parallel to the industrial economy. First, governments can use their land use rights as original capital. Second, governments can carry out infrastructural developments including water supply, gas pipes, power grids, and roads, through urban planning and accumulate urban infrastructure capital through build-operate-transfer (BOT), transfer-operate-transfer (TOT), governmental fundraising, joint venture, and business cooperation. Third, governments make use of the urban infrastructure capital to attract domestic and foreign capital in order to build up industries, promote urban economic growth, and enlarge local revenue collection. Fourth, governments take advantage of the urban infrastructure capital to increase employment, satisfy employers’ and residents’ demands in living and consumption, provide residential communities, public facilities, medical service, and education service for the massive labor force, and even regulate the

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national economy when necessary. Chongqing is a good case in point. In 2008, the Chongqing government won two 40-million-unit laptop projects from HP and Acer, respectively, by advocating “a processing trade integrating machine manufacturing and spare parts production.” It encouraged the entire chain of the notebook industry to settle down in Chongqing. Additionally, Chongqing implemented a reform of household registration and built plenty of public rental housing for the benefits of the general public. These efforts constituted a favorable environment for investment as well. A large number of farmers-turned workers were attracted to the city and they could get both urban registered permanent residency and spacious public rental housing. Not only the “seven connections and one levelling,” but also the basis of the industrial chain, steady supply of labor force, stability of employers made up the advantageous investment conditions of Chongqing. Consequently, many world-renowned brand owners, contract manufacturers, and parts manufacturers gathered in Chongqing and so Chongqing became an emerging city for the IT industry. Governments play a vital role in economic growth. In China, not only did the local governments use the urban economy to guide capital investment in economic development, but also the Central government arranged industrial layout and regulated the economy through economic planning. More importantly, the Central government minimized the losses from the financial crisis by increasing government investment to boost domestic demand in 1997 and 2008. Therefore, when carefully analyzing the motivations behind the “China’s Miracle,” governments have become an internal driving force for economic growth. In control of urban infrastructure capital (including land) and urban economy developed on the basis of the former, governments in fact became quasi-economic organizations, similar to commercial institutions but independent from the industrial economy. If there is anything called the “China’ mode,” I think it will be an emphasis on governments’ functions in economic development. Governments use the capital of the urban economy to lead the investment of industrial capital, regulate the national economy, and even drive domestic consumption by enlarging government investment in order to pursue the maximization of people’s interests rather than commercial profits. This is a very important feature of China’s mode. Certainly, when leading the urban economic development by making use of urban infrastructure capital, governments may exert a negative impact. For example, some cities either blindly built development zones, technology centers, and expressways or designed the urban layout centering on government buildings with grand city squares and skyscrapers, which only turned out to be

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desolated cities and scarcely used buildings and expressways. This resulted in an enormous waste of resources and money. Some cities in Guangdong Province proposed the “dual transformation” (of cities and industries). However, the global financial crisis of 2008 made the outcome of the “dual transformation” lower than the expectation. In many destination regions of the industrial transfer in Central and Western China, industrial parks were built but only a few enterprises moved in, not to mention the fact that Vietnam, India and many other developing countries were also favorable choices for transferred factories. The industrial basis for the processing trade in those countries was no less than in Mainland China. Besides, governments may also make mistakes in the decision-making of urban planning. It was a vital weakness of government-led resource allocation and can only be prevented and improved by scientific and democratic decision-making process and effective supervisory measures.

The Mismatch between Industrialization and Urbanization in China’s 60-Year Economic Construction Industrialization and urbanization are closely related to each other. The former creates supply while the latter creates demand. Industrialization pushes forward urbanization and the two should develop in parallel. During the 60 years since the founding of New China, urbanization has substantially advanced. The number of cities has grown from 132 before the birth of New China to 655 in 2008, and the urbanization rate rose form 7.5% in 1949 to 45.68% in 2008. According to the 2010 Blue Book of Cities in China, China’s urban population reached 620 million and the urbanization rate arrived at 46.6% up to 2009, and the newly-increased urban population per year exceeded 20 million between 1996 and 2005 and was around 15 million between 2006 and 2009. But China took a detour in its path of urbanization after 1949, resulting in a serious mismatch between industrialization and urbanization and the long-term dual economy of China. This is the root cause of China’s insufficient domestic demand. The lagged urbanization was first of all caused by the counter-urbanization in China’s urban development. The expansion of large cities was restricted in the hopes of developing small towns as substitutes. In the early 30 years of New China, the government planned to turn consumer cities into production cities. Chairman Mao Zedong said, “The people’s political power can be strengthened only when urban production is

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restored and developed and consumer cities are transformed into production cities.” Starting from 1952, the Chinese’ government was busy with economic construction, while the focus of urban construction was put on small and medium-sized towns as well as company towns with a small number of medium-sized cities. Large cities were not expected to be built unless it was for special reasons. The government aimed to control consumption and facilitate the primitive accumulation of industrialization. The Great Leap Forward of 1958 generated short-lived rash urbanization which resulted in reckless expansion of city scale and a surge of city numbers and urban population. Yancheng in northern Jiangsu Province intended to build a metropolis of 1 million, Zhuzhou of Hunan Province targeted a population increase from 200,000 to 600,000–800,000, and Xiangfan of Hubei Province planned to develop itself into a city of 1.2 million people. As a result, the population rate of China soared to 19.5%, the highest number before 1978. To reverse the situation, in November 1960, the National Planning Meeting decided on “a suspension of urban planning for three years,” mobilized 25 million workers to return to rural areas, and repatriated the unemployed migrant rural workers to their hometowns. Between 1961 and 1963, the number of cities totaled 168, a decrease of 40. In 1964, the urbanization rate plummeted to 14%, signifying the beginning of China’s counter-urbanization movement. Moreover, the decadelong Cultural Revolution sent more than 17 million educated youth to remote villages and strictly limited the conversion of agricultural to non-agricultural population. After all, the development of cities was inhibited for the sake of industrialization. In November 1978, the Third Central Committee Meeting of the 11th National Conference of the CPC announced the policy of Reform and Opening Up, but China’s urbanization was still not smooth as favorable policies were given to small towns for nearly 20 years. In general, China’s urbanization after the Reform and Opening Up policy was implemented could be concluded in three stages. The first stage was the 10-year development of small towns. In 1978, the State Council requested to “do a good job of urban consolidation,” and “control the scale of large cities while building more small towns.” A city with a population of over 500,000 was considered a large city. In 1983, Fei Xiaotong published his influential article “Small Towns, A Big Issue.” Shortly after, a decentralized development mode with small towns at the center became the mainstream among theorists and decision-makers, and, as a result, a large number of small towns were established all over the country. In 1985, there were only 1,851 towns in China, but the number of towns nearly quintupled to reach 14,182 in 1992.

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The second stage started when the Urban Planning Law came into effect in 1990. It stipulated that “the scale of large cities should be strictly controlled and a reasonable number of medium- and small-sized cities should be developed.” This policy relaxed the restrictions on urban development and the free flow of production factors. However, Decisions on Several Big Issues on Agricultural and Rural Work announced in the Third Central Committee Meeting of the 15th National Conference of the CPC in October 1998, once again put forward the strategy of developing small towns. In July 2000, the State Council switched to supporting urbanization and stated in Several Opinions on Promoting the Healthy Development of Small Towns that since the time and conditions for speeding up urbanization were ready, the government should seize this opportunity to implement urbanization. There was a serious defect in the strategy of developing small towns and cities in those 20 years. China followed the traditional strategy of restricting the growth of large cities and developing small towns instead, which led to the unbalanced urban development between 1978 and 1998. The number of small and medium-sized cities, as well as small towns, quickly increased while large cities remained at a small number and developed slowly. According to the data from the National Bureau of Statistics, during the 20 years, medium- and smallsized cities with a population less than 500,000 increased from 153 to 583, a growth of 3.8 times; small towns surged from 2,000 to 18,000, an increase of nearly 9 times; and large cities of over 500,000 people only saw a rise of 2 times from 40 to 85. In 1999, Wang Xiaolu and Xia Xiaolin conducted an econometrical analysis based on the data of 666 cities in China, and they concluded that the average scale of China’s cities was too small and large cities were generally underdeveloped. In 2006, Chun-Chung Au and J. Vernon Henderson, two American urban economists, also drew the same conclusion that China’s cities were generally undersized based on econometrical analysis and China’s data. Henderson also estimated that if the city size in China could be expanded by two times, the actual unit labor output would increase by 20%–35%. Statistics also indicated that the population percentage of large cities (which have over 1 million people) was 43% in the U.S. and 48% in Japan in 2005, an increase of two percentage points compared to the figure in 1990. The percentage in Australia was even as high as 60%. By contrast, China’s urban population, which was 376.193 million, only comprised 28.31% of the country’s total by the end of 2008. Serious consequences of excessive small towns would be that the population size could not satisfy the requirement of economies of scale, the service industry could hardly develop, and the ecological environment would be badly damaged due to a waste of land resources and the low efficiency of energy utilization.

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Things were changed in the third stage. At the end of the 1990s, the government abandoned the policy of restricted development of large cities and officially announced a new policy of “coordinated development of medium and small cities and small towns.” This was a breakthrough in China’s urban development strategy. Starting from the 10th Five-Year Plan, urbanization was for the first time given strategic importance in the national development and ideas of coordinated development among different regions and mutual improvement between urban and rural areas were proposed. In 2005, the policy of “industrial development repaying agricultural production and cities supporting villages” was promulgated. In 2007, the Work Report of the 17th National Congress of the CPC stressed, “focusing on increasing the overall carrying capacity of cities, we [the government] will form city clusters with megacities as the core so that they can boost development in other areas and become new poles of economic growth.” In 2008, the new Urban and Rural Planning Law removed the provision of “limiting the scale of large cities.” More importantly, city clusters were more an economic and cultural concept than an idea of administrative division. Therefore, concepts of urban belts and economic circles became popular. Later, the Bohai Economic Rim, Yangtze River Delta, and Pearl River Delta became the most prosperous city clusters in China’s economic development. The open economic zone of Xiamen-Zhangzhou-Quanzhou Triangle, urban agglomeration of Shandong Peninsula, Central–Southern Liaoning urban agglomeration, Central Plains Economic Zone, city clusters in the middle reaches of the Yangtze River, West Taiwan Strait City Belt, Sichuan-Chongqing urban agglomeration, and Guanzhong urban agglomeration also came on the scene. During the 10 years between 1998 and 2008, the development of large cities was sped up and the overall urbanization rate was further improved. The urbanization rate increased by 12 percentage points, an average annual growth of 1.24 points, while the annual growth rate was only 0.77 percentage points in the 20 years between 1978 and 1998. It is worth noting that after the latest global financial crisis, China’s government again put urbanization on the top of its agenda in 2009 and to prioritize the development of medium and small cities and small towns seemed to be an important part of future policy-making. Another reason for the mismatch between urbanization and industrialization in China was the restricted flow of the rural population to urban areas due to the urban-rural household registration divide. We say that industrialization has stimulated urbanization, not only because the industrial capital of industrialization built enterprises, expanded city size, and increased the number of cities, but also for the reason that industries which developed in

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industrialization attracted a large quantity of farmers to move away from the countryside and agricultural work and so instead become industrial laborers. This led to the growing number of workers. Here, the migration of the rural population played a significant role in economic growth. The significance was manifested in at least two aspects: For one thing, rural migrant workers increased the supply of industrial labor and expanded the number of workers, which constituted industrial productivity and thus contributed to the economic growth through industrial production. For another, as more and more of the rural population moved and worked in cities, they increased urban purchasing power and created consumption demand for industrialization, which also led to economic growth. Consequently, the urban-rural population ratio was changed, so was the ratio between urban and rural economies. During the 30 years between 1949 and 1978, China’s gross industrial output value grew by 39.18 times, but its urbanization rate only rose to 17.9% from 10.6% with an annual growth rate of 0.25 percentage points. The overall pace of urbanization was very slow. China implemented a planned economic system during those 30 years. To solve the problem of insufficient food supply, a divisive household registration system between rural and urban populations was carried out for the purpose of limiting the migration of the agricultural population to cities. This further strengthened the urban-rural dual economic structure in China. In those 30 years, the country faced an acute shortage of consumer goods, farmers were impoverished, and workers received low wages. So, neither of them could afford high consumption. The economy during the 30 years was more a production economy than a consumption one. After the Reform and Opening Up era started, the Chinese government introduced a policy of “leaving the fields without leaving the countryside” in order to develop the rural industry. This policy, however, deepened the dual economic structure. Besides, due to the divide in the household registration system, hundreds of millions of farmers rushed into cities and contributed their labor to industrialization, but they were forbidden from settling in cities and enjoying basic urban welfare and services. Of course, the biggest change in the urban economy after the start of the Reform and Opening Up era was the transition towards a socialist market economy. In particular, the production of consumer goods was developed in the early years of the reform, a group of people was allowed to get rich first, 17 million educated youth returned to cities, workers became better-off, and the dependency ratio was lowered. Consequently, there was a boom of consumption represented by the massive purchase of household appliances in the 1980s. But, although industrialization moved forward, the lagged urbanization sustained the huge rural population

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size. In these years, cities grew larger and larger and 160 million farmers worked in cities, but they were not counted as parts of the urban population due to the divisive household registration system. On the surface, the proportion of China’s urban population rose from 17.82% to 45.68% between 1978 and 2008, and the urban population reached 607 million by the end of 2008 (some said the number should be 602 million in 2009). However, if excluding the number of farmers without a permanent urban residence permit, the actual urbanization rate was less than 34%. So, some people called this phenomenon pseudo-urbanization or periurbanization. This was particular to China and a result of lagged urbanization. More importantly, farmers contributed their labor to industrialization, but the industrial sector did not grow the working class proportionally and cities did not accept them as urban citizens and grow the middle class. In 1994, when talking about the impact of rural population migration on economic growth during Japan’s industrial take-off, Hiroshi Yoshikawa specially mentioned that between 1995 and 1975, Japan’s urban household increased by 80%, which greatly stimulated household appliance production and consumption. Boosting domestic demand became a driving force for economic growth. China’s policies on rural migrant workers lacked a similar stimulus. In countries with a developed market economy, the middle class usually accounted for 80% whereas in China, the proportion of middle-income families was only around 23%. This indicated a deficiency of consumption power. In the Southeast Asia Financial Crisis of 1997, China showed the signs of overproduction. Premier Zhu Rongji repeatedly asked to activate domestic demand, but hardly any result was seen from the small middle class. When those people who got rich first purchased cars and houses, it was difficult to form another boom of consumption. After entering the new century, the trend of globalization fueled the robust economic growth of China, and the expansion of external demand and massive exports covered up the conflict between overproduction and underconsumption. The problem of overproduction was not revealed until the global financial crisis in 2008 when external demand shrank to a large extent. The pressure of economic structural adjustments became prominent. The policies of “sending home appliances to the countryside” and “stimulating automobile consumption” initiated in 2009 received a worse result than expected. The main reasons were the low spending power of rural migrant workers and the lack of a middle class in cities. These factors were the major obstacles for the growth of domestic demand. In addition, when urbanization was sped up, the urban-rural household registration divide prevented 160 million farmers-turned workers from being registered as urban residents and caused a series of negative impacts, such as desolation in most traditional agricultural areas, a massive loss of high-quality

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farmland, ageing of agricultural work force, the participation of farmers in non-agricultural production, an increase of left-behind children of migrant workers, a wider gap between urban and rural income, and more and more mass disturbances. Anyway, the mismatch between industrialization and urbanization has become an obstacle in current economic growth. In the future, the Chinese government has to solve this deep-seated problem for the sake of economic development.

Time-Space Compression Led Us to the Urban Age The lagged urbanization in China is now speeding up. The construction of highspeed railways has brought about many opportunities and stimulated the rise of a group of cities. Therefore, it is important to grasp this chance to accelerate China’s economic growth, promote an increase in domestic demand, and facilitate economic structural transformation by converting hundreds of millions of rural migrant workers into new urban residents. Originally, the Chinese government considered building 20 city clusters by 2030. But, to cope with the global financial crisis in 2008, China announced a 4-trillion stimulus package to expand investment and consumption and the Ministry of Railways committed to finish the construction of 40,000-kilometer railroads which was originally scheduled to be completed in the next 11 years. Local governments also joined the trend and invested in the construction of high-speed roads and inter-city railways, with the total length exceeding 10,000 km. Between 2008 and 2009, the Beijing–Tianjin Intercity Railway, Wuhan–Guangzhou High-Speed Railway, and Zhengzhou–Xi’an High-Speed Railway were successively put into operation. In 2011, the Beijing–Shanghai High-Speed Railway opened to the public. The whole world witnessed the rapid development of China’s high-speed railways, which had taken other countries several decades to accomplish. This encouraged the rise of numerous new city clusters and brought about huge changes to the timespace compression of cities. A high-speed train could carry 600–800 passengers, equivalent to the capacity of 10 buses or 3 passenger planes. It overcame the shortcomings of highway network (short-distance transportation) and air service (small carrying capacity). If we say that the advance and application of computers and information technology realized remote transactions and rapid settlement and turned what was expensive and scarce into something inexpensive and common, then high-speed railways realized the connection among the rising city clusters, formed 0.5-hour, 1-hour, 2-hour, 3-hour, and 4-hour economic circles, facilitated the fast flow of massive labor force, technologies, materials,

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and capital through time-space compression, brought about convenience and efficiency by taking advantage of the complementarity of cities, and generated the coupling effect. The high-speed rail network also offered a brand-new timespace environment for urban economic growth and created opportunities for domestic demand increase and economic structural transformation. Why did we say that the urbanization represented by the rise of metropolitan areas and city clusters resulting from the construction of high-speed railways and urban mass transit would create great opportunities for China’s future economic development? The reasons are as follows.

The high-speed railway greatly reduced the time-space distance between cities The Beijing–Tianjin Intercity Railway has a length of 115.2 km and a reduced travel time 29 minutes instead of 69 minutes. If compared to the 2-hour travel time in 1994, the time needed now is three quarters less. The Wuhan– Guangzhou High-Speed Railway shortened the journey time of 1,068.8 km to less than 3 hours. The Zhengzhou–Xi’an High-Speed Railway is 505 km long and it significantly cut the minimal travel time between Zhengzhou and Xi’an to 1.48 hours from more than 6 hours. At the same time, owing to the construction of this railroad, the journeys from Xi’an to Beijing and to Shanghai take, respectively, 7 hours and 10 hours less than before (11 hours and 15 hours). The Beijing–Shanghai High-Speed Railway allows a passenger to finish the 1,305-kilometer journey within 4 hours. Although after the personnel changes in the Ministry of Railways, trains were generally slowed to a maximum speed of 300 km/h, reducing operating costs and risks while improving efficiency, the fastest trains would take 4 hours and 48 minutes to travel from Beijing to Shanghai. Additionally, a slower class of trains running at 250 km/h was also operated for those lines, making more stops and charging lower fares and would take 7 hours and 56 minutes to complete the Beijing–Shanghai journey. Nowadays, whether a city is connected to the high-speed railway system or not becomes an important factor to influence external investment decisions.

The rise of new city clusters along the high-speed railways would upgrade component cities and towns Emerging city clusters along the high-speed railways will help to turn key cities into metropolises, secondary or ordinary cities into large cities, and central towns into medium-sized or small cities. For example, along the Beijing–

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Shanghai line, the Shanghai government positioned Hongqiao Station (in the west of the city) as a comprehensive transportation hub, and its surrounding areas would be built into a business zone with a coverage of 86 km2, including Minhang, Changning, Qingpu, and Jiading districts. It was said that Shanghai used to build its hopes on the individual development of the east (Pudong District), but now it finally switches the attention to the west. The Shanghai– Nanjing Intercity High-Speed Railway was designed to include 31 stations, but now only 21 were put into operation with 10 stations saved for fostering future economic growth centers. High-speed rail stations will bring about massive flows of population, materials, capital, and information. Surrounding cities should learn to take advantage of the impetus effect of high-speed railways and formulate a proper urban development mode after analyzing the relations among resources, economy, industry, and population factors and their own resource advantages based on reality, in order to form a coordinated and interactive relationship among those cities and bring the development of those cities to a higher level.

High-speed railways facilitated maximized resource allocation and accelerated the adjustment and improvement of industrial layout Statistics showed that in 2010, China’s social logistics cost amounted to RMB7.1 trillion, accounting for 18.1% of the GDP, twice as much as the cost of developed countries. Additionally, according to the estimate by the United Nations Development Programme, the circulation cost of China’s manufactured products approximately took up 20%–40% of the total cost while in developed countries, this proportion was 9%–10%. And among the national logistics costs, industrial products constituted 88.8%. The formation of a high-speed railway network created plenty of opportunities for us to maximize resource allocation, adjust industrial layout, raise logistic efficiency, and lower logistics and transportation costs. Aside from the long-range planning of “four vertical and four horizontal railways,” the Wuhan–Guangzhou High-Speed Railway connected the north to the south and Beijing–Shanghai High-Speed Railway linked the Bohai Economic Rim and Yangtze River Delta Economic Zone. It can be predicated that Guangdong, Hong Kong, and Macau will accelerate the industrial transfer towards inland areas, Changsha–Zhuzhou–Xiangtan City Cluster would be increasingly integrated in the Pearl River Delta Economic Zone, Wuhan City Circle gradually would exert its influence to coastal and riverside cities, and the economic ties and cultural cooperation between the Pearl River Delta and Guanzhong urban agglomeration would be redefined. The rapid transit system

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would promote the coordination of city clusters and enable internal industries and enterprises to achieve better resource reassignment and allocation and layout arrangement. As a result, corridor industrial economic belts along the railroads and new coupling effects between cities were formed, remarkably improving the structure, efficiency, and results of resource allocation.

Urbanization will create considerable business opportunities The practice of urbanization proved that when a population accumulates to a certain amount, there will be a demand for the tertiary industry, such as postal and telecommunication services, banking services, and hospital services. In around 1965, Japan’s urbanization rate reached 65%–70%. During that time, industries which generated a higher profit growth rate than the industrial average were composed of service, retail, real estate, and food and beverage industries. Statistics showed that among the existing 57,000 business agglomerations in Tokyo, 34,300 (60.2%) were built near the metro or light rail stations and more than 90% of the department stores were located within 100 meters of the stations. Prior to 2010, according to the information from China’s National Bureau of Statistics, the service consumption expenditure only accounted for 40.1% of the household consumption expenditure, while the proportion in developed countries could be as high as 60%–70%. It can be predicated that urbanization resulting from the construction of a rapid transit system in China will accelerate the development of the broad-sense service industry and the growth of real estate, logistics, tourism, culture, music, publishing, catering, and fitness industries. The agglomeration effect of city clusters will especially benefit the intermediary services industry, such as financial services, and accounting and legal services. Besides, there will be a rising demand for low-rent and affordable housing in the cities along the highspeed railways. At the same time, interchange cities will face an increasing need for passenger and freight transport services via intercity railways (trains and metros), public buses, and taxis, as well as commercial and catering services. It should be pointed out that the culture industry is an important component of the modern services industry and also a promising industry. During the 30 years since the start of the Reform and Opening up era, China’s middle class has developed to a certain degree and will continue to grow in the future. How to meet the increasing cultural and spiritual needs of the group is a challenge faced by China’s cultural industry. The advance of urbanization probably means a chance for the industries with excess production capacity. In 2009, the total retail sales of consumer goods was

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expected to increase by over 15%, the highest growth rate in the most recent 20 years which indicates the huge consumption potential of China after the financial crisis.

The construction of urban agglomerations and metropolitan areas promoted the development of strategic emerging industries Strategic emerging industries are also a valuable indicator to observe economic growth and are composed of new energy, new materials, bioscience, biological medicine, information networks, marine development, geological prospecting, and other industries. Now, the U.S. no longer regards “re-industrialization” as its priority strategy in reshaping its competitive edge and shifts to the policies and measures of vigorously developing emerging industries, encouraging technological innovations, and supporting medium- and smallsized enterprises. European countries have already made massive investments in exploring low carbon economy, biotechnology, and the “internet of things,” generating profound influence on the structural adjustment and economic development of China. I think that high-speed rail construction which brings about enormous economic benefits and the rise of urban agglomerations is also a strategic emerging industry and will exert a driving effect on other emerging industries within the same region. Therefore, it will create a far-reaching impact on the transformation of China’s economic development mode and the advance of the social economy, if the government can seize the opportunity offered by the emergence of urban agglomerations and metropolitan areas resulting from the construction of high-speed railways and urban rail transit to accelerate the development of emerging industries in the areas of new energy, new materials, low carbon economy, biotechnology, and the internet of things and promote the large-scale revolution of new technologies such as green energy, green transport, and green architectures.

The high-speed rail economy will bring a new round of urbanization boom in China and facilitate the migration of the rural surplus labor force to cities Ming Lu, Professor of Economics in Fudan University (China), once mentioned in an article that the difference in population size of different cities in China was far smaller than the world standard when he made a comparison based on the data of 2000. The current issue is how to transform the 160-million rural migrant workers into permanent urban residents, accommodate another 300

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million members of the rural surplus labor forces in the cities, and foster a certain portion of these people into the middle class. This is the key to domestic demand growth and economic structural transformation. However, China’s central and western areas lagged behind in urbanization, compared to the rapidly-developed eastern region. It is reasonable to build a batch of medium and small cities and small towns in areas with relatively high carrying capacity of resources and environment and accelerate the accommodating of industrial transfer in Central and Western China. But, it does not mean that China should not switch back to the old path of “priority development of medium- and small-sized cities and small towns” and carry out “townization.” To force the newly-development city clusters to wait for the growth of small towns is irrational. Now, let us talk more about the high-speed rail. The development of high-speed railways and rail rapid transit in China propelled the time-space compression of urban agglomerations and metropolitan areas to a new level and changed the world’s impression towards the high-speed rail age. This is not only an unprecedented accomplishment of the urban economy, but will promote the unpredictable leap forward of China’s economy across its vast territory, and facilitate the industrial structural adjustment, maximized resource allocation, and the shift of economic development pattern. It will lead us to the urban era. It is incomparable with the patterns of Japan and some European countries with a narrow territory. This great achievement cannot be undermined by the corruption of the railway minister Liu Zhijun. I think that the problems of China’s railway system can boil down to two aspects apart from the corruption. One is that too many projects were carried out at the same time. Efforts should be first concentrated on several vital projects like the construction of the Beijing–Guangzhou and Beijing–Shanghai railways and more projects would be undertaken later based on local conditions and previous experiences. Second is the high indebtedness which is also related to the above mentioned excessive projects. Of course, it is still questionable whether every train should run at a speed of 350 km/h, every line should construct ballast-less high-speed tracks, every high-speed railway should be brand new or can be a combination of new railways and existing ones like in Europe, train fares should be lowered or can be differentiated into several prices, and the corruption of Liu Zhijun has impacted the safety of highspeed railway construction. There may be serious decision-making mistakes and other blunders, but these are a result of the mixing up between government administration and enterprise management and belated structural reform in the Ministry of Railways.

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As for the question of heavy investment in railway construction and other similar super-large infrastructure construction projects, and subsequent high operational costs, I believe that we should focus on the social marginal benefit of infrastructure investment rather than consider the economic benefits and investment returns of the construction project itself. It was reported that as the high-speed train service between Beijing and Shanghai was about to open, regional governments along the line invested heavily in building supporting massive infrastructure, comprehensive supplementary facilities, and environment renovation works. Lands cleared up by the supporting construction projects will be auctioned by rail investment companies and regional land resources bureaus and the auction proceeds will be shared by the two parties according to a certain ratio after repaying the debts of rail construction. Behind the heavy investment is the expectation of a new round of land appreciation driven by the high-speed rail economy. Some experts suggested that taking Nanjing City as an example, the distance between Nanjing South Railway Station and the downtown was around 10 km and judging from the present situation, the local government was able to recover its total rail investment as long as it sold several tracts of lands and cultivated enormous benefits by developing the rest of the land. Besides, investment in public and infrastructure projects which cannot recover the money in a short term but have special benefits to the overall economy should receive more support from governmental appropriations rather than heavily relying on government bonds and bank loans. It should be remembered that when Bill Clinton was elected the President of the United States in 1993, he fulfilled his promise made during the election campaign by announcing the development of the National Information Infrastructure (NII). This project for expanding the “information superhighway” was expected to consume USD200 billion in 20 years and be mainly financed by private enterprise. But it was said that the government’s long-term investment was approximately USD30 billion, equivalent to the money put in the Strategic Defense Initiative, or “Star Wars” Program. This indicated that for such a large project like building the “information superhighway,” even this capitalist country of America had to resort to government investment. Unexpectedly, the Wenzhou train collision on July 23, 2011 raised hot debates on the safety of high-speed rail transportation. In fact, like any other transportation vehicles, high-speed trains also have a breaking-in period. And even regular operation may result in accidents. The Intercity-Express (ICE) of Germany started service on June 2, 1991, with a maximum speed of 250 km/ h and recorded zero accidents until the Eschede train disaster in 1998. A highspeed train carrying 287 people derailed and caused the deaths of 101 people

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and with another 194 people injured. After a five-year technical review and trials, the German public finally restored their confidence in the high-speed rail. Nowadays, ICE remains the first choice of travel for Germans. Similarly, on April 25, 2005, a seven-car commuter train came off the tracks on the JR West Fukuchiyama Line in Amagasaki, Hyogo, and 107 people were killed and over 500 others were injured. On the surface, it was caused by speeding by the train driver in an attempt to make up for lost time. But the investigation and trails focused on the management of the train company, and it was thought that the narrow leeway in the train’s schedule was the main cause for the speeding. In the end, West Japan Railway Co. President was believed to be the person who was ultimately responsible and so he was charged with negligence. By relating these accidents, I want to prove that even the safest train may be susceptible to unpredictable accidents. What matters is not the accident itself but to find out the cause, learn a lesson, and remove hidden dangers. After the 7.23 incident, Eric Jackson published an article named “Wenzhou Train Collision in the Eyes of a Foreigner” in the Chinese version of The Wall Street Journal on August 3. After expressing his deep sympathy to the families of the dead and injured in the accident, he soberly put forward, “In today’s microblogging world where messages spread rapidly, it is especially important to remain calm and keep a clear mind.” In particular, the article mentioned, “Although some departments had not performed to their best in this accident, we cannot deny China’s highspeed railway and its advantages just because of one disaster.”

Urbanization Bonus and Farmers-Turned Workers Speaking of urban development, it is impossible to avoid the urbanization bonus. Governments attract outside investment as they believe capital will create an urbanization bonus. But in China, the 160 million migrant workers are the real creators of the urbanization bonus, because they can provide cheap labor for cities’ industrialization. So, to achieve the urbanization with Chinese characteristics, the government should not only expand the size of cities and towns, but also transform the migrant workers into urban residents. What is the urbanization bonus? It refers to the benefits gained by continuously reducing the gap between urban and rural areas in urbanization after deducting the original rural earnings. In fact, the urbanization bonus arises with economic development, and is attributable to several factors, such as agglomeration economies, economies of scale, demographic dividends, and differential ground rents.

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First, as modern industrial production tends to be centralized, industrial capital is likely to accumulate and expand in the surrounding areas. New factories will be established and a large number of farmers will be attracted to work there, away from the countryside and agricultural work. These workers will become industrial laborers. As a result, the number of workers and the middle class will grow and new urban regions will be formed. The construction of urban infrastructure accelerates population flow and is beneficial to the concentration of labor, capital, and other production factors, thus generating agglomeration economies. Benefits can be gained through the centralized operation of capital turnover, commodity circulation, labor force training, technological innovation, product upgrade, and market competition by taking advantage of the clustering of production activities. Here, urban infrastructure construction works as a trigger which not only initiates economic development but also creates an urbanization bonus. Eastern coastal areas seized the opportunities offered by the Reform and Opening up policy to build large cities, such as Shenzhen and Shanghai (Pudong New Area), exerting agglomeration and radiation effects. In particular, Shanghai focused on the infrastructure construction of bridges and tunnels across the Huangpu River when developing the Pudong New Area. Take Xiamen City as another example. Xiamen is located on the southeastern coast of China and faces Jinmen Island across a stretch of sea water. It used to be a war front in the Chinese Civil War and a city with poor transportation infrastructure and in need of economic construction. After the Reform and Opening Up period began, the Standing Committee of the National People’s Congress approved the establishment of special economic zones in Shenzhen, Zhuhai, and Shantou in Guangdong Province and Xiamen in Fujian Province. Between 1981 and 1983, Xiamen Gaoqi International Airport was built thanks to USD21 million in loans from Kuwait under the permission of the State Council which generated an urbanization bonus greater than the economic growth. Therefore, we should focus on the social marginal benefit of infrastructure investment rather than the economic benefits and investment returns of the construction project itself. Similarly, the development campaign of the western regions also meant a historic opportunity for the construction of cities and towns. The 10th Five-Year Plan invested RMB100 billion to build the 18,000 km rail network, RMB120 billion to construct 15,000 km roads (within 20 years), and almost RMB300 billion to undertake West–East Gas Pipeline projects (Phase I and II). Among the above infrastructure construction projects, eight expressways passed through 452 townships or towns and 41,000 villages, driving the development of a considerable group of small towns. Second, within urban industrial clusters formed based on the highly-

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specialized division of labor and collaboration, each medium- and small-sized enterprise can achieve economies of scale through establishing an external cooperation relationship, thus realizing the integration between flexible production and mass production. Besides, the construction of the high-speed rail network and metropolitan areas will accelerate the rise of a series of city clusters and strengthen regional industrial integration and economies of scale. Third, a convenient transportation network is beneficial to the population flow and will attract young adults and the educated labor force to cities which will have earlier access to the demographic dividend. In addition, the technological development of high-speed rail transit will bring about dramatic changes to cities in the aspect of time-space compression and will further promote the movement of the population and the realization of the demographic dividend. Fourth, the growth of the urban economy and constant industrial upgrading contribute to the evolution of industrial structure. This gives rise to differential ground rents resulting from the economies of agglomeration. As a result, economic benefits from large cities are generally larger than from ordinary cities and those from downtown areas are always better than ones from the suburbs. In 1984, the World Bank mentioned in an investigative report of China, “Experience from other countries suggests, for example, that the economic cost of land can rise by as much as 25% per kilometer as one moves from agricultural land on the edge of an urban area to core land in the inner city. If the economic cost of agricultural land on the edge of a Chinese city is assumed to be RMB0.8 per square meter, the economic cost of land in the city center would be about RMB10 per square meter for Wuxi, for example, which has a radius of about 10 km, but would be as much as RMB120 for Shanghai, which has a radius of 20 km.” The report concluded, “For the Shanghai Bicycle Factory, for example, the economic costs of production in its present location are at least RMB10–20 per bicycle greater than if it retained the same excellent management but was located in a nearby medium-sized city,” as the enterprise can avoid certain additional costs of locating in a large city.1 Practices of both China and Western countries indicated that it was necessary to reflect the differential income in urban land price, land rent, and land tax. When formulating land or property tax policies, local governments have to make full use of the special economic lever of the urban economy — differential ground rent, and make enterprises fully aware of opportunity cost, sunk cost, marginal benefit, and differential ground rent when making spatial decisions. It will drive certain industries out of cities, moving towards where the cost is lowest based on the principle of comparative cost. As those industries

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are located away from large cities and closer to resource deposits, they give place to new industries or industries with high value added, thus pushing the development of industrial structure to a high level in large cities and central urban areas. In the above analysis, it seems that the urbanization bonus is only related to economies of agglomeration, economies of scale, demographic dividend, and differential ground rent in industrial development and does not involve farmers-turned workers who are divorced from agricultural work. But it should be specially stressed that the real contributors of the urbanization bonus are those farmers. In China, it refers to the 160-million rural migrant workers who lived in cities but who are unable to get permanent residency permits. Although industrial capital of industrialization has built industrial enterprises, without migrant workers providing the labor force for industrial production, capital cannot work. Thus, everything related to industrial development, such as economies of agglomeration, economies of scale, demographic dividend, and differential ground rent will come to nothing. After China implemented the Reform and Opening Up policy, cities introduced capital and encouraged enterprises to recruit migrant workers as a source of cheap labor force. Upon entering the new century, many transnational industrial groups relocated their manufacturing factories to China. On the one hand, industrial groups reduced the cost of products by paying low wages but increasing competitiveness. Chinese cities gained an urbanization bonus as a joint result of economies of agglomeration, economies of scale, demographic dividend, and differential ground rent. Farmers who were divorced from agricultural work were the driving force for all those. Without those farmers-turned workers, even the most powerful industrial capital will turn out to be a pile of steel. On the other hand, while industrial enterprises were set up during China’s industrialization and urbanization, the middle class was not formed or increased proportionately due to the household registration system. Over 100 million farmers-turned workers contributed to industrial output and revenue to cities but they were not granted urban permanent residence permits and they were excluded from regular employers and the rest of the urban population. At the same time, since they still occupied a farmland in their villages, this process inhibited the largescale development of agriculture. Additionally, rural migrant workers lived in urban slums and tightened their belts in order to save money to build new houses in their hometowns, which they may have no chance to move into. Moreover, due to the urban-rural household registration divide, those migrant workers had to return to the villages to find spouses and their children would be charged sponsorship fees and could only be enrolled as transient students

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if they went to schools in cities. And urban education did mean those migrant children would have equal access to further education or universities as native students. Migrant workers were prevented from enjoying basic urban welfare and services, not considered as the main consumers of consumption, and unable to participate in the upgrading of urban consumption structure. City governments (enterprise groups as well) did not need to provide urban welfare and social services such as housing, health care, children’s education to migrant workers and could save this part of expenditure as an urbanization bonus. This is a special kind of urbanization bonus created by China’s rural migrant workers to the urban economy. Cities give migrant workers “neither the right of settling in cities nor basic urban welfare and services.”2 Therefore, the result of governments reaping all the benefits from the urbanization bonus will be a rich country with poor people. One who has visited Europe and the U.S. will know that there are a large number of illegal Chinese immigrants (mostly, from Wenzhou and Fujian) in New York, Los Angeles, Paris, and Italy. On the surface, it was a result of the attraction and support from the pre-existing expatriates, but in fact, the local government looked the other way when enforcing immigration laws because the labor force was needed in order to achieve city development under the pressure of domestic short labor supply. Taking the U.S. as an example, illegal workers were engaged in labor-intensive industries which native residents were unwilling to do them, such as construction, farming, catering, and laundry services. Therefore, capitalist governments of developed countries knew that in certain instances, they had to relax control over illegal workers and illegal immigrants in order to reap the urbanization bonus. It has almost become a common practice. But any government cannot rely on this portion of the urbanization bonus for a long time, so they will, after a certain period, legalize those undocumented migrants for all sorts of reasons, including pardon and amnesty, to enable those people to enjoy the urbanization bonus created by them. When Barack Obama moved into the White House, he expressed many times the ambition to reform the immigration system, bringing hope to the 12 million illegal immigrants in the U.S. A report from the U.S. Immigration Policy Center revealed that the legalization of illegal immigration had done more good than harm to the U.S. economy. Because once illegal immigrants receive residency permits, they will step out of the shadows and earn more and spend more, and their legal employment and tax payments will inject new vitality to the U.S. economy. However, if those illegal immigrants were forcibly repatriated, it would cost the government USD206 billion in five years, about USD41.2 billion per year, equivalent to eight times the annual expenditure of

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the Department of Homeland Security. This is why several hundreds of millions of migrant workers must be turned into new urban residents. According to the statistics from Chang Xiuze, between 1999 and 2007, China’s total savings rate rose from 37.1% to 51.8%, an increase of 14.7 percentage points. Among this number, the governmental saving rate grew from 2.6% to 10.8%, 8.2 percentage points up; the enterprise savings rate increased from 14.6% to 18.8%, up 4.2 percentage points; and the household savings rate moved from 19.9% to 22.2%, up only 2.3 percentage points. In the “triple jump” growth of 8–4–2 (if just considering the integers), households were at the lower end while the government was at the higher end. This explained why the rise of China resulted in a rich country but poor people: The government occupied a considerable portion of urbanization bonus. In the 30 years since the start of the Reform and Opening Up era, farmers-turned workers have made large contributions to the prosperity of cities but they and their children were prevented from being registered as urban residents and enjoying the urbanization bonus created by them. Recently, the workers of Guangdong Honda factory staged a strike for a pay rise, and 18 Foxcoon employees attempted suicide due to their discontent over overly strict labor camp management. These incidents reflected the basic appeal of farmersturned workers for people-oriented economic development and a harmonious society. So, to realize the real urbanization with Chinese characteristics, the government has to solve the urban-rural household registration divide and offer urban welfare for the existing 100 million rural migrant workers and future rural migrants. The key is what policies the government should adopt in order to make those rural migrant workers truly become urban residents and have the economic capacity to consume cars and houses, like what Western countries did to legalize illegal immigrants. In addition to the reform of the household registration system, the government has to allow the free transfer, mortgage, and sale of rural land use rights. Rural migrant workers use the money received through transferring their land use right and village houses to settle down in cities. Like pre-existing urban residents, the new residents will also be entitled to equal employment opportunities, house and car purchases (renting first), education services to children, and urban healthcare and social insurance. Once hundreds of millions of migrant workers become new urban residents and own urban houses, it will bring about consumption growth of household equipment and appliances. At the same time, only when a large quantity of new residents drive a new round of urbanization will there be a 20-year high economic growth fueled by the automobile and housing consumption of the middle class in China.

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Urban Agglomeration Planning and High-Speed Rail Network: China’s Urbanization Marches towards a New Urban Age The future urbanization of China, according to the 12th Five-Year Guideline, is supposed to build “two horizontal and three vertical” urban agglomerations. 1. Along the Longhai Railway: Xuzhou city cluster, Central Plains Economic Zone, Guanzhong urban agglomeration, Lanzhou city cluster, and pan-Urumqi city group. 2. A l o n g t h e Ya n g t z e R i v e r v a l l e y : Ya n g t z e R i v e r D e l t a u r b a n agglomeration, Wanjiang River urban agglomeration, city clusters in the middle reaches of Yangtze River (Changsha–Zhuzhou–Xiangtan City Cluster, Wuhan City Circle, and Nanchang–Jiujiang City Cluster), Yichang–Jingzhou–Jingwen urban agglomeration, and Chengdu– Chongqing Economic Zone. 3. Along the eastern sea border from Dalian City (Liaoning Province) to Zhanjiang City (Guangdong Province). 4. Along the Beijing–Harbin Railway and Beijing–Guangzhou Railway from Harbin, Shenyang, and Beijing to Guangzhou and Hong Kong. 5. Urban agglomerations along the newly-developed western vertical line: Huhhot–Baotou–Erdos urban agglomeration (in Inner Mongolia), central Guizhou urban agglomeration (centering on Guiyang and covering Zunyi, Kaili, Anshun, etc.), central Yunnan urban agglomeration (centering on Kunming), and southern Yunnan urban agglomeration (including Gejiu, Kaiyuan, and Wenshan). Beside the above-mentioned urban agglomerations, “four vertical and four horizontal” high-speed railways were under construction. The “four vertical lines” refer to Beijing–Shanghai, Beijing–Hong Kong, Beijing–Harbin, and Hangzhou–Fuzhou–Shenzhen high-speed railways, and the “four horizontal lines” are Xuzhou–Lanzhou, Shanghai–Kunming, Qingdao–Taiyuan, and Shanghai–Wuhan–Chengdu high-speed railways. At present, the first “two horizontal and two vertical” urban agglomerations which had already been listed in the 12th Five-Year Guideline were gradually being connected to each other. The vertical line in Western China from Huhhot–Baotou–Erdos urban agglomeration, to Guanzhong urban agglomeration, then to Chengdu–Chongqing economic zone was newly

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developed. These urban agglomerations are expected to have population capacity of 50 million–100 million people at the most or 10 million–25 million at the least, and will become the major carriers of the rural-turned-urban population. The Zhengzhou–Xi’an section of the Xuzhou–Lanzhou HighSpeed Railway went into operation in 2009, the Beijing–Shanghai high-speed rail started service in 2011, and the Beijing–Guangzhou section of the Beijing– Hong Kong high-speed rail will open to traffic in 2012. High-speed railways between Chongqing and Kunming, and Chongqing and Guiyang were also under construction. The construction of the high-speed rail network will effectively connect urban agglomeration economies to social development. It was reported that the future spatial layout of urbanization would be divided into five categories: mega-urban agglomerations, large urban agglomerations, other urbanized areas (metropolitan areas, city circles, and urban belts), border or port cities, dispersedly distributed medium and small cities, and small towns. Differentiated urbanization plans will be implemented accordingly. Those five types of urban spaces will contain around 1 billion urban population and facilitate the transformation of China from peri-urbanization to urbanization. This can basically satisfy the demand for urban space when China’s population peaks at 1.46 billion in 2030 and the urbanization rate reaches 65%. Those five kinds of cities provide a clear outline for the future urbanization of both cities and towns in China. According to the estimate made by Sun Jiuwen, Head of the Research Center of Regional Economies, Renmin University of China, a one percentage point increase in urbanization rate will mean 12 million more job opportunities in cities. Following this logic, it can be predicted that the urbanization rate during the 12th Five-Year Guideline will rise two percentage points per year. The 11th Five-Year Guideline was expected to increase the urbanization rate by four percentage points during the five years, but the actual annual growth rate was 1.2 percentage points.3 A French newspaper, Nouvelles D’Europe, carried an article named “BeijingShanghai High-Speed Rail Brings about More than Just Speed” on June 15, 2011. It said, “It is an epoch-making achievement for land transportation to compress the travel time for 1,300 km into five hours. Despite the highlydeveloped global airline industry, especially in developed countries like the U.S. and Europe, the rail transportation which is less effected by the weather is more effective than airplanes considering the increasingly intensive changes of climate. The high-speed railways largely compensate for the biggest disadvantage of rails compared to airplanes (speed). Last year, the significant disruption of European air traffic was caused due to the dangers posed by

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volcanic ash drifting from Iceland, triggering the debate over the construction of high-speed rails across Europe.” The newspaper continued, “Undoubtedly, the significance and role of Beijing–Shanghai high-speed rail are profound and enormous from the perspective of a nation. The long-distance transportation capacity also reflects the strength of a country. The more people are transported per unit time and the longer the distance is, the stronger the country’s overall logistics capacity will be. In the vast territory of China, as long-distance population movements become increasingly frequent, the completion and improvement of railways, especially the high-speed railways which have a large transport capacity and a fast speed, will realize not only super-large-scale population transport but also the nationwide configuration of all kinds of production factors in the new environment.” To borrow the words of a Chinese scholar, “When China’s high-speed railways are being built along with the most large-scale urbanization in human’s history, when three world-class economic zones are connected by four to five hours travel on the high-speed railways, and when the ‘four horizontal and four vertical’ high-speed rail network links up the most of China, the changes brought about by the high-speed railways are not merely about the speed, but a shift in the concept of space and a revolution of lifestyle of the Chinese people, the formation of the world’s largest unified market, and the gradual emergence of Chinese standards in the global modernization.” The article ended with the conclusion, “It can be said that what the highspeed railways, including Beijing–Shanghai high-speed rail, bring to China is not only a faster speed, but also a deep reflection of China’s mode, standards, and road system.” 4 Therefore, there is reason to believe that the urbanization featuring high-speed railways, urban agglomerations, and metropolitan areas will usher us into a new urban age.

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Financial Globalization: Opportunities and Challenges for the Renminbi as a Global Currency

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Yen Appreciation Is a Timeless Topic In the midst of today’s financial revolution, financialization of the economy, and financial globalization, the renminbi is facing opportunities and challenges as a “global currency.” Here, we have to discuss yen appreciation, a story that never gets old. Japan’s economy was in ruins after World War II. In 1949, Japan started to use a fixed exchange rate of 360 yen to 1 U.S. dollar for 22 calm years. This drove the complete recovery of the Japanese economy. In the 20 years between 1955 and 1975, Japanese industries developed rapidly. The rural population moved and the number of urban families increased by 80%. This became a great driving force behind the increase in domestic demand, the production and consumption of household appliances, and economic growth. In the 1960s, Japan’s economy developed rapidly with an annual growth of over 10%. By 1968, the GDP of Japan exceeded that of the Federal Republic of Germany. The trade surplus increased gradually. In 1971, the United States negotiated with Japan on the topic of yen appreciation. The U.S. Secretary of the Treasury requested a 18% appreciation of the yen, while Mizuta Mikio, Japanese Minister of Finance, insisted on an increase below 17%. Mizuta Mikio reasoned that when Japan readopted the gold standard in 1930, a 17% appreciation of the yen had resulted in an economic recession. The Japanese thought that the number 17 is very unlucky and it was a taboo in the yen exchange rate. Mizuta’s story may have convinced the United States, and the Smithsonian Agreement was reached by the Group of Ten at the Smithsonian Institution. Japanese appreciation of the yen was set at 16.88%. The exchange rate was based on a rate of USD1 to JPY308, with a fluctuation band of plus-minus at 2.25%. This began the first stage of yen appreciation, and the yen changed from a fixed exchange rate to a floating exchange rate. Japan’s economic growth once fell from 10.2% in 1970 to 4.3% in 1971, the year the Smithsonian Agreement was signed. However this rebounded once it reached the trough in March 1972. Japan’s exports maintained a 19% growth in 1972, and trade surplus was at USD5.1billion. The United States had not defeated its opponent in the first round, and so they tried again after two years. In February 1973, the United States announced that the U.S. dollar would depreciate 10% against the gold. Japan had to transition to a floating exchange rate for the yen. Thus, the yen entered its second stage of appreciation. Between 1973 and 1985 before the Plaza Accord, the yen gradually appreciated to a floating exchange rate of USD1 to JPY250.

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During this period, Japanese cars won a larger and larger market share due to their low cost and high quality. In 1975, Japan replaced the United States as the largest exporter of cars in the world. Japan’s trade surplus also widened every year. The amount was USD8.7 billion in 1981, and it increased to USD46.1 in 1985. Exports to the United States grew by 74%. By the mid-1980s, Japan was the second largest economy in the world, with an economic size double that of Germany. In 1985, Japan’s net foreign assets reached USD129.8 billion, and replaced the United States as the largest creditor nation. In turn, the United States became the largest debtor nation. The United States could not bear such economic “threats” and friction. In September 22, 1985, the ministers of finance from the United States, the United Kingdom, West Germany, France, and Japan signed the Plaza Accord (which the Japanese greatly regretted) at the Plaza Hotel in New York. It ruled that the U.S. dollar will depreciate 30% against the other major currencies in two years. The yen entered the third stage of appreciation, and began a decadelong cycle of appreciation, starting with USD1 to JPY250 and ending with USD1 to JPY87. In 1995, the exchange rate even went to USD1 to JPY80. An expert from the Institute for International Economics once commented that the U.S. policy was to make the Japanese cook themselves in their own pots. From the end of WWII to the beginning of the 1980s, the economic growth rate of Japan remained higher than that of the United States and major European countries. After the signing of the Plaza Accord, Japan’s economy deteriorated dramatically due to the yen appreciation and export decrease. Between 1986 and 1987, the economy of Western developed countries grew from recovery to prosperity while Japan’s economy was under the extreme appreciation of the yen (or endaka, as it was called). To reverse the economic downturn, the Japanese government switched to activating domestic demand by adopting expansionary monetary and fiscal policies. Since January 1986, the Bank of Japan successively lowered the interest rate by five times and cut the discount rate to a historic low of 2.5% in 1987 from 5%, attempting to stimulate economic growth with a loose monetary policy. Japan had already initiated three “consumption revolutions,” and household appliances, such as color television sets and air conditioners, as well as automobiles, became quite widespread. The last chance for economic growth was housing commercialization. It has to be mentioned that prior to 1985, more than 85% of Japan working-class families lived in publicly subsidized apartment units. Owing to the Plaza Accord, Japanese people earned at least 20% more than before. So, the government started to promote the large-scale commercialization of housing and commercial banks made lots of housing

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loans to citizens. At the time of a low interest rate, real estate prices kept rising and stock markets were booming. Meanwhile, a large amount of “hot money” flowed in Japan resulting from the expectation of appreciation of the yen, and the Japanese government’s intervention in the market to maintain the exchange rate by increasing money supply. Leveraging yen appreciation and the prosperity in the real estate industry and stock markets, the Japanese government set the money printing presses in motion, and in 1989 alone, the money supply saw twodigit growth. Since the Euro-yen bond market was loosely regulated, financial institutions and enterprises in Japan also raised capital at low interest rates on the international market for domestic use. With excess capital in the markets and low interest rates, it was natural that capital flowed into the real estate industry and stock markets where profits were most likely to be made. As a result, house and stock prices soared and a bubble economy was formed. Additionally, the land price rise in turn induced Japanese companies to relocate their factories to Southeast Asia and China which offered cheap labor in order to free up the land for real estate development. These companies not only reduced production costs, but also received a large amount of capital by relying on land appreciation after compensating the removal expenses. Japan’s economic bubble was at its peak in 1989. The Nikkei index was around 13,000 points in 1986 while it surged to 38,957 points by the end of 1989, a threefold increase in four years. During the same period, the land price in downtown Tokyo rose by 2.7 times. This increased the purchasing power of the Japanese who later travelled all around the world, and bought up property in places like Hawaii. Japan’s Mitsubishi Estate Company spent USD1.37 billion to acquire control over the Rockefeller Center complex (including14 large office buildings) in New York and Sony Entertainment of Japan purchased Columbia Pictures. It seemed to some that the Japanese intended to buy up the United States and this stirred serious resistance from some Americans. As a response, Sony co-founder and chairman Akio Morita, and the then Minister of Transportation and leading LDP figure Shintaro Ishihara co-authored The Japan That Can Say No: Why Japan Will Be First Among Equals in 1989. The frantic house and stock prices increase and rampant speculation pushed the Japanese government to take decisive measures. On November 25, 1989, the Bank of Japan raised the discount rate to 4.25% (further to 6% in August 1990), in an attempt to prevent banks from lending money to speculators through implementing a tight monetary policy. Unexpectedly, this move became the last straw that broke the camel’s back and it pricked the economic bubble. In the early months of 1990, the Nikkei Stock Average had dropped to JPY29,000 from an earlier high of JPY38,000. The land prices in large cities were drifting down and

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between 1991 and 1992, the residential land price decreased by 22% in Tokyo, 36% in Osaka, and 13% in Nagoya. Japan’s bubble economy had come to an end. It now appears that although the rapid appreciation of the yen was related to the pressure from the United States in the Plaza Accord, the Japanese government’s inability to deal with the appreciation pressure, the decision to substantially cut the interest rate after yen appreciation, and the adoption of an overly loose monetary policy inflated the economic bubble. Everything has two sides. Despite the fact that the Japanese people have been lamenting that the 1990s was a “lost decade,” the annual growth rate of the GDP, though lower than that of the U.S. which was 3.4%, remained at 1.3%, making Japan the world’s second largest economy. Borrowing the words of Tang Chunfeng, “There were no significant rallies in Japan’s economy in a real sense, nor were the real recessions.” After the Plaza Accord, the yen went up, bringing considerable benefits to Japan. This forced industrial capital to move towards the point where the minimum cost is determined according to the principle of comparative cost. Japan started large-scale overseas investment. Tang Chunfeng revealed a set of data in his article published on August 6, 2009, in the Global Times. The article provided us with information about the benefits of yen appreciation. In 2004, Japan’s direct export was just JPY61 trillion, but the total sales of overseas Japanese companies reached JPY155 trillion, more than 2.5 times of the former. If directly converted into GDP, those sales would contribute USD3.5 trillion, accounting for 71.85% of Japan’s GDP. Meanwhile, the foreign assets of Japan grew to USD4.19 trillion, including the land and factories brought or built in other countries. If the above two factors are all taken into consideration, the total capital owned by Japan in other countries will amount to USD7.69 trillion (adding up to USD4.19 and USD3.5 trillion). This was a conservative estimate; however, it was 1.58 times the domestic GDP of Japan. It seemed that Japan had built a wealthier “nation” overseas. In 2004, Japan’s GDP reached USD4.87 trillion. With the overseas profits-turned GDP included, the total GDP of Japan would be as high as USD12.57 trillion, outnumbering that of the United States by USD0.83 trillion (equivalent to the U.S. Treasury securities held by China up to May 2009). That is to say, Japan accounted for one third of the World’s total GDP (USD35 trillion) in 2004. The United States was not the real No. 1 economy in the world. Instead, Japan was the biggest superpower.

Here, it reminds me of a political joke. It is said that once a Japanese emperor visited Brazil and one of the welcoming Japanese emigrants told the emperor, “I am honored to report to the Majesty that your people have owned a piece of

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land larger than the area of Mainland Japan.” Being very excited, the emperor fell to his knees with tears in the eyes. It is proper to state that although the yen appreciation brought about economic downturns and the bubble economy, the industrial capital of Japan made great achievements in overseas large-scale investment.

Financial Revolution and Financial Globalization Three revolutions have reshaped the modern world’s social and economic landscape. The first was the Industrial Revolution which was marked by the transition from human production methods to machine production, along with the increasing use of electric power. This revolution led to a huge leap in productive forces. The second was the Technological Revolution during which high and new technologies, replacing general technologies, became the primary forces of production. This ushered us in the Information Age and turned what was expensive and scarce into what was cheap and common. The last one was the Financial Revolution which built upon the processes of industrialization, informatization, and marketization, and ushered in a new age of capital. People called the financial developments in the 20th century the results of a “financial revolution,” as they had shaken or subverted the order in at least four aspects: First, after the collapse of the Bretton Woods System in the 1970s, currencies were no longer pegged to gold and the gold standard was abolished. Since then, money supply would not be limited by gold reserves and the dominant positions of gold, silver, and other precious metals were overturned. Second, the rapid advances in computers and information technology in the 1980s, especially internet technology, created new currency circulation channels besides cash and notes. The creation of electronic funds realized a quantum jump in the capital market and the fictitious economy and undermined the dominance of the real economy. Third, the Soviet-led Eastern Bloc composed of Communist states in Central and Eastern Europe disintegrated in 1991 and a market-oriented reform became the new direction for global economic development. As economic globalization pushed forward financial liberalization, each country gradually relaxed its control over financial activities and this paved the way for financial globalization. Additionally, it also required strengthening international financial supervision and country risk management. Fourth, in the past 30-year development of the global capital market, asset

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securitization boosted the capitalization of money. Fund management and asset securitization constituted the basis of capital market expansion and diluted the control of the indirect finances of banking. This was the most important aspect. The advance of the financial revolution realized the transition of human society from a money age to a capital age.

Three Major Features of Current Global Economic and Financial Changes The financial revolution played a positive role in fueling the development of the modern service industry, accelerating economic globalization, and capital transfer of the manufacturing industry, and promoting financial globalization and the fictitious economy around the world. This created considerable changes in the global economic and financial landscape. The new changes contained three main features.

The specialization, socialization, and marketization of industrial production accelerated the expansion of the modern service industry, especially producer and financial services During the over 200 years of industrialization, primary and secondary industries in each country always accounted for a lion’s share of the industrialization and the percentage of the service sector remained below 55% for a long time. Since the 1960s, the tertiary industry in the United States began to occupy a larger share. Subsequently, in the early 1970s, the proportion of the service industry in the United Kingdom, France, Germany, Italy, and Japan also showed a rising trend. It signaled that the demand for material goods had been basically satisfied and the social economy entered a “post-industrial era” dominated by the service industry. At present, around 60% of the world’s GDP came from the service sector. This percentage was as high as 70% in developed countries while in middle-income and low-income countries, the percentage was 49.3% and 47.5%, respectively. In 2010, the proportion of China’s service industry only accounted for 43% of its GDP (in 2003, the percentage was 50.7% in India). It worth noting that the tertiary industry in the modern economy goes beyond the scope of traditional consumer services, such as transportation, hotels, catering, and recreational facilities. Statistics showed that the proportion of consumer services appeared to have stabilized since the 1960s in developed countries and the pulling effect of economic development on consumer service

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became less and less obvious after per capita income reached USD10,000. The more the modern industries develop towards specialized mass production, the larger proportion of producer services is in the tertiary industry. Take the United States as an example. Consumer services accounted for 60% of the entire service industry in the 1960s, but the percentage dropped to 38% in 2004 whereas producer services occupied an increasingly large share. Considering the industrial revolutions in Western countries, the modern service industry including modern financial services is constantly evolving and growing along with the deepening of the social division of labor and the specialization, socialization, and marketization of the manufacturing industry. In the history of global industrial development, the manufacturing industry was the mainstay at the initial stage of industrialization; however, the service industry gradually became the principal driving force at the middle and late stages. This was an inevitable outcome of the highly-developed socialized production. It indicated that the industrial development experienced a gradual transformation from a lower to a higher stage. The organization of production also evolved from being all-encompassing to a specialized division of labor. During early industrialization, most manufacturing factories were “comprehensive” plants which could handle the production of multiple mechanical products. Later, the advance of production and division of labor created a need for specialized, large-scale, and industrialized production. Prior to World War I, there was a trend of specialized production of a certain kind of or one particular mechanical product(s) in a factory. After World War II, machinery factories no longer produced all parts of a machine, and instead, they were only responsible for a portion of key pieces and final assembly with other parts supplied by professional parts manufacturers. Meanwhile, process specialization, represented by specialized casting, welding, heat treatment, and molding plants, also arose. Later, as the industrial chain continuously extended towards upstream and downstream industries, specialization and socialization spread to the fields of research and development (R&D), design, logistics, procurement, brand marketing, supply management, information, consulting, legal services, and auditing which resulted in the emergence of the productionoriented modern service industry and increasingly specialized producer services. Since then, the division of labor in the industrial chain moved towards a direction of being more specialized, sophisticated, unique, and innovative. In the middle and late phases of industrialization, industrial division of labor entered a period of highly-developed industrialization. The manufacturing industry posed an increasingly higher demand for producer services, and the service industry gradually evolved into the main part of industries. The

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United States conducted a survey in 1997 which showed that among the total expenditures of American companies, money spent on information technology accounted for 30%, on human resources 16%, on marketing and sales services 14%, and financial services were 11%, which in total made up 71% of the aggregate expenditure. International experience suggested that when economic growth reached a certain level, further development of the secondary industry required effective support from the service industry, which would entail the specialization and socialization of the service sector and the industry capital transfer towards the tertiary industry. At that time, two trends arose in the industrialization of producer services. One was the formation of the integrated service industry which mainly focused on the needs of industrial users. As industrial users displayed more and more diversified and personalized needs, they were not satisfied with tangible products suitable for certain targets and environments. The industrial users required increasingly extensive services, from a single machine to a complete set, from machine sets to project contracting, and from turnkey projects to project consulting, maintenance outsourcing, and financial services. This allembracing service industry will help equipment manufacturers to enhance their system design capacity, production capacity of complete equipment, technological innovation capacity, trade services, and price influence in the international market. As an emerging industry, it can also extend the industrial chain, enrich the technology, knowledge, and information content of production, and improve the added value and international competitiveness of the manufacturing industry. The other trend was the rise of the modern service industry which underlined specialized and socialized services for production. It mainly referred to sectors which offer special services for producers and which develop by relying on new and high technologies (such as information technology), and modern management philosophies, operation methods, and organizational forms. It includes technical design (R&D, product and process design, and creative design), legal services, accounting and auditing, computer services (hardware and software consulting, data processing, data application, and e-commerce), consulting services (management consulting, engineering consulting, and tax consulting), brand marketing, and sales services (brand marketing, market research, information and informationalized services, and advertising), technical services (architectural services, engineering services, and technical testing and analysis), leasing services (transportation and construction equipment rental, and office facilities rental), labor recruitment (labor recruitment and personnel rules and regulations), operational support

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(security and industrial cleaning), logistical support (logistics, procurement, cargo transportation, storage, packaging, loading and unloading, circulation processing, and distribution supply management), and other services (secretarial and translation services, and exhibition). Companies in this industry have evident advantages in R&D, technologies, business operation, and sales networking. Industrial producers can rely on the technological innovation and market development capacities of those companies to develop new technologies and products with self-owned intellectual property and brands, and transport the parts, semi-finished products and final products that are made from raw materials at the lowest cost from one link in the supply chain to another link. Those service suppliers will also expand their customer reach to include both domestic users and international outsourcing clients and form a highend service industry featuring high technology, high investment, and high knowledge content in multiple fields, thus enhancing overall competitiveness. Meanwhile, the modern service industry has developed a series of service industrial clusters in key cities, especially in the highly-concentrated central business districts (CBDs) of metropolises, for example, industrial clusters providing financial business services and other high-end services, tourism and high-end consumption-oriented industrial clusters, and arts and culture-related industrial clusters. External economic effects such as complementary and sharing effects brought about by those industrial clusters are very evident. The trends of economic development are the specialization, socialization, and marketization of industrial production and the constant expansion of the industrial chain towards the upstream and downstream. As a result, producer services will develop faster than the manufacturing industry and the costs of production and transaction will be greatly cut. This will provide the primary and secondary industries with highly efficient and sound socialized service systems and providers and promote the technological advance and efficiency increase of the two industries. Finally, the overall economic efficiency will also be improved. More importantly, with economic development, every company needs to expand its business and capital, which will pose an increasingly high demand for financial services, especially capitalization services in the aspects of corporate financing, industrial consolidation, and capital operation. Consequently, financial services will become more and more diversified and specialized and a large financial industry including commercial banks, investment banks, fund management, asset management, and all sorts of financial markets, capital markets, and financial derivatives markets will gradually come into being. At present, international service trade accounts for one fourth of the total trade, and service consumption takes up half of the

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total spending. Therefore, the focus of the world economy has shifted to the production of service products. We have moved from an era centering on the manufacturing industry to an era of service economy.

Economic globalization sped up the global capital transfer, especially that from developed countries to developing countries As the transfer of the manufacturing capital from developed to developing economies became faster, the industrial structure was hollowed out (namely, deindustrialization) in developed countries where capital markets and the fictitious economy developed rapidly. In the past 100 years, with the advance of international trade, economic and financial development also requested corresponding cross-border expansion. After World War II, Western countries had a strong demand for trade and investment. This demand encouraged a batch of developing countries to participate in the international economic system and created a need for international industrial capital transfer. By the 1980s, economic globalization started to take shape. But the North-South Divide and the East-West Conflict, resulting from the subsequent 40-year Cold War, impeded the large-scale transfer of industrial capital to developing countries. As the Eastern Bloc disintegrated in 1991, the Cold War came to an end and the new parallel world market comprised of socialist countries as opposed to the capitalist camp collapsed. Peace and development prevailed and the world economy headed towards a unified market. The economic divide between developed and developing countries was removed and the demand of developed countries to transfer their industrial capital had been satisfied. Western countries proposed economic globalization again at this time because they intended to push the Soviet Bloc and developing countries to open trade and financial markets as an outlet for surplus products and capital. Unexpectedly, this move revealed the huge price gap in production factors between the West and the East and between developed and developing countries caused by the Cold War. As a result, the content of international capital flows was no longer concentrated on product exports and capital investment in primary goods. Instead, developed countries directly relocated their manufacturing industries to developing countries. In retrospect, the Chinese government proposed utilizing foreign capital after the announcement of the Reform and Opening Up policy in 1978, but during the entire 1980s, the major source of foreign investment in China came from Hong Kong and Macau, with most money going into the real estate and consumer goods industries. Among China’s capital inflows, only 40% was invested in the

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manufacturing industry in the late 1980s. A decade later, after the end of the Cold War, external capital from Europe, Japan and South Korea invested in China largely increased and the investment targets also shifted from the real estate and light manufacturing industries to heavy and chemical industries, especially in the latter half of the 1990s. By the turn of this century, the proportion of foreign investment in the manufacturing industry grew to 65% and even exceeded 71% in 2004. China became the developing country which received the most foreign investment. Under the drive by foreign capital, China’s export structure underwent changes. In 1994, electromechanical products for the first time outnumbered textile products in export and became China’s top export. In 2004, electromechanical products created a USD22.4 billion trade surplus for China. This was a historic change and since then, China was known as “the world’s factory.” However, although the heavy industry made up two thirds to three fourths of the manufacturing sector in developed countries, the requirements for the transfer of heavy industry were much higher than for that of light industry. So, basically the heavy industry has not been transferred yet. In the future, when China upgrades the scale and technologies of its heavy industry, the capital transfer of heavy and chemical industries from developed countries to China will reach a peak. Furthermore, if China can accelerate the development of the service industry and improve the capacity to undertake the international service industry transfer, China will become not only the world’s manufacturing center but also an important base for global service outsourcing. It will transform from being “the world’s factory” to being “the world’s back office.” This will greatly enhance the international competitiveness and marketing ability of China’s industries and mark a major breakthrough in China’s transition from a large trading nation to a trading power. Another consequence of the manufacturing industry transfer will be that developed countries will constantly reduce their production of material goods and capital owners gradually move away from material production. In the search for surplus capital, multinational groups will promote the prosperity of capital markets, especially the rise of investment banking and asset securitization. The rapid development of the fictitious economy will aggravate the hollowing out of industrial structure. As to this point, I will elaborate later.

Economic financialization invigorated the global capital market and fictitious economy, and controlled the movement of industrial capital After World War II, the global economy displayed a new phenomenon, namely, economic financialization. When the modern financial and economic

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development reaches a certain level, the growth of capital markets, direct finance, asset securitization, and financial derivatives will definitely lead to the rapid advance of economic financialization and the fictitious economy. It reflects the most important achievement of civilization created based on the modern socialized production laws by human society. As we know that in the market economy, money is transformed into interestbearing capital and will generate added value during the exchange between money and commodities in the real economy. As early as 100 years ago, Karl Marx pointed out in Das Capital, “Just because the money-form of value is the independent, tangible form in which value appears, the form of circulation M ... M’, the initial and terminal points of which are real money, expresses most graphically the compelling motive of capitalist production — money-making.” Marx concluded it as, “to make money without the intervention of the process of production.” 1 This sentence disclosed the profit-seeking nature of money capital. It was the profit-seeking nature that created the value discovery and optimized resource allocation functions of capital markets and fueled the growth of the fictitious economy. Therefore, it is not hard to understand why capital groups in developed capital markets launched several waves of business mergers and acquisitions. It was a result of the pursuit of profit maximization. This revealed that the development of money capital would lead to the control over the movement of industrial capital. In the first 20 years after World War II, financial development lagged behind economic development. There were no international securities and exchange markets or large-scale capital flow until the 1970s. Financial development was restricted by the real economy and it remained in a subordinate position. International finance was still a branch of international trade and it did not qualify as an independent economic discipline. The disintegration of the Bretton Woods system in 1970 changed this situation. At first, the Euro-dollar market emerged and surplus petrodollars were recycled back into Western financial markets; and then offshore finance became prosperous in Hong Kong, Singapore, and Bahrain. After the 1980s, securities markets and financial derivatives markets in the emerging countries and regions suddenly came into the focus of attention. Since then, securitization was developed, which led to the formation of all kinds of fictitious capital; money capital was able to be divorced from the production and circulation of material goods and could move freely; and money and finance were no longer connected to the reproduction of material goods and gained their unique movements. Additionally, the development of the internet closely tied together the trade, finance, and capital flows in the world’s major markets, pushing

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forward economic and financial globalization. Especially in the past 20 years, the development of the information industry and financial computerization made the capital movement overcome the restrictions of cash and bill payments, and the electronic funds flow realized remote and timely payments which accelerated the development of global capital markets and the fictitious economy. As a result, two comparatively independent economies, i.e., the real economy and the fictitious economy, coexisted in the modern economy. As the economic globalization continued to expand, the fictitious economy developed rapidly. The experience of economic and financial development taught us that the modern market economy comprises both real and fictitious economies. It includes not only factor markets of the real economy, such as commodities, land, labor, capital, and science and technology markets, and markets of the fictitious economy, such as finance, securities, futures, and financial derivatives markets, but also intermediary markets which provide intellectual services for real and fictitious economies. The modern market economy will adjust the supply and demand and the surplus and deficiency in factor markets through price fluctuations, and give full play to value discovery, risk aversion, and resource optimization functions of markets through asset price changes in capital markets and the fictitious economy, especially the changes of all sorts of asset-backed securities and financial derivatives. Therefore, investors can discover asset value, evade investment risks, and form profit expectations based on the prices, profits, interest rates, and exchange rates of different investment tools before making investment decisions. It will solve excess production capacity and promote the adjustments of the real economy and production structure by redirecting surplus capital into new industries. The advance of capital markets and asset securitization pushed forward money capitalization and turned surplus money via all sorts of means into profit-seeking capital. In addition, the modern market economy is in nature a fictitious economy in a certain sense, because markets achieve resource allocation through capital flows and the capital flows decide both the direction of resource flows in the real economy and the scale and efficiency of resource allocation. The fictitious economy is continuously expanding into the realm of the real economy, and the real economy is constantly integrated into the fictitious economy. Economists called this process “economic financialization” or “economic monetization.” Economic financialization is mainly manifested in three aspects: 1. The financialization of social assets, namely the continuous rise of the financial interrelations ratio (FIR) which is a quotient of total financial assets and gross national product (GNP). Over one century ago, the FIR was 0.07 in the United States, 0.03–0.35 in the United Kingdom, 0.12–0.15

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in Germany, 0.16–0.20 in France, 0.20 in Italy, and 0.021 in Japan. Between 1913 and 1935, the FIR in the above countries was generally around 0.70– 0.80 (0.32–0.40 in Japan). One century later, this ratio rose above 3.20 and the difference between each country was also narrowed. In 1999, the ratio increased to 4.02 and 3.78 in the United States and Japan, respectively. Developing countries generally maintained a ratio between 0.30–1.40 with a few ones recording a comparatively higher ratio, for example, South Korea had a ratio of 4.36, Singapore 3.82, Brazil 1.13, and Argentina 0.63. This indicated that the financialization of social assets greatly improved and the financial development gap among most countries was continuing to shrink. After the Reform and Opening Up era began, China’s FIR also increased dramatically. It reached around 2.3 in 2006 with the peak being 2.34. This showed that the Reform and Opening Up had sped up the economic development in China. Although China’s capital market still needs future improvement (the equity division reform was implemented in 2005), the economic financialization has greatly advanced forward. 2. The securitization of financing and investment. The financial development in human society followed the sequence of indirect finance before direct finance and short-term financial services before long-term financial services. In a quite long period of time, the social financing system focused on indirect finance and direct finance only comprised a small fraction of the total. People called this unbalanced development “financial tilt,” which is actually a large-scale tilt towards indirect finance. However, since the 1980s, non-banking finance developed rapidly in each country, giving rise to the financial disintermediation, that is to say banks were removed as financial intermediaries. It marked a reverse of the “financial tilt” and direct finance began to make up a similar proportion of or even a larger proportion than indirect finance. 3. The financialization of economic relationships. Social economic relationships are more and more reflected in debtor-creditor, equitydividend, risk-insurance relationships and other financial relationships.2 Economic financialization is not only a simple reflection of the real economy through money and finance, but also the expansion and penetration of the fictitious economy into the real economy before the fictitious economy finally gets the control over the real economy. At present, economic globalization propels the cross-border expansion of production factors and economic activities, and economic financialization develops intensively to blend with economic globalization. This provides international capital formation and its structural

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evolution with directions and promotes the economic integration of each country. Because of this, economic financialization, which develops markedly, became the primary characteristic of today’s economy. Financial development advances much faster than economic development. In 1947, shortly after World War II, the global trade volume was USD45 billion. But half a century later, the trade volume grew to USD6.1 trillion in 1997, plus USD1.2 trillion generated by service trade, an increase of over 160 times over 50 years. At the turn of this century, the global annual GDP was around USD4.5 trillion while the volume of currency trading around the world reached approximately USD1,000 trillion, 100 times the value of international trade. This was largely attributed to the rapid development of international financial derivatives. Now, the total value of the world’s financial assets greatly outnumbers that of the real economy, and the world’s economy is to a large extent reflected in the operation of global financial capital. According to the statistics from the International Monetary Fund (IMF), in 2006, the world’s total GDP was USD48.2 trillion, the market capitalization of global stock markets was USD50.8 trillion, the total assets of global financial institutions was USD190.4 trillion, and the total market value of global financial derivatives markets was USD485.7 trillion, respectively, equivalent to 105%, 385%, and 1,000% of the world’s GDP. The size of the U.S. derivatives products in 2010, according to Barack Obama’s State of the Union address, was as high as USD598 trillion. Based on the estimate of Wang Jian, the total value of global financial products including financial derivatives amounted to thousands of billions of U.S. dollars, tens of times of the world’s GDP. According to statistics, in the past 10 years, especially the past 5 years, the world’s real economy was growing at a rate of 5%, the growth rate of financial development was 20%–30%, and financial derivatives were increasing at a rate of 70%–80%. Coupled with the proliferation of low-interest dollars, this caused the worldwide excess liquidity and rapid advance of financial assets. The size of risks of financial markets greatly overshadowed the improving and adjusting functions of financial markets towards the real economy.

Reexamine the International Economic Imbalance from the Prospective of Economic Globalization Here, we have to clarify a concept. Under the framework of the WTO, almost every country participates in economic globalization. But up to now, every member country is a sovereign state. According to the traditional international economic and trade theories, people always form an opinion about a country’s

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economic and financial development, economic growth rate, trade surplus or deficit, foreign reserve size from the perspective of a single sovereign state. According to the traditional international economic theories, the saving surplus of a country represents its economic strength. It is often the case that developed countries export capital to underdeveloped countries and at the same time exploit the resources of the latter. Traditional economic common sense taught us that when a country’s trade surplus of deficit continues to expand, it must be caused by insufficient saving or saving glut. This reflects the internal and external economic imbalance of a country, which may evolve into a crisis in severe cases. If judged merely from the traditional economic theories, the trade surplus or deficit and the capital export of a single sovereign state can only be concluded as a serious “international economic imbalance.” This “international economic imbalance” will first show in the huge trade surplus or deficit of each country. Some countries maintain a large trade deficit, for example, the current account deficit of the United States reached USD700–800 billion, which means it needs the same amount of net capital inflow each year to sustain economic operation, while other countries record a trade surplus, for example China maintained “double trade surpluses” in its trade and capital accounts since the early 1990s. Based on the previous analysis, it may easily lead to the conclusion that both the United States and China go against the common sense of the traditional economic theories. In fact, the United States witnessed an adverse trade balance since the mid1980s, and the deficit in the U.S. current account corresponded to the sum of the trade surpluses of the Federal Republic of Germany and Japan. After the 1990s, its unfavorable balance of trade widened further, and the U.S. trade deficit was equivalent to the combined trade surpluses of China, Association of Southeast Asian Nations (ASEAN), Russia, Saudi Arabia and other oilexporting countries in addition to the surpluses of Germany and Japan. This “international economic imbalance” lasted for more than half a century with an increasingly larger scale. Economists repeatedly predicted global economic crises based on the traditional international economic and trade theories, but neither the U.S. economy nor the world economy has collapsed, except for the global financial crisis in 2008 which was triggered by subprime mortgages and financial derivatives rather than international trade imbalance. What puzzled economists then about the “international economic imbalance” was how developed countries suddenly shifted from capital and goods exporters into importers of capital and goods whereas developing countries evolved into manufacturing powers and goods and capital exporters. How did this reverse happen? Why did capital get exported from less developed

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countries to more developed ones? What continues to perplex economists is that, at present, it is emerging countries which often run current account surpluses. This was first seen in Germany and Japan, then in South Korea, ASEAN countries, and China, instead of in the economically powerful United States. Undoubtedly, it is a generalization to assess a single country’s economic and financial development without taking consideration of economic globalization. But the “international economic imbalance” formed based on the traditional international economic and trade theories became the theoretical tool used by the politicians of some large countries to provoke trade protectionism among domestic unemployed workers and put pressure on the exchange rates of surplus nations. The fundamental problem is that in the era of globalization, the imbalance of an individual country has been replaced by a new global equilibrium relationship and it will be meaningless to ask a country to maintain an internal and external balance. Therefore, there is a need to reexamine the world’s economy and the economies of sovereign countries from the perspective of globalization. The real concern of a country should be whether this imbalance is beneficial to itself and also conducive to its long-term sustainable development. It should be noted that economic and financial globalization brought about fundamental changes to the world’s economic pattern. 1. T h e e c o n o m i c d e v e l o p m e n t i n d e v e l o p e d c o u n t r i e s l e d t o t h e transformations of industrial structure. At first, the specialization and socialization of manufacturing industry increased enterprises’ expenditure on service. Then, the specialization and socialization of the service industry promoted the transfer of industrial capital towards the service sector. In the last 10 years, as the capital of the manufacturing industry was transferred to developing countries, Western countries started to concentrate on the financial industry. Economic globalization and financialization resulted in the gradual departure of capital from material production in developed countries and the rapid advance of capital markets and the fictitious economy. Currently, the competitiveness of the United States lies in human capital- and R&Dintensive industries and the modern service industry rather than the manufacturing industry. Examples of the R&D-intensive industries are the defense industry, pharmaceutical industry, information technology industry, and bio-engineering industry. The high-end service industry includes the R&D of the most advanced science and technologies, and financial, cultural, and recreational services provided by high-caliber

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personnel. Participants of these industries cover not only universities, hospitals, research institutions, information service providers, publishers, media and network companies, and various art centers, but also securities, futures, foreign exchange, and financial derivatives markets and financial institutions, venture capital firms, asset management companies, and financial intermediaries. Relying on these industries and facilities, the United States became the world’s knowledge and technological innovation center. By constantly injecting its economy with enormous vitality, it plays a leading role in the global market. The capital groups of developed countries continued to reduce material production in pursuit of larger benefits from capital markets and the fictitious economy. It might be the primary reason for the constant decrease of material goods production and the shrinking of related industries in developed countries which gradually lost their advantages in the production of material goods and ran long-term trade deficits. In 2010, the global trade volume was USD15 trillion and the annual turnover in the foreign exchange market was between USD1,000–USD1,400 trillion. The world’s GDP was around USD60 trillion while the volume of global financial transactions reached USD2,000 trillion. At present, the financial sector is the most important industry in the U.S. economy. To borrow the words of Xie Guozhong (2008), “It secures the dominance of dollars in global trade and as a settlement currency. Under the U.S. current account deficit, the benefits brought about by the U.S. dollars as a world currency account for 3% of the nation’s GDP. The special status of the dollars has created USD10 trillion economic value for the country.” Comparatively speaking, the trade deficit of the United States is a reasonable price to pay in exchange for the commanding height in the world economy. 2. Capital always moves towards the lowest cost in accordance with the principle of comparative cost. It is this rule that promotes the large-scale transfer of manufacturing capital from developed countries to developing countries and fosters the trade advantage of emerging countries. In the early 1990s, the end of the Cold War discontinued the economic estrangement between the East and the West and the huge gap in the prices of production factors resulting from the Cold War was fully revealed. The principle of comparative cost immediately took effect. The capital groups of developed countries, taking advantage of lower production factor prices and low-cost human resources in developing countries, propelled the industrial capital of developed countries to the least cost location and massively relocated the manufacturing industry to developing countries.

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For example, the average land price in the urban areas of the United States was around USD500 in 2006 while the price in China was less than USD300. For another example, it will cost Wal-Mart USD5 to acquire a pair of Nike shoes manufactured in China, but it can sell the shoes at USD170 in the U.S. market. It reflected the price squeeze and crucial exploitation of transnational capital. In fact, the actual cost for producing a pair of Nike shoes in the United States would be USD170, because the high levels of technology and productivity and a high standard of living determined the high wages of workers. Thanks to the economic globalization, the industrial capital of developed countries is able to manufacture the same products at the lowest cost by leveraging the low land price and low-cost labor in developing countries. It is the primary reason for developing countries to have obtained unprecedented strong trade growth. During the major industrial transfers in the world, such as the transfer of the textile industry from the United States to Japan, then to Southeast Asia, the transfer of the iron and steel industry from the United States to Japan, and the transfer of the automobile industry from Europe and the United States to Japan which later outsourced the parts manufacturing to Southeast Asia, what played a decisive role was the principle of comparative cost in the cost-benefit analysis. 3. The industrial transfer of developed countries changed the income structure of their residents. Taking the United States as an example, its high consumption did not totally rely on high income but the accumulation of family assets and the income from the assets. Stephen S. Roach called this an “asset-dependent economy.” For quite some time, people believed that American consumers were the primary engine for global economic demand. The proportion of U.S. personal consumption to GDP was 67% between 1975 and 2000 and since the beginning of 2002, the ratio averaged 71% before climbing to 72% in 2007. By comparison, the percentage was 58% in Europe, 55% in Japan, and 42% in China. But as was said previously, the U.S. consumption was not supported by its income. In the past six years (2002–2007), the income growth of the American people gained from work was relatively low and the ratio of net national savings to national income decreased from 1.4% to a negative value. The change was that as the middle- and high-income groups comprised the majority of the American people, property became the most popular carrier of wealth. More than 90% of the U.S. families held or invested in stocks or funds. Among the disposable income of the U.S. residents, property income constituted approximately 40%. Saving was no

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longer a priority for the American people. Consequently, the country has been suffering a long-term shortage of domestic savings and has to import foreign savings. The U.S. gaping current account deficit has absorbed around 75% of surplus global savings. In contrast, the consumption-deficit countries showed high personal saving rates: 8% in Japan, 14% in Europe, and 35% in China. But, considered from the perspective of economic globalization, the shortage in the U.S. net national savings was on the surface, and in depth, the United States owned a large portion of wealth under the item of residents’ assets. Therefore, to import surplus global savings is like to make bank loans by pledging assets after one spent all the earnings. Roach’s contribution was to summarize the U.S. affluent economy as an “asset-dependent economy.” For that reason, he believed that the imbalance in the U.S. economy reached an unprecedented degree, and the savings and consumption mode which overly relied on assets must be replaced. With the bursting of asset bubbles and the normalization of interest rates and the real estate market in the United States, there is reason to believe that American consumers will return to the income-oriented consumption mode. The share of the U.S. consumption in GDP will go back to the long-term 67% from current 71%. I suppose the “property income-based economy” may be a more proper name. However, this property income-based economy is possibly a common characteristic of affluent societies when their middle classes are continuously expanding and the proportion of property income is growing. In light of such a prosperous global financial market and fictitious economy, as long as the transnational transfer of industry and manufacturing capital in developed countries does not stop, the capital movement from material production to the capital market and fictitious economy will not end and the high-income of financial practitioners and property income of residents will continue to grow. Therefore, residents of developed countries will continue getting richer and richer, and the proportion of affluent class will also expand. Under such a circumstance, it is not realistic for American people to go back to the income-oriented consumption. But, isn’t the “property income-based economy” a dream pursued by all the developed countries and emerging countries? 4. The commodity and capital exports from developing countries to developed countries are a result of the relocation of the manufacturing industry to developing countries. Developing countries may suffer from a shortage of resources but have a dense population, so they can rely on their low-cost land and labor to manufacture products, but due to

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weak domestic spending power, they have to squeeze themselves into the international market. As a result, those developing countries earned a large sum of foreign exchange and since there is no corresponding product in the counterpart countries for those foreign exchange earners to trade in exchange, the foreign exchange was used to purchase government bonds or other financial products from importing countries. This capital export is in fact a transfer of surplus savings to developed countries at a moderate price. It should be said that developing countries have been supporting the U.S. industrial capital transfer from material production to financial industry with low-cost capital and inexpensive commodities for many years. Therefore, I agree with Guo Shuqing’s conclusion that the United States has enjoyed the low-cost capital and cheap commodities of developing countries over the years, which is perhaps a reason for the unprecedented prosperity of its economy. Is the U.S. economy an imbalanced one? Although there is a substantial deficit in the U.S. current account, there is also an equal surplus in the capital account. So overall, the international balance of payments is balanced in the United States. In the past 20 years, multinational corporations and global ordering were highly popular and the crossborder transfer of manufacturing capital became commonplace. The capital account surplus of a country has a large chance to be a result of investment from foreign companies and at the same time the trade surplus of a country is also most likely created by foreign-owned enterprises. Guo Shuqing concluded this in an implicit way: “It is hard to tell by intuition who creates the trade surplus, who will benefit from the surplus, and who will be the largest beneficiary.” But what Bo Xilai, Minister of Commerce of China, said in 2007 brought out the crucial point: “The trade surplus is in China while the profits are in the United States.” Under the prospect of economic globalization, surplus saving is no longer a feature of economic prosperity as stated in traditional economics. At present, countries with surplus savings can transfer their savings to those with inadequate savings as easily as domestic residents use consumer credit to purchase a product in the market. Taking the United States and China as examples, China is running a saving surplus while the United States suffers from a savings deficiency. Now, China has exported goods to the United States, but instead of receiving cash in full, China has to purchase a bunch of long-term government debts or other financial assets at suitable interest rates. Statistics said that foreign investors now hold USD16 trillion in the U.S. financial assets. This partially discloses the

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secret of the transfer of surplus savings between countries. Now, we can have a clear picture about the trade surplus in China and the trade deficit in the United States: The capital groups of the United States relocated the manufacturing industry to China through investment, which resulted in a surplus in the U.S. capital accounts; the manufacturing factories produced consumer goods by leveraging low-cost land and labor force in China, but due to the low purchasing power of Chinese farmers and farmer-turned workers, China had to export those goods at low prices; American residents purchased the cheap products exported from China but paid the producers the low-cost money absorbed by selling the U.S. government bonds to China, and although China transferred its surplus savings at a reasonable price to the United States, the U.S.-funded enterprises in China contributed a trade surplus to China. The trade deficit in the United States grew so large that the U.S. government debt reached the ceiling of USD14 trillion. With a constantly weakening dollar, can any other country, such as those in the European Union, replace the United States in the world economy? According to research by Guo Shuqing and Wang Jian, the Euro area as a whole is balanced; although there is a big deficit country in the non-Euro zone, i.e., the U.K., Switzerland, Sweden, and Norway run large trade surpluses; even if Russia is not included, the rest of Europe records a surplus in its current account; so, it is not practical, at least at the present stage, to count on Europe to replace the United States. Now, major capitalist countries are constantly widening the negative trade balance with principal developing countries and the European Union and Japan follow the development route of the United States; therefore the strong Euro cannot be sustained for a long time. The closer the economic pattern of Europe is to that of the United States and the more capital is transferred to the fictitious economy, the less powerful is the Euro. The competition between the Euro and the U.S. dollar for dominance in the world’s market will continue, but in the long run, the Euro cannot replace the dollar as the world currency.

Financial Globalization: Challenges and Opportunities for the Renminbi as a Global Currency Financial globalization and economic financialization, marketization, and liberalization have made up an irresistible trend. In the past 20 to 30 years, competition among the great powers has gradually shifted from military to

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financial fields. The Asian financial crisis brought about long-term financial weakness in the region and Asian countries were subject to the financial hegemony of economic superpowers. Therefore, the rise of China must depend on the tremendous support and push from the financial development for the economy. China must not only come up with a financial development strategy to build up its financial strength, but also seize every opportunity to turn the renminbi into a fully convertible currency of the world. In the 20th century, the United States grabbed the financial hegemony from the hands of the old colonial empire, the United Kingdom. In addition to its enormous economic and financial strength, the new hegemonic power owned the world’s most developed financial market system, which could effectively allocate financial resources among different countries or regions around the world. Besides assuming the position of a global currency, the U.S. dollar became the first choice for each country as the settlement and reserve currency. Thus, the United States was entitled to seigniorage. Lastly, the United States was able to use international institutions as a power tool to reinforce and maintain its financial hegemony. This clearly shows that financial strength assumes equal strategic importance and influence as military strength. Deng Xiaoping once said, “Finance is the core of the modern economy.” Since China’s Reform and Opening Up era began in 1978, and especially in recent years, financial reforms and development have advanced markedly. Now, the problem faced by China is that although economic globalization has contributed to the rapid rise of China and China has surpassed Japan to be the second largest economy in the world, indirect finance still comprises a large portion in China and this results in financial weakness and incomplete and underdeveloped financial markets of China. Chronic financial weakness is likely to be accompanied by bullying from powerful countries who have financial hegemony. As China continues to accumulate its economic and financial strength and integrate itself into the world at an increasingly fast speed, it will be faced with more and more competition between large powers. Despite all the risks and setbacks, China will definitely contribute to changing the current global economic and financial landscape and become a power in reshaping the world’s economic and financial order. In light of this, China needs to both raise the awareness of the risks and possess the courage to take part in the competition. In the times of the global financial crisis, not many currencies can be trusted against depreciation. Since the renminbi is a strong currency, it should evolve into a global currency and gain the initiative in international currency affairs. The Chinese government has to achieve full convertibility of the renminbi as soon as possible and establish the international standing of its currency. The strategic target of renminbi

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internationalization is not only promoting the status of the Chinese economy in the world, but also improving the stability of the global economy and making China benefit from it. In fact, under financial globalization, the renminbi faces both opportunities and challenges in becoming a global currency. Actually, China is now undertaking the internationalization of the renminbi. In 1994, full convertibility on the current account was realized with only the capital account being under control. The best benefit from capital account controls was that China was guarded against massive speculative capital inflows and outflows during the 1997 Southeast Asia financial crisis, and during the 2008 global financial crisis trigged by the U.S. subprime mortgages. But capital controls delayed the full convertibility of the renminbi, and prevented the renminbi from becoming a global currency and being widely used in international economic transactions. This allowed financial superpowers to put pressure on the exchange rates of the renminbi in trade negotiations. To cope with these disadvantages, China has successively signed bilateral currency swap agreements with South Korea, Malaysia, Belarus, Indonesia, Argentina, Iceland, and Singapore, with the swap size reaching RMB803.5 billion (around USD120 billion). The renminbi trade settlement pilot scheme between Mainland China and Hong Kong was implemented in July 2009. The cross-border trade settled in renminbi has totaled RMB1 trillion and the Renminbi deposits in Hong Kong have exceeded RMB500 billion. The current problem is that the bilateral currency swap and the renminbi cross-border settlement bring about unexpected side-effects. As the renmimbi has become a hard currency and its exchange rate is expected to rise, many central banks and foreign enterprises are only willing to receive the renminbi instead of paying it. Statistics show that the amount of renminbi held by foreign central banks through currency swaps totaled almost USD100 billion. Apparently, these countries were attracted by the expectation of unilateral appreciation of the renminbi. Similarly, the World Bank issued renminbi-denominated bonds in Hong Kong capital markets in early 2011. The two-year fixed rate bonds with a coupon of 0.95% turned out to be a success for people who eyed the annual appreciation rate of 3%–5% of the renminbi. Therefore, Yu Yongding concluded that the advance of renminbi settlement reduced the exchange rate risk of not so much Chinese enterprises as foreign companies. Another side-effect was the covering up of all sorts of legal and illegal arbitrage. It is said that recently a foreign group asked its Hong Kong subsidiary to borrow dollars at a low interest rate with its renminbi deposit as collateral in order to pay for the goods produced by its Mainland China subsidiary. This probably can be called legal arbitrage in trade activities. However, there are also

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illegal renminbi cross-border flows operating under the guise of international trade. According to bankers and analysts, some enterprises took advantage of the high interest rate of the renminbi in Mainland China and the low interest rate of dollars in Hong Kong to perform interest arbitrage. The profits from each trade can be as high as hundreds of billions. The speculative and arbitrage funds transferred between Mainland China and Hong Kong without real trade contracts are what people usually called “hot money.” Furthermore, cross-border settlement has increased rather than decreased the exchange reserves of China. It was contradictory to the goals of the renminbi trade settlement pilot scheme. According to the statistics of China’s Central bank, China’s foreign reserves increased by USD1.53 trillion to reach USD3.2 trillion in the second quarter of 2011. The growth in the foreign exchange reserves obviously added difficulties for the Chinese government to press down on inflation. In the previous period, the inflation rate of China surpassed 6%. More foreign exchange reserves mean that the Central bank has to print more money to offset dollar inflows into China. To go a step further, the renminbi internationalization will mitigate domestic inflation as the renminbi will be held by other countries’ governments as a reserve currency for one thing; for another, the Chinese government will be able to absorb domestic and foreign savings in capital markets to fund banks and government debts. However, delayed internationalization of the renminbi will centralize the passively supplied money in the domestic financial system and the less developed financial markets cannot fully soak up the excess liquidity. Too much money and too few assets will easily lead to the inflation of goods and assets. The failure to turn the renminbi into a global currency will bring China more foreign exchange reserves, which will inflict the exchange rate risk on China due to the appreciation of the renminbi and the depreciation of reserve currencies. At the same time, foreign exchange assets purchased by those foreign reserves also probably face a drop in value as the global inflation rate rises. Due to a lack of full convertibility of the renminbi, China’s Central bank has to increase its money supply to purchase foreign exchange, which will lead to a growing risk of domestic inflation. Even though China can still hedge against the risk by issuing central bank bills, making foreign exchange swaps, and adjusting renminbi reserve ratio and interest rates, these actions will add to operational costs. Statistics showed that between 2003 and 2010, the hedging costs of China’s Central bank exceeded RMB1 trillion. The increase in the deposit reserve ratio is also a kind of tax levied on commercial banks. It will decrease the profitability and competitiveness of financial institutions to a certain extent and encourage the removal of intermediaries in the capital supply.

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For China, opportunities coexist with challenges. The priority is to deepen the reforms of the financial and exchange rate policies. I agree with Lou Jiwei that China is well positioned to realize full convertibility on the capital account. At the initial stage, China still can impose some regulations over foreign debts, short-term capital flows, and money laundering. After the full convertibility of the renminbi is realized on the capital account, it is very likely for the renminbi with such a large economic scale to achieve internationalization, thus stabilizing the global economy. When exchange controls were substantially reduced on the current account in 1994, China’s foreign exchange rate reserves only totaled USD16.6 trillion. Although many people doubted this exchange rate reform, China succeeded in introducing a managed float system and relaxing exchange controls. In contrast, today China possesses USD3 trillion dollar reserves, banks are more powerful than at that time, and the government’s financial status is sound. China’s enterprises also become more responsible than they were before as a result of ownership reforms. That is why I believe China has better conditions to achieve full convertibility of the capital account. The renminbi internationalization is a request based on real demand and also the road that China must take. China will neither go back to the days of the fixed exchange rate as used during the Southeast Asia financial crisis, nor adopt a linked exchange rate as Hong Kong does. So the question then is how to decide an appropriate exchange rate to allow full capital account convertibility before achieving a floating exchange rate. The whole world is looking forward to this reform. It probably will not be a smooth process and China may have to deal with the sudden inflows and outflows of speculative capital after the reform. But, the key is to improve the exchange rate formation mechanism. Most importantly, the government must set a proper exchange rate and ensure the exchange rate fluctuates with market demand instead of letting the unilateral appreciation dominate the market. If China loses this current opportunity and allows the appreciation expectation to accumulate in the market, the future reform will be more difficult and China may fall into a vicious circle of fighting with speculative capital betting on the renminbi appreciation.

Accumulating Financial Strength to Cope with the Games between Superpowers As I have stated previously, under economic globalization, the competition between superpowers has moved from the military field to the financial one. We know that the Bretton Woods system was a set of institutional systems

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and rules formed under the lead of the United States to establish the U.S. financial hegemony and the dollar dominance. In fact, the United States dominated the operation of the International Monetary Fund (IMF), the World Bank, and the General Agreement on Tariffs and Trade (GATT). During the Southeast Asia financial crisis in 1997, the IMF claimed to give financial support to the countries struggling in the crisis with the condition that those recipient countries had to open trade and financial markets. It reflected the same interests shared with the United States, but the IMF’s proposal was firmly rejected by Malaysia and South Korea. Since the Southeast Asia financial crisis, all sorts of forces in the international system appealed in different ways for fundamental changes in the existing international financial system and closer coordination and cooperation in international financial regulations and supervision. But a radical reform in the outdated international financial system is a kind of worldwide institutional innovation. The questions are who will lead the reform, namely, which countries will be the principal participants, and what kind of basic rules should be followed in the reform. During the previous major financial crises in the 1990s, including the European currency crisis, Mexico’s financial crisis, and Southeast Asia financial crisis, almost every crisis began with speculative capital from large economies and ended up with business mergers and acquisitions. Japan, already in an economic recession, eventually received a great deal of worldwide attention after the start of the 1998 Southeast Asia financial crisis. In the summer of that year, I met in Singapore and Hong Kong the regional presidents for Asia of several large investment banks and what they talked most was the undergoing acquisitions of Japanese enterprises. This showed that in an era of the internet and financial globalization, it was common to use financial capital to control industrial capital. According to the estimate of the IMF, the Japanese bank industry lost as much as USD750 billion in the crisis. Under economic globalization and economic financialization, when financial development significantly elevated the economic resources allocation capacity and efficiency of a country, it also rapidly accumulated its own systematic risks. But the precautionary and control measures against financial risks usually lagged behind financial expansion. International supervision and coordination made up the weak link in the global financial development. In the previous financial games, developed countries had obvious advantages and benefits while developing countries found themselves in a disadvantageous position and could not avoid losses. Therefore, for a long time, people entertained an illusion that financial crises would never break out in developed countries. Certainly, developed countries had a high degree of financialization.

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They were ahead of developing countries in reversing the financial imbalance between indirect and direct finance and were the places where major financial centers were located. Their financial regulation was comparatively sound and effective. In developed countries, the credit expansion impulse was strictly restricted, the quality of credit assets was generally better, and the excessive development of financial resources seldom occurred. Therefore, compared to developing countries, developed countries were less likely to precipitate a financial crisis. But the problem was that as securities markets, futures markets, and financial derivatives markets advanced dramatically in developed countries, these markets obviously tended to generate bubbles. The prices in the global securities market rose by seven to ten times in the past decade, largely breaking away from the performance and growth rate of the real economy. In addition, the 2008 financial crisis resulting from the U.S. subprime mortgages and related derivatives showed that the financial institutions, financial staff, and credit rating agencies during the U.S. financial development were so confident and optimistic that they contributed to the massive expansion, high leverage ratio, and rating defects, and regulatory loopholes of several high-risk innovative financial products, such as collateralized debt obligations (CDOs) and credit default swaps (CDS) during multi-layered securitization of financial innovations and their globalization. It led to high speculation and widespread bubbles of derivative products. The economic financialization pushed people to closely follow these steps. Since the fictitious economy developed rapidly around the world, if China lagged behind in economic financialization, it would have to be subject to powerful economies and miss this excellent opportunity of development during the adjustment of the global financial landscape. In particular, as the U.S. subprime crisis had evolved into a global financial crisis and impacted the restructuring of the U.S. financial industry and the United States shifted its attitude towards sovereign wealth funds from being vigilant to seeking help, this created both opportunities and challenges for a rising power like China. Although people now often talk about the recession and crises of the U.S. economy, we must clearly realize that the U.S. economy remains the most powerful economy in the world. The United States stepped out of the manufacturing industry in the 1980s, but still maintained absolute competitiveness in knowledge-intensive industries, especially the financial service industry. The U.S. financial industry, especially the investment banking industry, gathered financial elites from all over the world and will not easily give up its financial hegemony. Therefore, during this global financial structure reform, China should not rely on sheer luck and aim too high.

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In the face of the global financial crisis, while stimulating the economy and expanding domestic demand, China has to establish the strategy of rejuvenating the country through financial development to accumulate financial power and respond actively to the games of financial superpowers. 1. To establish the strategy of rejuvenating the country with financial development. China should set up medium- and long-term plans for financial reform and economic opening up in order to serve its core goal of the rise of China. It is necessary to create conditions for building a larger and stronger domestic financial industry, and strengthen the industry’s ability to resist risks. China has to open the trade and financial markets, develop the capital market and the fictitious economy, and expedite economic financialization. The Chinese government should encourage the domestic economy to grow in competition with international capital and seize every favorable opportunity to develop while the government has to familiarize itself with and master the law of motion of industrial capital in order to steer and control the economic development at the appropriate time. 2. To build Shanghai into a top modern international financial center and make the best use of the existing international financial center Hong Kong and its highly open and free markets. In March 2009, the State Council decided to turn Shanghai into an international financial center and international shipping center by 2020. This was not only a long-cherished dream of Shanghai’s but it also was an adaptation to the demands of China’s political and economic development. In the 19th and early 20th centuries, the international financial center was London. This corresponded to the colonial economy of the “British Empire on which the sun never sets” and the international status of the British pound. Since the rise of the U.S. economy, U.S. dollars soon became the world’s currency and New York replaced London to be the international financial center. Although China is still a developing country if judged from the per capita figures in its economic development, it has evolved to be the world’s second largest economy, next only to the United States considering comprehensive national power. For this reason, China must have the international financial centers, matching its economic strength and the international status of the renminbi. Besides, Shanghai was the international financial center of the Far East before the liberation. So, it is absolutely necessary to push forward the development of the modern

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service industry and advanced manufacturing industry in Shanghai and gradually restore the city’s status as an international financial center. Whether Shanghai can become an international financial center depends on whether it can rapidly realize the economic transformation during the Reform and Opening Up era despite the challenging economic environment. Shanghai was the world-known financial center prior to 1949 and it still maintains a higher level of financial awareness than the rest of the country. The decline of Shanghai in the financial field resulted from four factors. First, after the founding of New China, the planned economy was implemented. It repelled markets and the market economy and paid little attention to financial development. Second, imperialist countries imposed an economic blockade on China. Third, the Chinese government adopted the wrong policy of transforming consumer cities into production cities. Lastly, after the implementation of the Reform and Opening Up policy, Chinese enterprises still did not get used to market competitions, the financial markets did not developed comprehensively, and the Chinese government was overly strict in economic and financial management without giving sufficient freedom to the opened-up fields. To build Shanghai into an international financial center and restore its status in the world to what it was before China’s liberation, the government has to make great efforts in urban environment, market construction, transportation network, exchange of information, and economic and financial management. As to the challenges to build Beijing, Tianjin, and other large cities into financial centers opened up to the world, I believe that it will do more good than harm to open up more financial cities to the world as we have to cope with the games of superpowers anyway, and by doing so, we can better advance the socialist cause with Chinese characteristics and the socialist market economy. At the same time, we should be aware that China’s advantage lies in that it has Hong Kong. Hong Kong is known for its high degree of openness and freedom, which is unparalleled by other Chinese cities. It has supported and promoted the previous stage of the Reform and Opening Up era of China in a sea of capitalism. In the days of closed financial markets, Hong Kong actually acted as the international financial center of China. Considering present international and domestic economic and financial situations, none of Shanghai, Beijing, or Tianjin is ready to play the role of being an international financial center. So, the priority is to make the best of Hong Kong, the available highly open and free international financial center, and use Hong Kong as the forefront to

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effectively allocate financial resources to China’s advantage and flexibly cope with the competition among great powers. Even when Shanghai is built into an international financial center, the status of Hong Kong in China’s economic and financial fields can only be reinforced rather than weakened. Before the liberation of China, Hong Kong was not counted as a financial center. The economic development of New China and the economic blockade against China by Western countries contributed to the current status of Hong Kong and turned it into an international financial center. Meanwhile, during China’s Reform and Opening Up, the high degree of freedom and openness of Hong Kong greatly supported the growth of China’s economy in external trade, economic cooperation with foreign countries, and the absorption of foreign investment. After the regime shift, Russia and many Eastern European countries also wished to have a highly free and open city like Hong Kong. Now, the rise of China makes this international financial center assume more responsibilities of innovation and openness. For Mainland China and Hong Kong, it means both opportunities and challenges accompanied with the rise of China. Mainland cities can strive to be financial centers but they also should be willing to play a supporting role for Hong Kong for a certain time during the Reform and Opening Up era. 3. To properly handle the relationship with the United States while strengthening the international cooperation against global financial crises. China’s Premier Wen Jiabao once said, “For China and the United States, cooperation benefits both while contention hurts both.” It was a farsighted guiding principle complying with the fundamental interests of people in the two countries. American consumers are the primary source of global demand and China is a major producer of global consumer goods. Although experiencing the financial crisis, the United States is still irreplaceable by any other country in the world. As the United States and China are, respectively, a large consuming country and a large producing country, the economic cooperation between the two is inevitable. The strategies of cooperation can be categorized into three kinds. The best choice is to enter into a trade security agreement based on which the United States can significantly reduce the controls over both technology exports to China and the mergers of American companies by Chinese enterprises in exchange for not only financial cooperation with China but also more exports and less trade deficits. The second best plan is to stick to the status quo for the time being, but it will inevitably lead to a continuous trade decline and worsening trade frictions. Certainly, China

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has to boost its domestic demand, especially domestic consumption, and gradually shift its economic growth mode. But if China suddenly stops purchasing the U.S. government bonds, narrows trade deficits by reducing imports and exports to the United States, and totally replaces trade with domestic demand, it will end up in a loss on both sides. This is the worst option that the two countries should avoid. 4. To unite emerging markets to participate in the reform of the international financial system. The international economic organizations should be reformed at an appropriate time to enhance the voice of emerging countries. Meanwhile, the world’s reserve currency system should be reformed to diversify the global currency and break the hegemony of the U.S. dollar. China must guard against financial risks and strengthen financial supervision to prevent the financial aggression by economic superpowers with financial hegemony. As the current financial crisis spread to the whole world, the asset prices of each country dropped to a level that has the best investment value. So China must seize the opportunity to invest in the desperate financial conglomerates in order to be integrated into the global economy and benefit from the global market. 5. To return to industrial production and properly arrange the proportion between finance and industry. An important lesson from this global financial crisis is that the development of financial markets and the fictitious economy cannot be separated from the real economy. The solution is to return to the industrial production and reshape the proportion between finance and industry. At present, even American President Barack Obama has emphasized a smaller proportion of the financial industry in the future U.S. economy in order to take the financial sector back to the state it was in in the 1970s and the 1980s and no longer be half of the economy. Therefore, China should also not overlook the role of industry. The financial sector was too big in the United States but too weak in China. In China, both financial and service sectors should be developed, but they have to be proportionate to the industrial sector. High-end financial and service industries cannot be blindly developed with the hope of overtaking the United States and other developed countries. China must learn from the lessons drawn from the mistakes of the United States and focus on expediting heavy and chemical industrialization and urbanization, upgrading the industrial structure, and promoting the cross-border transfer of manufacturing capital from developed countries to China. The Chinese government has to attach importance to the development of the real economy and

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lead the reasonable growth of physical investment whether during the revitalization of Northeast China, the development of Western China, the rise of Central China, or the development of metropolitan areas and county-level economy. To revitalize the nation through financial development is the pressing task for the Chinese government under the new situation of the rise of the great powers. China has to build up solid financial and economic strength, timely and steadily open its financial markets, seize every opportunity to turn the renminbi into a global currency, and participate in the reform and restructuring of the international financial system. It should both guard against the attacks of speculative capital on financial markets and calmly deal with the games among financial superpowers during the economic financialization and financial globalization in order to learn to prevent, control, and manage risks in the course of financial opening and development. Financial regulators have to familiarize themselves with the rules of capital flow, especially the common practice of speculative capital, and impose strict financial supervision to prevent the financial shocks from the massive capital flows to China’s economy and finances after the full convertibility of the renminbi. Most importantly, it is vitally important to let financial markets and the fictitious economy serve rather than impair the real economy and truly make China’s financial sector bigger and stronger.

To Accelerate the Production-Oriented Modern Service Industry, Especially the Modern Logistics Services A major characteristic of current global economic development is that a large share of the service sector is linked to GDP. The proportion was 73% in developed countries while the world average was 69%. According to China’s 11th Five-Year Guidelines, the ratio between the service industry and GDP was expected to reach 43.3%, but in fact the ratio was 43.0%, 0.3 percentage point smaller than stated in the plan and 30 percentage points less than that of developed countries. China’s service sector — no matter if compared to developed countries, middle-income countries, or even some low-income countries — still belongs to the backward group. Therefore, China has to not only grow its financial service industry but also expedite the production-oriented modern service industry, especially the modern logistics industry.

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Shortly after the Reform and Opening Up era began, the Chinese government proposed to develop the tertiary industry. But why did the modern service industry still lag behind? This was related to the rapid development of industrialization, delayed urbanization, the deepening of economic globalization, market entry restrictions of private capital, and many other factors. In particular, too many institutional obstacles and overly extensive government intervention limited the development of the service sector. However, the root cause for the sluggish development of the service sector did not lie in the service industry itself, but the insufficient specialization, socialization, and marketization of the manufacturing industry. As the upstream and downstream companies in the manufacturing industry have not yet realized specialization, the modern service industry cannot go deep into the upstream and downstream of the industry chain to provide comprehensive and convenient socialized services. Besides, the fast growth of China’s industry was attributed to the adjustment of the global manufacturing pattern. If excluding the manufacturing exports, the proportion of China’s service industry will be up nearly five percentage points.3 In the mid-1980s, China’s National Machinery Committee introduced a reform of production specialization and socialization in the manufacturing industry to transform a group of small but all-embracing manufacturers into specialized factories in cities and separated a large batch of specialized and socialized casting and forging, plating, welding, machine repair, heat treatment, and tool and die factories from those all-inclusive manufacturers. This was the first reform in the industrial structure aimed at specialization and cooperation during China’s industrialization. Despite being carried out in an administrative rather than market manner, this industrial reform actually solved the high consumption with low efficiency and low productive capacity with high pollution in urban industrial production to achieve higher asset efficiency and make production be more cost effective, efficient, and environmentally friendly. Later, as the National Machinery Committee was abolished, the reform towards specialization and socialization in the manufacturing industry stopped. Additionally, the monopoly of state-owned enterprises and numerous systematic defects in corporate governance made most enterprises prefer comprehensive production and diversified operation rather than specialization and collaboration which were beneficial to the deepening of the division of labor in the upstream and downstream industry chain and the society as a whole. Since there are not many highly specialized manufacturing enterprises in China and the existing ones pay little attention to reforming operation flow and promoting business outsourcing, the tertiary industry built upon the extensive

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social division of labor and market provision of services to reduce transaction costs can hardly develop. Another problem in the modern service industry is that production-oriented modern services develop slowly. The two problems are interrelated and interact on each other. The competition in the modern industrial economy has shifted from between different enterprises to between supply chains. Enterprises strive to obtain competitive edges for sustainable development through improving their relationship with the upstream and downstream enterprises and consolidating and optimizing the information flow, knowledge flow, material flow, service flow, and capital flow in the supply chains. In the global competition, supply chain logistics management has become a core topic for business decisions. The mainstream trend of modern logistics management is to extend towards supply chain management and service chain management. The focus is to consolidate logistics operation from market projection and order management to storage and stock management and from raw material transport to finished product distribution and product maintenance and recycling, and integrate logistics into the service chain. This enables enterprises to fully exploit and utilize external and global resources, technologies, and capacities to enhance their own core competitiveness by outsourcing logistics and supply chain management and other unrelated businesses. It should be noted that during the development of the modern service industry, logistics and manufacturing industries were highly related to each other. Among the global total logistics income, 88.8% was contributed by the industrial goods transport. However, logistics has not fully displayed its value in China. The logistics industry did not develop in China until this century. The understanding of most Chinese companies about logistics still centered on the integration of transport and storage and their industrial ideas still lingered in the traditional logistics age when the focus was on the transporting of finished goods from producers and sales networks. As the transportation during the production of manufactured goods was absent, it resulted in a lack of the inbetween logistics services whose size was a multiple of the existing delivery of finished goods. At present, developed countries have generally adopted supply chain management and basically realized zero stock or near-zero stock. Goods are always in circulation and will not stay in warehouses for more than 24 hours. In contrast, China’s logistics remains at the level of the 1980s and continues the habit of maintaining large inventories. Many Chinese cities relied on heavy and chemical, coal, and grain industries and the factories both purchased and produced huge quantities of materials or goods to be stored in the warehouses. As the land prices went up, the storage costs constantly

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increased. Many products were manufactured in the west and processed in the east before being sent back to the west for sale. During this process, it would add to a great deal of logistics costs. This indicates that the sluggish development of China’s logistics industry is related to not only the delayed revitalization and growth of itself, but also insufficient understanding towards industrial companies and the backward reform of the industrial system. Therefore, reforms should be carried out in at least two aspects. First, industrial producers have to update the traditional understanding of logistics. They should recognize the needs to divorce logistics management from main businesses to be handled by third-party logistics providers, and integrate logistics outsourcing into supply chain management in order to improve their core competitiveness. Second, the logistics industry must upgrade its services by developing towards intelligent logistics. All sorts of costs can be minimized if production, storage, delivery, and sales are smoothly connected via the internet. Only in this way can industrial customers and logistics service providers form long-term win-win partnerships. Then, logistics enterprises can expand the business scope, improve value-added services, and grow larger and stronger. After entering the 21st century, China’s logistics industry moved into the fast lane of development. At present, there are nearly 100 logistics enterprises with a business size of above RMB1 billion, and the business income of large ones even surpassed RMB100 billion. This was hard to imagine a few years ago. Overall, China’s logistics companies are large in quantity and rich in variety but small in scale and poor in quality, and they generally face the problems of low efficient logistics tools, extensive logistics management, and low-level application of logistics informatization. In 2010, the total social logistics costs in China amounted to RMB7.1 trillion, accounting for 18.1% of the GDP, doubling the percentage (round 8%) of developed countries like the United States and Japan. According to the estimate by the United Nations Development Programme (UNDP), the logistics costs for industrial products made up roughly 20% to 40% of the product costs in China; however, the proportion was 9% to 10% in developed countries. A research report from the World Bank in 2007 asserted that as it was affected by high toll rates, China had one of the highest logistics costs in the world. China charged the highest toll rate, but had the lowest toll affordability. Information said that among the 140,000 km toll roads in the world, around 70% (100,000 km) is in China. The National Development and Reform Commission (NDRC) of China also admitted, “The charging standard for expressways in China is too high and the tolls on roads and bridges account for one third of transportation enterprises’ costs.” Some experts pointed out that when taking into account

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traffic fines, the proportion could be as high as above 50%. This explains why road and bridge operators topped the list of profiteering industries. In 2009, the average gross margin and net margin of 14 listed toll collecting companies in Shanghai and Shenzhen was 64.2% and 36.6%. This clearly shows the wealth transfer effect. One obvious example is that during the 2008 Chinese winter storms, the government waived the tolls of travelling roads, bridges, and tunnels for vegetables and other farm products. This would save RMB2,000 per truck for transporting chilies from Hainan to Wuhan province, which would reduce chili wholesale prices from RMB4 to RMB2.2 per jin (0.5kg). Although this preferential policy was temporary, it showed that curbing monopoly played a decisive role in improving logistics efficiency and reducing logistics costs, especially transport costs. When the world’s manufacturing industry became more and more specialized, socialized, and market-oriented, and constantly spun off production-oriented modern services, the modern service industry, including the above-mentioned services, grew to be more and more professional. But, China lagged behind in this regard. For example, engineering design has already adopted scale management or professional management internationally, but China is still held back by the separation between departments and policy constraints. Likewise, the well-known big four accounting firms are very competitive in the global market with their businesses ranging from accounting and auditing, tax consulting, corporate mergers and restructuring; at the same time, some small- and medium-sized accounting firms which have a professional division of labor and offer powerful socialized services can also generate high profits; however, most Chinese accounting and auditing firms are neither large enough to achieve economies of scale nor small enough to be professional and they are short-sighted in business development. In still another example, bill discounting, credit card marketing, and the urging of the clearance of debts are generally outsourced to specialized financial service providers in foreign countries, whereas in China, large banks monopolize those businesses and leave no chance for the service industry. To go one step further, the development of the modern service industry and that of the financial service industry can affect and reinforce each other. Take the field of modern logistics as an example. Logistics companies have to provide financial services for supply chains. However, it is hard for most small- and medium-sized companies in the upstream or downstream of a supply chain to get loans due to the lack of the forms of collateral and sound financial statements required by traditional commercial banks. The capital shortage will severely impair suppliers’ capacity to fulfill orders and the

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quality of orders completed and so slow down the sales and product turnover of retailers. It will further impact the smooth operation of the entire supply chain and even restrict the competitiveness of core enterprises. By contrast, in foreign countries, the financial services provided by banks can meet enterprises’ demands for supply chain management, either from purchase-order financing which happened when producers placed orders with suppliers, to the factoring business through which accounts receivables are sold to factoring companies, or from the pledge of movables and warehouse receipts during logistics process to policy financing established based on the credit of insurance companies. Banks are able to provide a series of financing service products, including purchaseorder financing, movable property financing, warehouse receipt financing, factoring, accounts receivable financing, policy financing, corporation overdraft, confirmed warehouse financing, and e-commerce financing, throughout each link and the whole process of a supply chain. By offering the supply chain financing business, banks can not only lower risks from the loan business, but also promote the development of upstream and downstream enterprises in the logistics or supply chain and strengthen the cooperation between banks and core enterprises. For China, the growth of core enterprises and the effective, smooth, rapid and sound development of the entire supply chain can be achieved, if banks are able to create innovative supply chain financing products to both fulfill customers’ needs and achieve risk control, regard these products as an important carrier and platform of liquidity support provided to enterprises, and offer tailored comprehensive supply chain financial solutions based on the features and demands of each customer. Therefore, to advance the specialization of the manufacturing industry, boost business outsourcing, develop production-oriented service industry (especially logistics services), and provide systematic financial innovation services, enterprises, governmental departments, and banks have to renew both their knowledge and management and implement in-depth reform towards intensive economic growth instead of simply updating the businesses. It should be specially pointed out that one of the main sticking points for inadequate specialization of the manufacturing industry and the absence of a production-oriented modern service industry is the hindrance from the existing tax system to the development of the service industry. During the 2011 National People’s Congress (NPC) and the People’s Political Consultative Conference (CPPCC), known as the “two sessions,” Xu Shanda, member of the national committee of the CPPCC and former Deputy Director of the State Administration of Taxation, said that the failure to meet the targets of the 11th Five-Year Guideline by the service industry had much to do with excessive high taxes and fees.

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The Chinese turnover tax system is currently composed primarily of value-added tax (VAT) and business tax (BT). The manufacturing industry is subject to VAT while the service industry is subject to BT. The tax base is the total volume of business turnover. However, this tax system contains three problems. First, the BT of the service industry is levied on the gross income rather than the value-added part as practiced in the manufacturing industry, so this has caused double taxation. The more the division of labor extends, the heavier the BT is. As the division of labor is increasingly specialized, the commodity turnover involves more steps. Therefore, duplicate taxation becomes more and more severe. It inhibits the subcontracting and outsourcing among service providers and distorts the allocation of market resources. Second, since different taxes are applied to the manufacturing and service industries and the BT levied on the service industry is not deductible, it cuts off the deduction chain. This has not only prevented the production-oriented services from divorcing from the manufacturing industry, but also limited producers’ demand for outsourcing services, inhabiting the development of the producer service industry. It will encourage industrial business groups to develop internal service supply and give up purchasing services from outside, thus impeding the development of service outsourcing. Third, VAT is the premise for export rebates. As the service industry is subject to BT, the export of services cannot claim a tax refund. It harms the expansion of the trade in services. This is a typical example where superstructure severely hampers the development of productivity, the adjustment of economic structure, and the transformation of development mode. The most notable flaw in the Chinese tax system is double taxation. As a typical case, Guangzhou Hongfeng Logistics Company shipped nearly 1,000 tonnes of steel from Guangdong Panyu Cargo Terminals to Haikou City, Hainan Province, the total freight costs were RMB19,902. The company paid RMB688.34 for tax on shipping charges when the steel was loaded onto a ship. But when the ship arrived at the Haikou dock, the logistics company had to pay another RMB657.35 handling tax for outsourcing the unloading business to the Haikou dock which was an independent legal entity. Since all the taxes paid around freight terminals could not be refunded, the company’s gross profit was reduced to RMB216, after deducting freight and handling charges. During this process, the logistics company was double taxed RMB657.35, almost half (48.87%) of the total taxes (RMB1,345) paid and 3.04 times the gross profit.4 People from the China Society of Logistics expressed that currently railroad and sea-road intermodal transportation was the sector that was hardest hit by double taxation.

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The negative impact from the current tax system on the service industry is also obviously reflected in financial leasing. As we have mentioned previously, the high tax levied on the aircraft leasing business was an example of the hindrance from uncoordinated fiscal and taxation systems to the modern service industry. In the long run, governmental departments and banks in China have to reinforce investigation and research in order to formulate a whole set of policies and measures concerning market access, tax breaks, financing, corporate mergers, and industrial consolidation for promoting the specialization and socialization of industry chains and the development of financial services. Meanwhile, the investment banking industry has to be developed based on the practices and experience of Western markets to provide tailored financial services for the formation and consolidation of the domestic emerging service industry. As far as I can remember, during the reform of the manufacturing industry towards specialization in the 1980s, there was also a problem of an incongruous tax system. At that time, the government encouraged specialization and cooperation in the manufacturing industry, but the tax system levied higher taxes on all-embracing factories than specialized ones. And the more cooperative links there were, the higher the taxes paid and the lower the profits. This reversed the reform direction to indulge the development of “big and comprehensive” or “small but all-inclusive” companies. Later, this mistake was corrected after China Construction Bank (CCB) conducted a survey to report the problem to the relevant authorities. From here we can see that to promote China’s tax reform by adding the service industry into the scope of VAT reform will greatly boost the development of the modern services. It is reported that Xu Shanda, former Deputy Director of State Administration of Taxation, suggested that the next step after unifying corporate income tax rates for domestic and foreign-funded businesses, and introduction of the VAT reform, should be a BT reform, and the BT should be replaced by the VAT in the service industry to accelerate the development of the service sector. The Outline of the 12th Five-Year Guidelines (draft) required the speeding up of “the development of producer services.” It specifically stated that the government should “enhance the division of labor based on specialties, accelerate innovation of service products and service models, and facilitate integration of producer services industry and advanced manufacturing industry, thereby promoting the accelerated development of the producer services industry.” The government must “systematically expand the financial services sector, vigorously develop the modern logistics sector, cultivate and develop the high-tech service sector, and standardize and improve the commercial services

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sector.” It is really a targeted development plan. Information from the official website of China’s Central government said that Wen Jiabao, Premier of the State Council, chaired the State Council Executive Meeting on June 8, 2011, to study and plan the tasks for the sound development of the logistics industry. The meeting underscored the need to formulate complete supporting policies and measures to facilitate the sound development of the logistics industry, based on the problems found in policies that restricted the logistics industry development since the Adjustment and Revitalization Plan of the Logistics Industry was issued by the State Council in March 2009. The meeting put forward eight measures to counteract those problems. 1. Effectively alleviate the tax burden of logistics companies. Relevant departments shall improve the pilot measures for the balance payment of business tax by logistics enterprises, further expand the scope of pilot program, and comprehensively popularize the pilot measures. 2. Increase policy support for logistics land use. Approvals should be given to logistics industry development that makes use of obsolete factory sites, old warehouses, and unused or insufficiently used land. 3. Facilitate passage for logistics transportation. Tolls for bridges and highways should be reduced. 4. Relax the rules for business qualification and administrative licensing, gradually reducing the administrative approvals and improving processing efficiency. 5. Encourage the integration of logistics facilities and resources. The government should support large advantageous logistics enterprises to integrate logistics facilities and resources and encourage small- and medium-sized logistics enterprises to form alliances. It will also guide storage and transport facilities in the industry to carry out communitybased logistics services and support the development of a joint distribution trade for commercial transportation. 6. Promote innovation and high tech application in the logistics industry. 7. Increase investment in the logistics industry. Governments at all levels should increase investment in infrastructure, and actively guide the banking financial institutions to increase credit support for logistics enterprises and expand financing channels for those enterprises. 8. Promote the logistics industry for agricultural products. Direct distribution between farms and supermarkets, farms and schools, and farms and enterprises should be vigorously developed. The government must improve the agricultural VAT policies and encourage large-scale

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enterprises to engage in agricultural logistics. The establishment of a cold chain logistics system for key species and in key areas should be accelerated. Government investment and policy support for the agricultural wholesale markets and farmers markets should also be increased. Policies of green channel delivery of fresh agricultural products and of vehicles 24 hours a day in the city’s traffic system, with convenient docks, must be strictly implemented. The development of the modern logistics of food and cotton will be accelerated.5 Media reported on this meeting by stating, “The State Council works hard to combat the chronic diseases in the logistics industry.” The meeting urged all localities and departments concerned to strengthen the organization and coordination and detail the policies and measures before seriously implementing them. It can be expected that the modern logistics and service industries will be largely improved. International experience shows that when the per capita GDP of a country or region exceeds USD3,000, its urbanization and industrialization will speed up and its industrial structure and consumption pattern will also dramatically change. The per capita GDP of USD3,000 is a turning point in economic development, and passing that point, consumption will be more active. At present, China’s per capita GDP has crossed the USD4,000 mark and therefore the expedited development of the service industry becomes a top priority. According to the Outline of the 12th Five-Year Guidelines (draft), the share of the value added from the service sector in GDP is expected to reach 47% in 2015, with an annual growth rate of 4%. Although remaining lower than the world average, this percentage denotes lots of room for the future development of the modern service industry and the financial industry which provides financial support for the former.

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Socialist Workers and Capital

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Prologue: An Anecdote about When to Implement Communism Sometime around 1950, there was story widely repeated in Shanghai. It was said that during the first Chinese People’s Political Consultative Conference (CPPCC) in Beijing, a capitalist asked Liu Shaoqi, the Party leader: “When will the Party implement communism?” Liu replied wittily, “When workers live the same way as you capitalists do, it will be the time for communism.” At that time, Shanghai had just been liberated by the Chinese Communist Party (CPC) and workers participated in the revolution by upholding the banner of “Workers of all lands, Unite!” But, the kind of life the workers should live after the CPC took power had not been carefully considered. The conversation between the capitalist and Liu Shaoqi was passed on by word of mouth and it generated much speculation among the communist cadres. People wondered whether capitalists would worry about communism if workers really lived the same way as capitalists — having fish and meat three times a day, living in townhouses and villas, equipping their houses with refrigerators and washing machines, using diesel engines to keep warm in winter (back then, there was no heating system in Shanghai) and air coolers to cool down in summer (air conditioners were not introduced then), and getting around by car. Later, as Mao Zedong criticized the consolidation of the New Democratic social order and the bourgeoisie, the anecdote was forgotten. However, Liu’s answer was still a beautiful and ideal vision in my mind. I always feel that the future life of workers should be as affluent as capitalists’, otherwise what is the meaning of revolution? Certainly, after experiencing all kinds of political movements and a series of “permanent revolutions,” I for one would rather continue the present simple life than dream about workers and cadres leading a “luxury” life the same as the bourgeoisie. Not coincidentally, Yanhuangchunqiu magazine published an interview with an unemployed worker in the United Kingdom by Wang Zhen in 2008. At the end of the 1970s, China’s Vice Premier Wang Zhen paid a state visit to the United Kingdom. He was very surprised when hearing that in the U.K., most workers, office clerks, intellectuals, and the petty bourgeoisie, accounting for 70% of the country’s population, were able to own private houses and family cars, and take yearly holidays abroad. This seemed ostentatious to the Chinese people. To show that he cared about the poor and the suffering, the Vice Premier requested to visit an unemployed worker. The Chinese Ambassador to the U.K., Ke Hua, accompanied the Vice Premier to the house of an unemployed British worker. It was a two-story building of over 100 m 2 with a separate dining

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room and living room. The living room was furnished with a sofa, television, and decorated silverware cabinet. At the back of the house, there was a small garden of approximately 50 m2. The worker was out of work and so exempted from taxation and he was also entitled to free medical care and free compulsory education for his children. After seeing this, Wang Zhen got mixed feelings. He was astonished that unemployed British workers who he originally thought should strive against poverty in fact lived better than the Chinese Vice Premier. Ambassador Ke Hua told the Vice Premier, “Once a cleaner told me he could earn GBP100 per week, and an elevator operator told me his weekly wage was GBP150.” According to the then exchange rate of GBP1 = RMB5.91, their respective weekly incomes equaled to RMB591 and RMB886. Wang Zhen was a rank-five senior government official and he earned around RMB400 per month. His weekly income was less than RMB100, equivalent to one sixth of that of a British cleaner and one eighth of that of a British elevator operator. Yu Ri, the Economic and Commercial Counsellor at China’s Embassy in the U.K., wrote in his article, “Living 10 Years In the United Kingdom: Rediscover Capitalism”, that when asked about his impressions of the United Kingdom, Vice Premier Wang Zhen answered unexpectedly, “I think the British government has done a good job; material wealth is greatly abundant, the gaps between workers and peasants, rural and urban areas, and manual and mental labor have basically been eliminated, social justice and public welfare are given due attention; and if it were the Communist Party which was in office, the United Kingdom would be an ideal model of a communist society.” The above two stories all talk about workers. The first is a revolutionary vision while the second is the reality of British workers (in particular, unemployed workers) in the eyes of Wang Zhen. As a side note, I visited France in 1981. During that time, China was still suffering from the extreme shortage of consumer goods and commodities were supplied by ration coupons and queuing. By contrast, Paris and Lyon were abundant in material wealth and prioritized social welfare, as Wang Zhen said. The workers of the factories visited by me even owned private cars and around 20 workers’ cars were parked in each yard of those factories. The President of China Construction Bank Jiangxi Branch from our delegation said with surprise, “These factories have as many cars as our provincial government!” To minimize foreign exchange expenditures, our delegation stayed at the Embassy of China in France and had chicken and hairtail for lunch — these were rare and delicious things in China during that time. But the chef of the embassy called these “food of the third world.” Later, when attending the reception banquets and business luncheons held by some banks in France, we found out that neither chicken nor

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hairtail were served and instead, there were only some other kinds of fish, beef, duck, and goose. My first impression of the material abundance in France came from the scenes of everyday life: Cement was used in roads and buildings, glass was used in automatic doors of hotels and shops and in the aluminum windows in high-rise buildings, and paper, instead of rags, was used when cleaning. Even the packaging was more luxurious than that of our commodities. At that time, I thought that even with such material abundance, capitalist France was still not qualified for socialism, let alone China. The reason why I related those stories is because I will now go into a serious topic: turning workers into men of property and creating the conditions for increasing the property income of the masses. The above stories can serve as a lead-in to the discussion of more serious matters. Now let us cut to the chase. The proletarian party upheld the banner of “Workers of all lands, Unite!” during the revolution and the reason why workers (proletarians) followed the communist party to join the revolution was by no means for continuing poverty and forever being proletarians but to get rid of poverty and become the masters of the world. So when the revolutionary party came into power, it had the responsibility to turn the workers into men of property, upgrade low-income earners into middle-income ones, and create conditions to make more people have income from property. This is crucial for building socialism with Chinese characteristics and the socialist market economy in China.

Turn Workers into Men of Property In the economic life of China, workers are being transformed into men of property. This is a major change in Chinese society. This change is multifaceted and progressive. Originally, Deng Xiaoping Theory allowed “a group of people to get rich first” after the Reform and Opening Up policy was launched. But as the State Council issued the document to reform the housing system, workers suddenly owned the property right of their houses. In this way, workers were really transformed into being men of property which thus led to some fundamental changes in the material life and ideological field of China. In 2000, I wrote an article named “To Turn Workers into Men of Property,” discussing the four aspects of changes in the transformation of workers into men of property. After the shareholding system was introduced on a pilot basis in 1990,

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workers were allowed to invest in stocks. The new kind of stock was called individual shares, which could be further classified into employee shares and social individual shares. Before going into this issue, we have to mention a premise: Socialism follows the principle of distribution on the basis of labor. But there is both simple labor and complex labor. The latter is also expanded to include technical innovation and management innovation, which is now referred to as “human capital.” The problem is that in the real world, the quantity, quality, and reward of labor vary greatly among different people, so does one’s consumption. Therefore, there is a possibility of workers delaying their consumption, which is the source of the dozens of billions of urban and rural household saving deposits. The saving deposits reached more than RMB6 trillion in 2000, RMB17 trillion in 2007, RMB21.8 trillion in 2008, RMB26.08 trillion in 2009, and RMB30.33 trillion in 2010. The funds from delayed consumption that we are now talking about are also the capital source of workers to purchase stocks. We know that when Marx expounded the future socialism, he once assumed that the means of production would be owned by the society whereas the means of consumption would be owned by individuals. However, he did not discuss whether the fund from delayed individual consumption could be transformed into a production fund and how the transformation would be realized. At the initial stage of New China, workers were allowed to put their funds from delayed consumption into banks and receive interest in return. But the left-wingers in the Cultural Revolution opposed this practice and criticized that interest was income from exploitation. So they proposed to abolish interest and introduce interest-free deposits. This was self-contradictory: Since there is no interest, then why bother to make deposits? After this new policy was implemented for a while, deposits sharply decreased, thus impairing credit balance and control. As a result, the practice of interest-bearing deposits resumed. The theoretical explanation was that interest on deposit was a kind of reward given to workers for supporting the construction of socialism by postponing consumption. Similarly, the theoretical basis for allowing workers to purchase stocks in the pilot scheme of stock markets was also deduced from the above logic. Now that the interest received by workers from saving their delayed consumption funds in banks which will lend out the money for developing production was not regarded as exploitation, stock dividends received by workers through bypassing banks and directly investing their labor income into stock markets for developing production should also be inferred as a kind of reward for delayed consumption.

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Science and technology personnel were allowed to contribute their scientific and technological innovations as equity investment. At the beginning, investment in the form of proprietary technology was limited to 20% of the total registered capital, and could not exceed 40% under special circumstances, according to the policy during the pilot project of joint-stock companies. Later in the Company Law, the maximum proportion was redefined as 20%. In late 1999 when the National People’s Congress (NPC) Standing Committee modified the Company Law, it decided to extend the proportion of technology investment in high technology companies, and the specific measures shall be prescribed by the State Council. To permit technology investment is not only an acknowledgement of technology as complex labor but also recognition of the primary productive forces of science and technology being able to be invested like material capital, despite the term of “human capital” having not come up yet at that time. In such a way, science and technology personnel would share profits according to their contribution of technology investment and become men of property. At the moment, no one worried that a class of men of property would be formed accordingly, because those who contributed technology were also workers, in particular talents of technologies, and their number was definitely small. The pilot program of incentive compensation and managerial ownership was approved at the Fourth Plenary Session of the 15th Central Committee of the CPC in 1999. It was the first time that the Chinese government had allowed managers to enjoy the property rights of companies with their excellent management and equated management with material capital in the income distribution. This proposal was further confirmed in the Report of the 16th Party Congress in 2002: Technological knowledge and managerial skills could participate in the distribution of income according to their respective contributions the way other factors of production (such as labor) do. A more updated term for the technological and managerial investment is “human capital.” The last change was the reform of the housing system. The housing system reform started to be discussed at the end of the 1970s and after many years of discussion, no serious policy was implemented, except the housing provident fund scheme. After all, if the capitalization of housing distribution cannot be really put into practice, the housing system reform can hardly go anywhere. However, in 1999, the State Council ordered to abolish the welfare-oriented public housing distribution system and replaced the housing distribution in kind with housing distribution in money (cash allowance). It for the first time turned the years-long discussion into a radical reform by capitalizing the public housing distribution to enable workers to own their own property.1 In this way,

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starting from 2000, Chinese workers who had dedicated half of their lives to their work were able to receive a large amount of housing allowance based on their respective length of service; therefore with just a few additional savings, they could manage to buy a house and become men of property. This reform was not impeccable, for it did not fully realize the capitalization of housing distribution, thus it was unable to truly activate the secondary market of real estate. But it successfully turned millions of workers into men of property and accumulated experience in building up a mass basis. Of course, this has nothing to do with exploitation and the underlying principle remains distribution according to labor. The above four changes, especially the housing system reform in 1998, transformed the Chinese proletarians who had seized power into men of property, 50 years after the socialist revolution in China. However, this has nothing to do with privatization. The reform neither privatized the stateowned assets of state-owned companies, nor made private capital to exploit the Chinese proletarians. Instead it allowed Chinese workers to use their work (including excellent intellectual work) and earned income to become men of property through either improving consumption conditions or postponing consumption. Therefore, I ended my article with the following sentences: To turn workers into men of property will be a significant and profound power for breaking away from the shackles of thoughts. It again proves the truth in Deng Xiaoping Theory: Poverty is not socialism, and development that is too slow is not socialism either. The objective of proletarians to call for “Workers of all lands, United!” is by no means to continue being havenots, and by doing so, “the proletarians have nothing to lose but their chains; they have a world to win.” 2 For this reason, the government has to first lift workers from poverty, create better living and consumption conditions, and turn men of no property into middle-income earners and owners of their own earned income. Meanwhile, to develop too slowly is not socialism. A socialist country must mobilize all the positive factors and constantly encourage workers to put temporarily unused consumption funds in investment. All the citizens should get engaged in the lifelong pursuit of socialist construction and ensure a rapid growth of socialist economy. To turn workers into men of property is not a socialist utopia, but a reality for socialism with Chinese characteristics.

As a side note, the phrase of “the Chinese proletariat who has seized power” mentioned above is a common way to express the idea, but in fact it

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was not precise. Because when the Chinese revolution achieved a victory in 1949, the proportion of the industry sector accounted for less than 10% and the industrial population made up less than 5% in 1950. So China had no typical proletariat as was described in the classic theories of Western countries. Strictly speaking, after the victory of the revolution, it was the working class based on the alliance of workers and peasants and with Chinese characteristics rather than the proletariat who seized power in New China. After the revolution, a land reform was implemented to realize “land to the tiller” and the entire countryside became a society of small property owners who were the owners of their respective land. Overall, the movement of “turning workers into men of property” in China had been in place since the land reform in the 1950s and was reinforced during the implementation of the contract responsibility system (namely, to fix farm output quotas on a household basis). Following that, the technology investment in the 1980s, the opening of stock markets and the introducing of manager stock ownership in the 1990s, and the housing system reform in 1998, jointly enabled China to finally step into an ideal society where workers are men of property.

Expand the Middle-Income Group, and Unite All Builders of Socialism with Chinese Characteristics In 2002, the Report of the 16th Party Congress proposed to “bear in mind the objective of common prosperity, and try to raise the proportion of the middleincome group and increase the income of the low-income group.” This was the extension of the revolutionary practice of leading workers to become men of property by the ruling party and its priority was: to turn workers into men of property, upgrade the low-income group to the middle-income one, and constantly enlarge the proportion of middle-income earners. But, who belongs to the middle-income group? Except for the working class, with the intellectuals as part of it, and peasants whose income has been increased, the report clearly stated, “Emerging in the process of social changes, entrepreneurs and technical personnel employed by non-public scientific and technological enterprises, managerial and technical staff employed by overseas-funded enterprises, the self-employed, private entrepreneurs, employees in intermediaries, free-lance professionals and members of other social strata are all builders of socialism with Chinese characteristics.” 3 I think “all builders of socialism with Chinese characteristics” comprise not only high-income earners but also a larger percentage of middle-income earners.

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It was for the purpose of advancing the progress of history, especially for the purpose of “bringing all positive factors into full play and bringing new forces to the great cause of rejuvenating the Chinese nation” that the 16th Party Congress declared those people to be “builders of socialism with Chinese characteristics.” Accordingly, the meeting advocated, “We must respect work, knowledge, competent people and creation; and this should be an important policy of the Party and state to be conscientiously implemented in society at large,” and claimed to “unite with the people of all social strata who help to make the motherland prosperous and strong, encouraging their pioneering spirit, protecting their legitimate rights and interests and commending the outstanding ones in an effort to create a situation in which all people are well positioned, do their best and live in harmony.”4 It is worth noting that the report put forward “the principle that labor, capital, technology, managerial expertise and other production factors participate in the distribution of income in accordance with their respective contributions, thereby improving the system under which distribution according to work is dominant and a variety of modes of distribution coexist.” This was an important innovation in theory. Certainly, Marx discriminated between simple and complex labor and between physical and mental labor. But, workers were not well educated at that time, and complex and mental labor have never been more common than they are today, nor have they played a larger role in the society. In the age of Marx, since electricity had just been discovered, the impact of science and technology on the economy was not obvious. The contribution rate of science and technology in economic growth barely reached 5% in the early 20th century. After World War II, metallurgy, machinery, and chemical industries developed and the average contribution rate increased to 49% between the 1950s and 1970s. After the 1980s, owing to the rapid advances of electronic technology and information technology, the contribution rate soared to 80%. Science and technology truly became the primary productive force and made an outstanding contribution to economic growth. Management was just divorced from production in the times of Marx and capitalists evolved into being “coupon clippers.” However, the real scientific management did not make any significant contributions to the expansion of production and circulation and the improving of efficiency and earnings until the 1980s. Capital was described as a product stained with blood in Das Kapital. Now, we have to accept the contribution of capital in the construction of socialism with Chinese characteristics and establish the principle of distribution according to work. Although the Report of the 16th Party Congress did not clearly state the specific contribution of capital as a factor of production, it admitted capital’s role in

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production and circulation. People ought to acknowledge the contribution of capital and “all legitimate income, from work or not, should be protected.” In fact, Marx later specially mentioned in the Communist Manifesto, the “bourgeoisie, during its rule of scarcely 100 years, has created more massive and more colossal productive forces than have all preceding generations together.” Besides, Marx held different views towards different kinds of capital. He once believed that in the cooperative factories of the laborers themselves, “the antithesis between capital and labour is overcome within them, if at first only by way of making the associated labourers into their own capitalist, i.e., by enabling them to use the means of production for the employment of their own labour.”5 Marx considered share capital as “capital of directly associated individuals,” and thought that as share capital assumed a social nature through the socialization of capital, it manifested itself as a social power and product. He called share capital “the most perfected form (turning into communism).”6 From here we can see Marx admitted the positive contribution of share capital to the social production. Having confirmed the principle of production factors participating in the distribution of income in accordance with their respective contributions, the 16th Party Congress clearly stated in the report that “It is improper to judge whether people are politically progressive or backward simply by whether they own property or how much property they own…. It is necessary to foster notions and form a business mechanism in conformity with the basic economic system in the primary stage of socialism and create a social environment in which people are encouraged to achieve something and are helped to make a success of their career, so as to unleash all the vitality contained in work, knowledge, technology, management and capital and give full play to all the sources of social wealth for the benefit of the people.” If we say that Deng Xiaoping proposed the idea of “letting some people get rich first,” then the 16th Party Congress set up a mechanism to encourage and support a part of people to get rich first and turned Deng’s idea into a concrete measure for “raising the proportion of the middle-income group.” When the 16th National Congress of the CPC was convened in 2002, the proportion of the middle-income earners in China was still low. According to Dong Furen, the percentage was around 16%, Lu Xueyi estimated the proportion to be between 15% and 20%, and Xiao Liang suggested the percentage in urban areas was only about 10%. However, under the influence of the policies of the 16th Party Congress, the middle-income group would experience an “explosive growth.” At that time, I wrote in one article that in order to build China into a moderately prosperous society in an all-round way, the proportion of the middle-income group should be raised up

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to 30%–40%. Only when an olive-shaped society is formed, can we conform with the basic economic system in the primary stage of socialism. With the deepening of Reform and Opening Up and economic and cultural development, this part of the people, together with the constantly growing working class, will become important forces for promoting the development of advanced productive forces and all-round social progress in China. Generally speaking, based on the international experience, when a country’s per capita GDP reaches USD2,000–USD3,000, its middle class or middle-income group will significantly expand. If middle-income earners become the majority in a society, they will play a role of being a social stabilizer and at the same time, the government’s burden to subsidize the vulnerable group will be lessened. The experience of Nordic countries has proven that such a social structure is beneficial to social stability and lasting prosperity. The middle-income group proposed by the 16th National Congress is basically similar to the middle class in Western countries. The only difference is that the middle-income group is defined based on the income level whereas the middle class is classified based on household property. According to the authorities of the Ministry of Finance and National Development and Reform Commission, China’s urban households (a family of three) whose average pretax income was between RMB60,000 and RMB200,000 belong to the middleincome group. In other words, if the average per capita income in a dual-earner family is above RMB30,000, the family can be categorized as the middle-income group. Here, the middle-income group is decided by sustainable earning power rather than consumption level or the amount of property. Western countries have the tradition of consumption on debt and consumption credit service enables their citizens to sustain a high level of consumption on the basis of credit. Under credit consumption, the credit limit for the German middle class can be 2.5 times their income. The middle-income families in Western countries do not have full property rights to all of their property and most Western countries allow personal bankruptcy. Therefore, we should be prudent in the analysis of the consumption and property of the middle-income group. What did it mean by making “the middle-income earners become the majority in a society”? An idea proposed by the Policy Research Office of the CPC Central Committee once was that “55% of the population will be middle class whose annual household income exceeds RMB60,000 by 2020, with 78% of city dwellers and 30% of those in rural areas reaching that status, and 2% of the population will record an annual household income of over RMB200,000.”7 According to the Annual Report on Urban Development of China No.4 released by the Institute for Urban and Environmental Studies Chinese Academy of

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Social Sciences, China had 230 million middle-income residents in cities in 2009, making up 37% of the total urban population. Families with their Engel’s coefficient, or the proportion of income spent on food, standing between 0.3 and 0.373 were considered as middle-income residents, according to the report. It also showed that the proportion of lower-income residents of China’s urban population was still too large. Despite dropping below 60% since 2005, the proportion remained above 50%. The expected olive-shaped society has not been formed. However, the report predicted that the number of middle-income dwellers in Chinese cities would rise 2.3% annually from 2010 to 2025; their proportion would approach 47% by 2020 and it is likely to pass 50% around 2023; and in 2019, the urban middle-income group would for the first time outnumber the urban lower-income group, namely the so-called “olive-shaped society” would first appear.

Properly Deal With “Distribution According to Capital” China has implemented the income distribution system in which distribution according to work is dominant and a variety of modes of distribution coexist at the primary stage of socialism. Here, the “variety of modes of distribution” includes distribution according to capital. The 16th National Congress of the CPC in 2002 further stated, “We should establish the principle that labor, capital, technology, managerial expertise and other production factors participate in the distribution of income in accordance with their respective contributions, thereby improving the system under which distribution according to work is dominant and a variety of modes of distribution coexist.” It clearly classified capital as a kind of production factor which must “participate in the distribution of income in accordance with their respective contributions.” The Report of the 17th National Congress of CPC in 2007 put forward, “We will adhere to and improve the system whereby distribution according to work remains the predominant mode and coexists with various other modes; we will improve the distribution system to allow factors of production such as labor, capital, technology and managerial expertise to have a rightful share according to their respective contribution” in the section of “deepening reform of the income distribution system.”8 Compared with the Report of the 16th Party Congress of CPC, this report changed the wording from “establish” to “adhere to and improve,” which indicated this distribution principle had gained a foothold in Chinese society. In this section, we will specifically talk about “distribution according to

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capital.” There was a misunderstanding about this concept in the past, namely to regard “distribution according to work” as the sole principle of income distribution in a socialist society while considering “distribution according to capital” as a non-socialist mode and equating it with income from exploitation. This is wrong. It should be clarified that capital in “distribution according to capital” includes not only the capitalized surplus value of capitalists but also the capitalized household property of workers. First, workers can also use the money and materials converted from the past materialized labor as capital in the search for profits through investment. Second, the investment capital of workers (in stocks, for example) which is converted from past materialized labor is the surplus of labor income and the subsequent returns on investment (such as stock dividends or money from stock appreciation) is a kind of non-labor income received following the principle of “distribution according to capital,” but the income, the same as interest on deposits, is the reward from socialist countries to encourage their workers to support socialist construction by postponing their consumption. Third, to practice “distribution according to capital” in order to encourage workers to dedicate the capital from their past materialized labor to investment is a necessary distribution method for mobilizing socialist workers. To perform income distribution according to work is not merely to abolish exploitation, but to arouse the enthusiasm of workers when there are neither capitalists nor exploitation. We oppose the “iron rice bowl” and “eating from one big pot,” namely, the equalitarianism in income distribution, because it does not appear conducive to arousing but even harming the enthusiasm of workers. But socialist production has to mobilize not only the living labor of workers, but also the capital and materials from materialized labor. To allow distribution according to capital is to encourage socialist workers to contribute parts of their consumption funds to socialist construction at the expense of delayed consumption, which can mobilize the materials and capital from materialized labor. In order to mobilize socialist workers, a socialist society not only practices “distribution according to work,” but also is willing to give financial support to workers who participated in socialist construction through carrying out “distribution according to capital.” It is not only acceptable but also necessary for socialism at its primary stage to perform “distribution according to capital.” Now that we can tolerate and maintain the practices of capitalizing surplus value and “distributing according to capital” for both domestic and foreign capital at the primary stage of socialism, we ought to reward and encourage workers who contribute their surplus labor income by postponing consumption

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to support socialist construction through “distribution according to capital.” It is in nature a practical and realistic policy formulated based on the reality of the primary stage of socialism.

Foreign Experience: How Did Western Countries Create a Middle Class? People’s focus on the 12th Five-Year Guideline is around the government’s goal of “making people rich,” namely to turn the present “rich country, poor citizens” into “strong state, wealthy people.” Here, an important question is how to create a middle class. I will start with the lessons from Western countries. The rise of the middle class in the United States can be attributed to Roosevelt’s New Deal. Now when people talk about the New Deal, they usually focus on the policies of state-centralized investment and work relief which stimulated investment and consumption demands, implemented in response to the Great Depression in the 1930s. Later, some people questioned the effect of the two policies and argued that it was World War II that brought about investment and consumption demands and the revitalization of the U.S. economy. But what cannot be ignored is that the Roosevelt administration implemented a series of policies and measures to narrow the wealth gap and promote equality, leading to the expansion of the middle class. On the one hand, Roosevelt issued many policies to improve people’s livelihood and guarantee the basic lives of ordinary people, such as affordable public housing, freedom of association and unions to workers, price control over key commodities against inflation, control over the wartime gains of workers in many key industries, medical insurance, unemployment insurance, social security for the retired, etc. On the other hand, he raised taxes on the rich. First, the federal tax levied on company profits was increased. Later, statistics showed that the average tax rate grew from less than 14% in 1929 to 45% in 1955. Second, the income tax was raised. The top rate was only 24% in the 1920s, but grew to 63% during Roosevelt’s first term in office and further rose to 79% during his second term. Third, the estate duty was also added. The top rate of estate tax successively went up from 20% in 1929 to 45%, 60%, and 70% before finally reaching 77%. One of the outcomes of those policies was that wealth was significantly decentralized and the middle class accounted for a larger share in the society. The richest 0.1% of the American population controlled about more than 20% of the nation’s wealth in 1929, but the percentage decreased to around 10% in the

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mid-1950s. Another change was that the real income of middle-income families had basically doubled since 1929. For example, only one third of American families had installed a home telephone in 1936; by 1955, 70% of families had a home phone and most families owned a car, while 70% of households had access to a fixed telephone line and most families owned a car. In a word, Roosevelt’s New Deal had turned the country with a huge rich-poor divide in the 1920s into a middle-class society after World War II.9 Japan was another case. Liu Di once wrote an article to introduce the middle class in Japan. He said that the Japanese economy grew rapidly after World War II, and from 1950 to 1973, Japan’s Gross Nation Product (GNP) increased at the rate of over 10%, creating a miracle in the world economic history at that time. From 1955 to 1975, the Japanese people who thought themselves “middle class” increased from 42.5% to 77% while those who deemed themselves “lower class” decreased from 57.4% to 21.8%. By the end of World War II, around half of the Japanese population lived in rural areas but now 86% resided in cities. Liu Di believed that Japan achieved urbanization and turned farmers into citizens in the space of one generation and it was the long-term large-scale postwar urbanization movement that formed the middle class and middleclass consciousness in Japan. On the one hand, Japan built an olive-shaped society through its taxation system. In Japan, even though you are a president in a company with an annual income of JPY30 million, it is impossible for you to lead a luxurious life due to the heavy tax duty. In contrast, an ordinary staff member (who belongs to the middle class) with an annual income of JPY5 million is able to raise a family of four. Although not affluent, the middle class can still afford houses, cars, and eating out and almost every family lives in a flat with two or three bedrooms and a living room. On the other hand, during the rapid growth of the economy, massive amounts of farmers flooded into the cities. Municipal authorities took accommodating farmer-turned citizens as their priority. At that time, each city strove to expand residential building areas, for example the urban area of Tokyo constantly stretched westwards accompanied by the relocation of universities and other cultural facilities. In addition, local governments issued various policies of low-rent housing and large cities like Tokyo and Osaka built a few new towns to solve the housing shortage. Governments also erected lots of collective apartments as government-owned low-rent houses which solved the housing problem of millions of Japanese. Liu Di said, “Japan did not completely deprive the richest, but knew to push the middle class to the foreground and made them to play a leading role in politics in order to stabilize the political system. As to the business tycoons, they have to display their industrious entrepreneurship in order to win a place in the

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society.” SoftBank Corp founder Masayoshi Son and Uniqlo founder Tadashi Yanai are the best examples. Certainly, there are rich people in Japan, but their wealth is bound by social responsibilities and society and social media keep a close eye on the rich. It is very likely for a rich man to bring disgrace and ruin upon himself, if he uses his money to achieve a malicious intent. For this reason, rich people can hardly cause a stir in a society with such a powerful middle class.10 Equally important, after the Great Depression in the 1930s, Keynesianism prevailed, and leaders in the U.S. and Europe advocated using public construction projects to solve unemployment in the hopes of addressing market failure by active government intervention. Meanwhile, labor-management coordination successively appeared in the U.K., Germany, France, Sweden, Norway, and the U.S. on a national scale and class compromise replaced class confrontation. Subsequently, business owners in developed countries shared a portion of profits with workers and adopted stock ownership plans, such as technology investment, employee stock ownership, and managerial ownership, as incentives to management and technical personnel, greatly easing the conflict between labor and management. After World War II, as the capitalist production advanced, Western countries promoted national welfare, namely, governments use the transfer payment to establish and subsidize public utilities, implement and improve a set of social welfare policies and systems, and intervene in social and economic activities in order to regulate and ease class conflicts and ensure social order and the functioning of economic life. Those countries claimed to be welfare states. In the second half of the 20th century, the ideas of the welfare states were promoted to other European countries, especially the countries where the Social Democratic Party or the Labor Party formed the government, to become the basic system and the zeitgeist of Western societies. Among them, the most typical were Nordic countries and they were regarded as showcases of welfare states. For example, Sweden was a typical welfare state which adopted an economic pattern of “using equal and equitable distribution to integrate economic growth with private ownership. Since then, middle- and high-income population increased and a middle class which Marx failed to predicate was created as a result. It has been 60 years since the founding of New China. In the last 30 years of the Reform and Opening Up era, China’s socialist market economy maintained its high growth with an annual growth rate of over 9.7%, but its middleclass families only accounted for 23% of the national population. Among the 607 million of the urban population, around 160 million was rural migrant workers. They made a huge contribution to China’s industrialization but were

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excluded from the urban population and the working class. They received low wages and were deprived of social security and welfare benefits, such as access to public housing, medical care, and local schools, and thus were unable to be parts of the middle class. As a socialist country, China is now building a moderately prosperous society, but it has not yet turned the majority of workers into the middle class and formed an olive-shaped society. Although China is already a strong country, its people are still not wealthy. Therefore, the Chinese government has to formulate policies to solve the important issues, as to how the 12th Five-Year Guideline should lead the reform of the income distribution system, make people rich (namely, to increase the income of workers), turn the 160 million and future migrant workers into urban dwellers, and create a middle class and an olive-shaped society in China.

The Property Income of Chinese Citizens There are two premises for property income. First, allow people to own property. This is no longer a problem anymore. The Report of the 17th Party Congress in 2007 stated a goal of enabling “more citizens to have property income.” Here, property includes both movable and immovable property. Bank deposits and securities are movable property while houses, land, and collectibles belong to immovable property. Property is the premise of property income. You have to first have surplus money before you can have or buy property. To allow people to have property, the key is to protect private property. Otherwise, people will be unwilling to accumulate property and there will be no property income. During the planned economy, China adopted the system of people’s communes whose characteristic was being “large in size and collective in nature,” and private plots were even requested to “cut off the tail of capitalism.” People were scared of talking about “private ownership” and all housing was owned by the state. At the end of 1978, the savings deposit balance of rural and urban residents was just RMB21.06 billion. Considering the total population of 962 million at that time, the savings deposit per capita was merely RMB21.82. People owned no other private property, not to mention property income. In 2002, the 16th National Congress of the CPC stressed to improve the laws to protect private property, and the Property Law later came out as a result. The law was officially launched in 2008 after rounds of discussions. Approximately 58 years later, New China finally gained a law for protecting the property of individuals. Second, allow people to use property to gain income, including income

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derived from the transfer of the right to the use of their property. It is not helpful to frequently call for “cutting off the tail of capitalism.” This is also not an issue any longer. The so-called property income refers to dividend income from property operation, and interest, rent, and appreciation gains received from the transfer of the right to the use of property, for example, interest on deposit and national debt, income from renting houses, bonus from stock investments, profits from stock appreciation, and capital gains from the transfer of houses. Currently, there are three main characteristics of residents’ property income in China: First, the property income of urban and rural residents increased substantially, but the property income of most residents is still very limited. It has not been very long since the Chinese people began to accumulate their property. In the first 40 years of New China, people barely owned any private property except a small amount of personal savings. The government bond market was not opened in China until the 1980s. The opening of its stock market was even later in 1990. In the mid-1990s, the housing provident fund system was implemented and the sales of commercial housing were permitted. The real housing system reform was not put in place until the welfare-oriented public housing distribution system was abolished in 1998. After that, people were able to accumulate a large amount of household or private property. Based on the above analysis, Chinese people have accumulated property for less than 20 years. According to the National Bureau of Statistics of China, the per capita property income of urban residents reached RMB520 in 2010. Compared with the data in 2005, it was an increase of 169.7% with an average annual growth rate of 22%. The per capita property income of rural residents was RMB202, RMB114 higher than in 2005, an increase by 1.3 times with an average annual growth rate 18%. The property income of both urban and rural residents grew faster than the country’s GDP. Therefore, the five years during the 11th Five-year Plan was a booming period for the property accumulation of the Chinese people. Among Chinese residents’ property, the most important ones are real estate, financial assets, and land (mainly rural land). The respective proportions are: Real estate accounts for 60%, financial assets 20%, and land 10%, and they totally make up 90% of residents’ property. However, most residents have limited property income. For one thing, property income largely centers around rich people. In 2006, around 18.2% of households owned property income. Among them, the per capita property income of the top 10% of households was RMB1,279.28, while that of the bottom 10% of households was only RMB35.29.

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For another, most housing and rural land belongs to property of necessity, namely something that is necessary for living. In 2007, the property for living accounted for 71.4% of total family property while the investment-oriented property only comprised 26.9%. Taking Guangdong Province as an example, there was just 14% of urban households who owned more than two houses and only 9.4% of families had houses for rent. Second, compared with the international figures, the proportion of property income in the total personal income of Chinese residents is still very small. In the United States, the property income accounted for around 40% of the disposable income, and more than 90% of citizens owned stocks, funds, and other securities. In the disposable income of Chinese residents, approximately 70% was from the wages or salaries and income from property constituted only a small fraction. According to the data of the 11th Five-Year Plan, the proportion of income from wages or salaries of urban residents in total income was 68.9% in 2005 and that number dropped to 65.2% in 2010, a decrease of 3.7 percentage points; the proportion of net operating income was 8.1% in 2005 and it rose to 10.2% in 2010, an increase of 2.1 percentage points; and the proportion of property income was 1.8% in 2005 and it further grew to 2.5% in 2010, an increase by 0.7 percentage points. Overall, the contribution of property income to the income of China’s residents is still very small, not only lower than that of net operating income, but also far lower than that of either transfer income or income from wages and salaries. Third, the national income gap and property gap tend to continue expanding. According to the commonly used indicator for measuring income inequality — Gini coefficient, inequality in China stood at around 0.3 in 1987. Although the international standard considered below 0.3 as “perfect equality,” the principal challenge in wealth distribution for China was to correct the egalitarian practices of the “iron rice bowl” and “eating from one big pot” at that time. In 1993, China’s Gini coefficient closed to 0.4, but was still within the reasonable range (between 0.3 and 0.4). In 2002, the Gini coefficient rose to 0.447 in China, exceeding the international warning line of 0.4. As a result, the 16th Party Congress diverted more attention to equality. Afterwards, China’s Gini coefficient tended to stop expanding and even shrink. The five years between 2002 and 2007 were a period of steady and fast growth of rural residents’ income. However, statistics of 2007 showed that China’s Gini coefficient grew to 0.47, and the income gap significantly widened. In addition, according to the statistics from the World Bank, China passed the Gini coefficient warning line of 0.4 after 2000 and showed an upward trend year by year. The indicator rose to 0.496 in 2006 and reached 0.48 in 2007 (above 0.6 was considered “high

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inequality”). The World Bank’s report also indicated that the ratio between the average income of the richest 20% of the population and that of the poorest 20% was 10.7 in China, while the ratio was 8.4 in the United States, 4.5 in Russia, 4.9 in India, and 3.4 in Japan.11 Since the calculation of the Gini coefficient is very complex and there is no standard calculation method, the National Bureau of Statistics of China currently does not include the indicator into its statistics and the Gini coefficient from each research division and expert is quite different. In 2010, the Jiusan Society, one of the eight legally recognized political parties in China, submitted a proposal on improving national income distribution structure to the National People’s Congress and Chinese People’s Political Consultative Conference. The proposal mentioned that China’s Gini coefficient reached 0.41 in 2010, going beyond the warning line and about 10% of Chinese households owned 45% of the total property of urban residents. But according to another report, the Gini index in China approached 0.5 based on the investigation of the Chinese Academy of Social Sciences (CASS).12 The income disparity in different industries is much more obvious. According to the statistics released by the National Bureau of Statistics of China in 2010, the wages in China’s securities industry were six times higher than the average wages of the society and the income gap between the industry with the highest average income and that with the lowest average income reached 11 times. Later, according to the statistics from the Institute of Labor and Wage Studies in the Ministry of Human Resources and Social Security, this gap was further expanded 15 times. If the securities industry is calculated together with the financial industry, the income gap between different industries was still as high as 6 times. In other market economy countries, the income gap between the highest-paid industry and the lowest-paid industry between 2006 and 2007 was around 1.6–2 times in Japan, U.K., and France, and 2.3–3 times in Germany, Canada, the U.S., and South Korea. Judged from existing data, the income disparity between different industries in China is the largest in the world.13 People pay close attention to the yawning income gap and Western economists generally considered that a Gini coefficient above 0.4 signaled economic stagnation. After 2004, China’s Gini coefficient surpassed the internationally recognized warning line, but China still maintained rapid economic growth. According to Zhao Renwei’s research, the reason for a high Gini coefficient lied in that China was on its way towards urbanization and industrialization, the urban-rural dual economic structure had not been completely changed, and the urban-rural income gap had always been large due to historical reasons. In fact, if calculating the income gap in urban and

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rural areas separately, neither of their Gini coefficients reached the warning line of 0.4. Therefore, Zhao Renwei concluded that to simply apply the warning line of 0.4 to China during the country’s urbanization and industrialization was not practical and the severity of income disparity should not be exaggerated. However, Zhao Renwei also thought that the Gini coefficient of income distribution displayed a downward trend while that of assets distribution was on the rise in China. China’s Gini coefficient of income inequality surpassed that of developed countries and it was likely to cause the further widening of the assets disparity. As income and assets are interrelated, it should be noted that current high income inequity will lead to the fast growth of assets disparity. According to the preliminary study of the Institute of Economics of the Chinese Academy of Social Sciences (CASS), in 2007, the Gini coefficient of asset distribution was around 0.55, 10 percentage points higher than that of income disparity which was 0.45 based on its calculation. According to international experience, the asset inequity is generally larger than the income inequity in developed countries. The Gini index of income distribution was 0.3 in Western Europe, 0.4 in the United States, and 0.2 in Northern Europe, but the Gini index of assets distribution is usually higher than 0.55 and may reach 0.6–0.7 or even higher. Assets and income distribution are interactive. Policymakers should prevent the vicious circle of income inequality deteriorating assets inequality. At the present stage of China, as the system of socialist market economy needs to be further improved, the gap after the primary distribution of national income is, to a large extent, not a result of market competition. It is necessary to deepen the reform and give the full play of the basic role of the market in resources allocation in order to narrow and eliminate the urban-rural income divide resulting from the dual economic structure, the regional income gap due to ideological and institutional factors, the income disparity among different industries caused by administrative monopoly, and the individual income inequality arising from the unsmooth flow of labor. Some analysts believed that by 2020, if the proportion of the middle-income group reaches over 50% in China, its Gini coefficient will at least decrease to 0.36 (0.44 in urban areas and 0.31 in rural areas).

To Increase the Labor Income of Residents Is the Prerequisite for Increasing Property Income For most residents, the formation and accumulation of property is based on surplus labor income. Accordingly, the proportion of property income is closely

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related to the level of labor income or wage income. The general rule is that the higher the wage income of residents is, the larger proportion of property income is in their total income. To raise property income, the Chinese government must narrow down the income distribution gap and increase labor income such as salaries and wages. At present, the growth of residents’ income lags behind if compared with that of the country’s economic aggregate. Although the mean value of residents’ income has been improved significantly, the majority of residents still receive a relatively low income. Statistics showed that the proportion of workers’ pay in GDP, namely, the income distribution ratio, was above 50% in most Western countries with market economies (58% in the United States, for example). However, the income distribution ratio was obviously low in China, just between 15% and 20%. This is also a reason for the low property income of Chinese residents. Generally speaking, there are eight measures to increase the labor income of Chinese residents. 1. Establish a sound mechanism of regular pay raises for workers. The Report of the 17th National Congress of the CPC stated, “Vigorous efforts will be made to raise the income of low-income groups…. We will gradually increase the share of personal income in the distribution of national income, and raise that of work remuneration in primary distribution…. A proper balance will be struck between efficiency and equity in both primary distribution and redistribution, with particular emphasis on equity in redistribution.” 14 The Chinese President Hu Jintao pointed out in his speech at the Meeting Commemorating the 90th Anniversary of the Founding of the CPC, “We should ensure that development is for the people and carried out by the people and that they share in the fruits of development,” and “[we will] make more efforts to regulate income distribution, [and] pursue prosperity for all.” 15 Therefore, only when the Chinese government increases the income of the low-income group via various means and steadily improves the labor income of workers on the basis of creating more employment opportunities, can surplus labor income be turned into property. Only when a mechanism of regular pay raises is established, can the share of work remuneration in primary distribution and the share of personal income in the distribution of national income be increased. To this end, the government has to build relevant laws and strengthen institutional construction to ensure constant pay raises and the income surplus of workers. Only in this way can the workers become prosperous and receive more property income.

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The so-called “Income Doubling Plan” of China must target the core of the conflict by comprehensively readjusting the distribution of profits. But it cannot do that without a series of solid institutional guarantees, such as the forthcoming Guidance on Strengthening the Regulation of Income Distribution and Wage Ordinance. It is of particular importance to link wage growth to the rise of consumer price index (CPI), raise pensions and subsistence allowances for the retired and the poor, improve the minimum wage, integrate collective enterprises which have not purchased insurance into the basic old-age insurance program, and limit high wages in monopoly industries. Since the above reforms involve the interests of all parties, it has caused frequent delays in the announcement of relevant laws and regulations, but the Chinese government must overcome all difficulties to provide the institutional guarantees for the reforms. 2. Raise the income of farmers. Farmers belong to the low-income group. Currently, the income of three farmers can only equal that of one urban dweller. Therefore, it is crucial to improve the income of farmers (including farmers-turned workers) to allow more people to own property. The per capita property income of rural households is significantly lower than that of urban households in China. In 1997, the per capita property income of farmers was RMB23.61 while that of urban residents was RMB124.39, with the ratio of the two being less than 19%, the lowest in history. In 2002, the per capita property income of farmers arrived at RMB50.68 while that of urban dwellers dropped to RMB102.2, and the ratio between the two was 49.63%, the highest in history, but it remained below 50%. Between 2003 and 2007, the growth rate of property income of urban residents was 2.44%, 2.86%, 11.05%, 12.87%, and 15.25%, respectively, faster than that of rural residents. The property income gap was gradually widened. To enlarge the proportion of the middle-income people, the Chinese government must speed up urbanization, and continuously narrow the income gap between urban and rural residents. It is hard to imagine a society of common prosperity where more than 50% are in rural population. Many experts suggested promoting and deepening the land system reform and, above all, regard the regulating of land transfer as an important means to raise the property income of farmers. I believe that there are two key aspects in increasing the income of farmers (including farmers-turned-workers): First, to reform the household registration system and help the 160 million farmers-turned-workers to settle down

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in cities and receive the same treatment as urban residents; and second, on the basis of promoting the transfer of land use rights, scientific farming, and large-scale operation of agriculture, to build a new socialist countryside and increase the agricultural production and income. The pork price surges in 2008 and 2011 resulted from the low degree of largescale production, specialization, and factory farming in the pig raising industry, which led to cyclical price fluctuations (“pig cycle”) in pork production. It was reported that the large-scale pig farming accounted for 80% in the United States. In China, the annual hog production is more than 500 million head, with over 60% being free-range pigs, which explains why the “pig cycle” is shortened and pork price frequently jumps. It is clear that the small-scale peasant economy is suitable for neither capitalism nor socialism. 3. Curb monopoly. The wages of monopoly industries are generally higher than the wages of general industries. However, the high wages come from neither high management skills nor high production efficiency, but the monopoly position of some industries. The Research Report on Income Distribution in China edited by Department of Employment and Income Distribution of National Development and Reform Commission (NDRC) showed that one third of the revenue of administrative monopoly industries was generated from all kinds of franchises. Therefore, a policy of dual control over total payroll and wage scales in those industries must be implemented in order to narrow the income gap between different industries. High and illegal charges, low service quality, and poor production efficiency still exist in some monopoly industries. To solve these problems, the Chinese government has to first establish a cost control mechanism and second, reform the price formation mechanism. On the basis of these, supervision and inspection of fees charged by monopoly industries should be strengthened and once unauthorized price hikes or illegal charges are discovered, relevant institutions or companies must be seriously punished. The most fundamental solution is to accelerate the reform of stateowned monopoly industries and relax the control over basic industries (such as railway, telecommunication, and power), service industries (such as banking and publishing), and parts of urban public utilities in order to cut off the relationship between local governments and stateowned enterprises. The Central government should gradually reduce its holdings in the state-owned enterprises which are unrelated to the

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public interest, before finally transforming these enterprises into profitoriented modern enterprises controlled by social capital. For state-owned enterprises involving public interest, the Chinese government has to own the direct control but will not seek profits. 4. Strengthen the role of taxation in adjusting income distribution. The Chinese government has to intensify the regulation on high-income earners and relieve the burdens on middle- and low-income groups. The individual income tax threshold is too low and tax collection and administration methods are not sufficient. The income tax on salaries makes up a comparatively large proportion in the total individual income tax and the tax’s role as a lever has not been given full play. Statistics showed that at present, 80% of the individual income tax in China came from the working class, and the rich who occupied over 40% of the social wealth often evaded their taxes. According to the estimate by the Organization for Economic Co-operation and Development (OECD), the ratio of tax paid to tax payable of the individual income tax was only around 50% in China whereas the ratio in some developed countries such as Sweden and Germany was close to 100%. Tax evasion is illegal with no exception. Therefore, the government must strictly put in place the legal system of taxation, intensify the punishment for tax evaders, and allow full play to the role of taxation in regulating income distribution. It is necessary to raise the individual income tax threshold and improve the law on and strengthen the collection of individual income tax. At present, the income inequality among urban residents is predominantly reflected in the differences in wealth ownership, and the individual income tax plays a limited role in regulating income distribution. Real estate, returns on financial assets, and the inheritance and transfer of property must be taxed by creating appropriate tax types and tax rates to lower the excessively high income. In addition, the individual income tax system should be reformed by replacing the schedular income tax with the unitary income tax. Not long ago, Lou Jiwei said in the 16th World Congress of International Economic Association (IEA) that most Western countries adopted the unitary income tax, and only China in the BRICS implemented a scheduler income tax. He added that currently China’s individual income tax consisted of 11 taxable items which worked like 11 independent income taxes; and only income from salaries was taxed on the basis of a progressive tax rate, and all other individual incomes adopted a flat tax. Lou Jiwei thought that China should also introduce the unitary income tax system and the major

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obstacle was not the formulation of the tax law but the complexity in tax collection and management which required sufficient knowledge and powerful measures in this regard. As a former Vice Finance Minister, Lou Jiwei has a say in this issue. 5. Speed up the improvement of the social security system and increase the transfer income of urban and rural residents. This is not only beneficial to bridging the income gap but also to consolidating the middle-income group. The social security system mainly includes old-age insurance and medical insurance. At the present stage, China’s social security system targets urban residents and its coverage in rural areas is small with a low benefits level. The social security system lacks legal protection and has weak mutual aid capability. It is even difficult to maintain the sustainable development of the rural cooperative medical service. The old-age insurance is usually managed by the Central or federal government in Western countries; however in China, it is part of the responsibilities of local governments from county-level and municipal governments to provincial ones. Although there is a unified planning about the old-age insurance at the provincial level, the management still rests upon lower-level governments. Capital arrangements, balance of payments, and standards of insurance policies are in the hands of provincial governments. The defects in this management system are the inconsistency in policies of different provinces and the separated arrangement of capital, especially the prohibited transfer of insurance accounts making the old-age insurance very unfair for migrant rural workers. Therefore, China’s Central government has to unify, with great determination, the management of nation-wide welfare systems, like the old-age insurance, to ensure the consistency in policies and unified arrangements of capital. 6. Enlarge the input in people’s livelihood and equalize basic public services. Basic public services can provide the most fundamental protection to the majority of residents, especially the low-income group. They are the most effective means of governments in regulating income distribution through transfer in kind and perform the function of redistribution. The proportion of government consumption in China’s GDP, if compared to that of other countries, basically conforms to the present development stage of China. But the consumption on public services only accounts for a small share in government spending in China. This is related to the lagged transformation of government functions. Therefore, it is necessary

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to accelerate the formulation and implementation of basic public services standards, increase public services investment in backward and rural areas, and continuously improve the accessibility and equality of basic public services. To improve the accessibility and equality of basic public services, it is important to pay attention to the reform and development of the education system, vigorously develop science and technology, and improve the quality and ability of low-income earners. These are effective measures for enlarging the middle-income group. Among them, to develop education, especially the higher education, and improve the training of human capital is a decisive factor. As the economic development enters the later stage of industrialization and the age of informatization, factors such as technology and management play a more and more important role in production and take an increasingly larger share of profits from the hands of traditional capital owners, becoming a major source of income increase. This is what we called “distribution according to productive factors.” Therefore, the Chinese government has to enlarge its investment in education and increase all sorts of material support and institutional arrangement for workers to receive higher education in order to ensure equal and effective training to the all new labor force. Yang Yiyong mentioned in one of his articles that the 2000 Nobel Laureate James J. Heckman, the Henry Schultz Distinguished Service Professor of Economics at The University of Chicago, pointed out when giving a speech in Peking University that China’s investment on human capital was lower than the world average and even lower than some of the developing countries; the imbalance between the input in physical capital and that in human capital would retard the economic development in China; human capital was the ultimate decisive factor of China’s wealth; and if the Chinese government could improve the education level of its residents and enable them to adopt to modern technologies, China’s potential would be given full play. Yang Yiyong also cited statistics from World Bank’s World Development Report 2006: The world average public expenditures on education as a percentage of GDP was 4.8%, and Sweden and Germany spent more than 8% of its GDP on education. China’s education budget accounted for only 3% of the country’s GDP in 2003. Some scholars used the statistics of education and health investment as the total investment on human capital and found that every additional RMB100 million investment in human capital would bring about a

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nearly RMB600 million GDP increase in the following year, while every additional RMB100 million investment in physical capital would only generate about RMB200 million GDP growth. According to Heckman, in 1995, China, at all levels of government, spent about 2.5% of its GDP on investment in schooling. At the same time, roughly 30% of its GDP was devoted to physical investment. In the United States, those figures were 5.4% and 17%, respectively. In South Korea, they were 3.7% and 30%. The ratio of physical investment to human capital investment was 12 : 1 in China, 8 : 1 in South Korea, and 3 : 1 in the United States. China was far below average in its expenditure on investment in human capital.16 To promote the equal availability of basic public services and enlarge the investment in people’s livelihood, the government also should increase its spending on rural infrastructure and give priority to the projects with direct economic rewards. By increasing financial provision and credit supply to rural areas, the rural consumption environment will be improved, agricultural and rural economic structures will be adjusted, and the income of farmers will be raised. At the same time, the Chinese government also needs to improve its services in the labor market and increase public investment in labor skills and in-service training. The mechanism of transforming and upgrading human capital should be established for the unemployed and educational security should be regarded as an important part of social security in order to improve workers’ quality and adaptability to changes in job roles and safeguard the interests of workers by enhancing market vitality. It is necessary to strengthen and expand competency-based education and technical education and offer all sorts of vocational training and education for farmers in addition to the general education. 7. Encourage indigenous innovation and self-employment, create external conditions to stimulate people’s enthusiasm for entrepreneurship, and expand the channels for increasing the wealth of the masses. The government has to establish measures to protect the lawful incomes and private property of residents and entrepreneurs in the distribution system and the wealth created via legitimate and reasonable means should be respected and protected in order to raise people’s enthusiasm to create material wealth. Incentive mechanism in income distribution should be implemented in all enterprises, a reasonable distribution system where income is distributed according to productive factors should be built, and the reform in primary distribution should be promoted. The government

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must pay special attention to preventing equalitarianism in the public ownership system, improving the market economic system, encouraging the income distribution according to productive factors such as labor, capital, technology, and management, protecting all legitimate income, from work or not, and raising the proportion of the middle-income group. 8. Choose the right path for urbanization and accelerate the process of urbanization, especially the expansion of middle-sized cities. Cities with a population of 300,000 and 500,000 will be expanded to accommodate 500,000 and 1,000,000 people, respectively, within 5 to 10 years. The government authorities should promote the integration of rural and urban productive factors in middle-sized cities, which will become great incentives to national economic growth and create new middle-income earners. Additionally, it is also necessary to regulate the income distribution order. First, an income monitoring system should be built to prevent tax evasion; second, the government should raise the minimum wage, establish a collective wage negotiation system, and promote the implementation of Labor Law and Labor Contract Law to protect the legitimate rights of workers. Special efforts should be made in preventing wage arrears for migrant rural workers, which ought to be an important part of regulating urban income distribution order. Overall, to raise the labor income of residents is the precondition for increasing property income in China. The Chinese government has to made active efforts in regulating not only redistribution, but also primary distribution. It must strive to improve the Socialist market economy and standardize the order of income distribution. Efforts should be made to not only deepen the distribution reform and overcome market distortion and malfunction, but also solve the market generalization and failure and the transformation of government functions in order to make the invisible hand of the market and visible hand of the government play their due roles in a coordinated way.

Conditions Will Be Created to Enable More Citizens to Have Property Income An important task highlighted in the Report of the 17th National Congress of the CPC is “to create conditions to enable more citizens to have property income.” Many experts called it a significant innovation in the traditional income

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distribution theory. In capitalist countries, “to create conditions to enable more citizens to have property income” is part of governments’ responsibilities. To call it an innovation is because the traditional socialist theory did not acknowledge private property in the past, let alone income from property, but now the Chinese government not only legalizes property income but also creates conditions to let more people to own property income. “To create conditions to enable more citizens to have property income,” the focus is “to create conditions.” Conditions should be made in every aspect from ideological understanding to the legal system and the market environment. But how to “create conditions to enable more citizens to have property income”?

To develop a correct view of money The Central government must insist on the basic principle of “development is the hard truth,” help people to form a healthy attitude towards wealth and devote themselves to growing property income, and enable Chinese citizens to share the economic benefits from the country’s economic growth. In the 60-year history of New China, the Chinese people received the traditional education of “taking class struggle as the guiding principle” for more than 30 years and were prohibited from speaking of capital for over 40 years. To help people to end all the debates about whether the reforms are capitalist or socialist and form a right attitude towards wealth, the government has to clear up all the confusion and set things right. People should no longer be afraid of speaking of capital but understand that the socialist society also has capital. In the past, people only knew how to make ends meet and pinch pennies, but now they have to learn how to make money beget money and convert money into capital to produce profits. The concept that becoming rich through investing one’s accumulated wealth is as glorious as doing it through hard work should be established in the society. To enable people to abandon their jealousy and hatred towards the rich, the government should first urge people to earn higher pay through legal means and gain property income, and encourage them to become middle- or upper-income earners and contribute to raising the proportion of the middle-income group. The Chinese government has to enrich residents’ financial knowledge and foster their multi-channel investment awareness. Investing and financing knowledge should be popularized through newspapers, the internet, and other channels to enable ordinary citizens to gradually understand how to make investments and manage money and switch from saving to investing. The government should let the residents know that besides the interest from saving,

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they can also obtain dividends, a bonus, and appreciation of assets through purchasing bonds, stocks, funds, insurance, and other financial products and increase the value of their property through buying or renting houses as well as other real estate investments.

To provide sufficient financial products and investment channels The Chinese government has to deepen the financial reform and encourage banks and financial institutions to provide more financial products as well as financing and investing channels to each group of people for them to allocate their assets based on their wealth and risk preference. Currently, the varieties of financial products in China’s financial markets are not sufficient enough to meet people’s demands for gaining property income. Apart from some of the middle class and the high-income group who can afford high-risk and high-return stocks, funds, trust plans, and other financial products, the low-income earners and working class have to put the majority of their income into housing despite their rising disposable incomes. But housing belongs to the property of necessity, namely something that is necessary for living. If people live in instead of rent their houses, there will be no property income. Even though their house prices go up, they cannot sell the houses for profit. Besides, there are also many restrictions on selling houses in cities, such as houses built on collectively owned rural land are not allowed to be sold. At present, the investment composition of urban residents is mainly comprised of bank saving, supplemented by insurance, funds, and stocks investment. However, the yield on deposits is pretty low. In early 2010, the oneyear deposit rate was 2.25% and the CPI rose by 3.3% in that year; from October 2010 to February 2011, the one-year deposit rate reached 3% after the Central bank raised the interest rate three times, but compared to the CPI increase of 4.9% recorded in January 2011, bank deposits could not offset inflation and showed a negative interest rate. The development of personal investment and finance services provided by financial institutions lags behind, and there is no suitable comprehensive financial market for the low-income group. At the same time, investment channels and structure are not well developed and the threshold for investment and financial management is too high. Among the financial products of banks, the minimal requirement for investment is RMB10,000 and some products even require more than RMB50,000. It discourages the participation of the middleand low-income earners and aggravates the unfairness in income distribution at the starting point.

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Therefore, banks and financial institutions should be encouraged to speed up financial product innovation, open more investment channels, and lower the investment threshold. It is imperative to create some basic financial products targeting ordinary investors who lack investing experience, and offer a wide range of financial services including saving, investment, and risk management. As the saying goes, “If you leave “Managing Money” alone, Money will manage to leave you alone.” Therefore, it is necessary to improve people’s personal finance skills and create more financial channels to enable people to preserve or increase the asset value. Common prosperity will be achieved if more and more families learn to manage their money. On the basis of being fully aware of investment risks, the Chinese residents should establish a right attitude towards wealth and understand that personal finance does not mean the pursuit of the highest returns but the search for the most suitable financial plan according to their family structure, risk tolerance, and asset lifecycle. Financial institutions should highlight the differences between different financial products and introduce investment instruments and channels with stable returns and small risks for the low- and middle-income groups in order to enable all the citizens, no matter how little income or property they have, to gain property income through asset management. This is also a requirement for making “more citizens to have property income.”

To actively promote the sound development of the capital market and build a more open and transparent investment market The capital market, as an important platform for the masses to increase property income, can create opportunities for general investors to grow their wealth. In recent years, China’s stock markets realized significant breakthroughs and fundamental changes through constant reforms. At present, the A-share market has approximately 130 million accounts, but excluding the 30 million idle accounts and 30 million–40 million fund accounts, there was only 60 million active stock accounts. So, by far, the capital market is still exclusive to the minority. This requires the Chinese government to make more people realize the significance of the capital market and encourage them to gain property income through participating in the capital market. It should also be pointed out that due to the distortions in the early system of China’s capital market, some policies and regulations overly focused on the financing function without paying sufficient attention to developing and realizing the full potential of the capital market, which resulted in many historical problems and systematic defects. For example, timeliness and

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reliability of information disclosure by listed companies still needs to be improved; many listed companies have the bad habits of prioritizing financing over restructuring and investment over returns; and there was an imbalance between stocks and bonds in the market structure. These are also the reasons for the low confidence of investors and the long-term weak market in recent years. Under the new historical background, “to create conditions to enable more citizens to have property income” requires the government to develop the capital market into an important platform for the masses to increase their property income. Efforts should be made in improving the basic functions of the capital market. First, the government has to develop a series of basic financial products including stocks, bonds, financial derivatives, and other fixed-income products and establish a multi-layer market system to fulfill investors’ demands for not only diversified investment products, trading systems, and trading methods, but also hedging instruments and investment portfolios, in order to turn the capital market into an attractive and comprehensive market which can “enable more citizens to have property income.” Second, it is necessary to encourage enterprises to improve their management and competitiveness and urge listed companies to operate in full compliance with applicable laws and regulations, strengthen good-faith construction, and increase the asset quality. Basic systematic construction and constant deep reforms should be implemented to improve the market competition mechanism and increase the efficiency of resources allocation, thus stabilizing the confidence of the participants of the capital market. Third, the financial authorities have to intensify the compliance management towards securities institutions for the sake of ensuring the sound operation and sustainable development of these institutions, foster high-quality resources for listing, and propel the capital market to offer better services for “enabling more citizens to have property income.” Fourth, the government should take protecting the interests of investors, especially the legitimate rights of medium and small investors, as the primary target of the capital market reform. It has to raise the personal finance skills and risk resistance capacity of citizens through education while ensuring equality, fairness, and openness in the market by cracking down on illegal activities and improving the financial services to investors. Relevant systems and mechanisms should be set up to provide constant protection to investors and make sure that people have the confidence to enter the market and engage in long-term investment.

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Fifth, the government has to strengthen the supervision of the capital market, improve relevant laws and regulations as well as the market discipline mechanism, and prevent power rent-seeking in order to push forward the steady and healthy development of the capital market.

To develop investment funds markets After 12 years of fast-track growth, China’s fund industry has developed 62 fund management companies with over RMB3 trillion in assets under management by the end of 2010. Among them, 657 mutual funds managed RMB2.51 trillion, social security trust funds RMB3.15 trillion, enterprise annuities RMB106.7 billion, and separately managed funds for specific clients RMB112.4 billion. Although developed very rapidly, China’s fund industry remains small in terms of the total assets under management. The size of the U.S. mutual funds was approximately 1.5 times that of personal savings in 2005. However, the assets under the management of investment funds (RMB2.51 trillion) in China only equaled to 8% of the saving deposits of urban and rural residents (RMB30.3 trillion) in the same period. Statistics showed that the assets managed by the entire fund industry in China only accounted for 1.7% of the world total, and China ranked No. 10 in the global asset management list. It was inconsistent with China’s status (the second largest) in the world economy. Considering China’s future economic development, the speeding up of urbanization, and the fact that the country will not enter into an aging society until 2030, the wealth of Chinese residents will rapidly increase, thus bringing about a larger space for the development of the fund industry. The major task of the fund industry is to manage wealth for others, that is, to continuously provide more and better services to “enable more citizens to have property income.” In particular, financial institutions should improve the services offered to tens of millions of individual investors who are mostly salaried workers. They have limited capital, time, and investment experience, and cannot tolerate high risks. Many of them focus on short-term gains and tend to blindly follow suit, indulging speculation and blind investment in the stock market. This is a major reason for the high turnover rate and high speculation in China’s stock market. To solve the problems, financial supervision authorities have always been encouraging financial institutions to develop investment funds in the securities market as vigorously as commercial banks developed savings deposits in the financial market in order to turn investment funds into a professional investment vehicle which can unite tens of millions of individual investors and manage the wealth for them. As a result, mutual funds developed rapidly in recent years

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and became the most popular investment products for Chinese residents. The proportion of open-end investment funds held by individual investors grew from 52.98% at the end of 2005 to 74.21% in 2006. After 2007 this proportion remained above 99% and even reached 99.88% in 2009. At the present stage, if we want to “create conditions to enable more citizens to have property income,” it is imperative to vigorously develop mutual funds. First, encourage the competition among fund management companies in product variety, product quality, and service quality. Once people’s demand for product varieties is basically satisfied, they will raise their demand for product quality. Only when people or fund clients improve their taste and discernment in personal finance and are able to discriminate between good and bad financial managers and service suppliers, can unreliable fund managers and poorly performing companies be eliminated from the market and the fund industry move to a new height. At present, many fund companies only look for big clients and focus on separately managed accounts (or segregated account management) with one or multiple owners. But these companies should not forget that small clients of mutual funds are the basis of their businesses, and “to create conditions to enable more citizens to have property income” should be their target. In short, pursue returns and profits. Only when the funds of a fund company generate high returns, will the size of the funds grow; and only when the fund company displays a good overall performance, will the company be able to develop more funds. Second, push fund companies to pay attention to corporate governance. Investment funds are the best representative of the trust business. Compliance, professionalism, and integrity are the foundations of the fund industry. Only when fund companies make great efforts in standard management and honest operation and place “protecting the interests of fund holders” above all other things, can the companies and the industry at large have a bright future. Otherwise, the funds will be discredited let alone the fund companies. Third, strengthen supervision. As the former President of China Securities Regulatory Commission, Shang Fulin, has said, we have to stick to three bottom lines: No institution or people are allowed to get involved in rat trading, unfair transactions, or tunneling; and once found guilty, those involved will be punished.

To enliven the real estate market Currently, among residents’ personal property, housing takes up about 60%. Most houses are the property of necessity and cannot be sold or rent for cash,

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thus they are unable to generate property income. In 2010, around 6 billion m2

out of 13.2 billion of the total floor space of residential buildings in urban areas

were built as a response to the target of “getting out of the housing plight” before the housing reform from the early 1980s to 1998. This large amount of

residential housing is the main body of the present housing reform (which also includes the houses built in the cities of the old industrial base areas in the 1950s

and the makeshift houses erected during the decade-long Cultural Revolution).

But according to Chen Huai,17 buildings constructed at that time can no longer

meet the needs of people for better living conditions, in terms of either housing

layout or dwelling size. These residences have to be rebuilt in the next 15 to 20 years. On the basis of this, some people predicted that among the residents

who had purchased a public house, 80% wanted to buy a new one to expand their living space. Therefore, the future development of the real estate industry should not only enable low-income workers to be able to live in low-rent or

affordable housing, but also adapt to the upgrading of the housing consumption to make people be able to replace their “pigeonholes” of welfare housing with larger dwellings.

An alternative is to ask the public utilities department to buy those buildings

which need to be rebuilt and renovated them into low-rent housing before tearing down for reconstruction.

Of course, it is essential to improve the regulations on house transfer and

lease, and standardize house trading and leasing activities in order to enable

residents to receive legitimate property income from investing in real estate. Here, what is inevitable is that cities have to modify their laws to allow houses

built on collectively owned land in suburbs, such as houses with limited property rights, to be sold or rented.

In Western countries, banks offer a service called “reverse mortgage.” It

is a loan available to retired homeowners to enable them to receive a regular stream of income from commercial banks against the mortgage of their homes

in order to pay for their living expenses as well as travel and entertainment

spending. After the homeowners pass away, banks will consider the residual value of the mortgaged houses as inheritance and demand the heirs pay off the loans. This transforms the immovable house property into income-generated

capital to satisfy the consumption needs of the retired. The Shanghai Municipal

government planned to conduct a pilot project of this service earlier on. Banks

in other provinces should also be encouraged to make relevant exploration and innovations to enable senior citizens to have property income.

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To advance land reforms in rural areas The Central government has to carry forward the rural land system reform and promote the capitalization of land in order to enable farmers to increase their property income through the land reform and land transfer. At present, there are about 160 million migrant rural workers who are prevented from being registered as urban residents due to the urban-rural household registration divide, and more than 100 million mu (66,667 km2) rural vacant land, equivalent to approximately 1/18 of the nation’s total arable land.18 As a result, most of the traditional agricultural area became dilapidated and high-quality farmland was abandoned and lost, which hampered the large-scale development of agricultural production and reduced farmers’ income. Here, the key solution is to capitalize the land-use rights transfer, namely, to allow more flexibility to rural land-use right, and facilitate the land transfer and the conversion of land into cash on the basis of guaranteeing farmers’ long-term land-use right over their contracted land. First, to allow farmers to turn the land-use right of their contracted land into a stable stream of income through subcontract, transfer, or mortgage, and the subsequent income can be used as the seed capital for migrant rural workers to settle down in cities. Second, to clearly define the property rights of rural house sites, innovate the transfer and replacement methods of house sites, and allow farmers to share the benefits from land appreciation. Third, to encourage private capital from industrial and commercial sectors to set up large-scale farms (such as pig farms) or enterprises of agricultural and sideline products, especially the enterprises integrating agricultural production, processing, and sale, and allow these enterprises to take over the land-use right of rural contracted land from farmers or directly absorb farmers’ land-use rights as capital stock. Fourth, to encourage banks to offer mortgages on the land-use right of rural contracted land. What changes will the capitalization of the rural land-use right transfer bring about? Supposing that each of the 160 million migrant rural workers owns 0.6 mu or 400 m2 (96 million mu in total, close to the 100 million mu vacant rural land) and the price for per mu land is RMB10,000, these migrant rural workers will get approximately RMB1 trillion from the capitalization of the land-use right transfer as seed capital. On the other hand, large-scale farming can be developed on the 100 million mu vacant rural land. However, the above calculation is just based on 160 million migrant rural workers and 100 million

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mu vacant rural land, and if we take into account 674 million total rural population and 1.8 billion mu (1.2 million km2) arable land, both urban and rural economies will grow by leaps and bounds and the millennium-long small-scale peasant economy will be completely reshaped. In this way, China will be able to have modern large-scale agriculture with features of scientific farming and intensive cultivation and Chinese farmers will truly receive stable property income from the capitalization of land.

Respect and Protect People’s Rights to Own and Control Capital In the previous parts, we talked about the recognition of workers’ (including intellectual workers’) ownership of capital and their participation of income distribution according to capital as well as the motivating of socialist workers to make investment, namely to devote parts of their consumption funds (as well as the goods and money from their materialized labor) to support socialist construction by delaying consumption. Now, we will move on to the topic of the rights of capital. We know that the socialist revolution imagined by Marx and Engels in the Communist Manifesto in 1847 was like those that happened in developed capitalist countries, such as the United Kingdom, in the 19th century. The ruthless exploitation by the capitalist class gave rise to the polarization between the rich and the poor and the expansion of the proletariat. The proletariat has to unite to overthrow the existing rule of the bourgeoisie and “will use its political supremacy to wrest, by degree, all capital from the bourgeoisie, to centralize all instruments of production in the hands of the State, i.e., of the proletariat organised as the ruling class; and to increase the total productive forces as rapidly as possible.”19 The problem is that as science and technology made remarkable progress and the capitalist productive forces developed rapidly, economies in developed countries became more prosperous and the governments adopted a series of policies and measures to reconcile class conflicts. Consequently, the extreme inequality anticipated by Marx and Engels did not appear and a huge middle class, which Marx and Engels failed to predict, arose instead. So, there was no violent socialist revolution in the countries where productive forces were highly developed, nor were there precedents for how to deal with the bourgeoisie after the workers came to power. However, Russia, after its revolution in the early 20th century, lagged behind in industrial development and capitalism was not fully developed there. China was a semi-colonial and semi-feudal society before 1949. Due to the double oppression

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from colonists and bureaucrats, the formation of national bourgeois capital and the private capital of the society as a whole were damaged and squeezed, social credit was not adequately developed, and the efficiency of capital formation was very low. After the successful revolution in 1949, China adopted a policy of “using, restricting, and transforming” towards capitalist industry and commerce. The rights of capital were greatly harmed since the government of New China announced the transition from new democracy to socialism, especially during the decade-long “Cultural Revolution” for the purpose of preventing the restoration of capitalism. After the founding of New China, the basis of the national economic system was the ownership by the whole people; but it was the state who exercised the power of capital formation and workers received low wages and practiced egalitarianism. They have not become the subject of capital accumulation and formation. Moreover, the system where the state acted as the subject of capital formation implemented in public-owned enterprises was admittedly very inefficient. After the Reform and Opening Up era began, the CPC advocated emancipating people’s minds, seeking truth from facts, keeping up with the times, and realizing inclusive growth. It implemented a policy of “letting part of the people get rich first,” allowed workers to become men of property, admitted that capital, the same as labor, technology, managerial expertise and other production factors, can participate in the distribution of income in accordance with their respective contributions, and clearly stated the necessity to “encourage, support and guide the development of the non-public sectors,” “create conditions to enable more citizens to have property income,” and “enlarge the proportion of the middleincome group.”20 The Constitution of the CPC passed during the 17th National Congress of the CPC not only claimed that “The Communist Party of China is the vanguard of the Chinese working class…. The realization of communism is the highest ideal and ultimate goal of the Party,” but also made it clear that the Communist Party of China is also the vanguard “of the Chinese people and the Chinese nation; It is the core of leadership for the cause of socialism with Chinese characteristics and represents the development trend of China’s advanced productive forces, the orientation of China’s advanced culture and the fundamental interests of the overwhelming majority of the Chinese people; and The Communist Party of China takes Marxism-Leninism, Mao Zedong Thought, Deng Xiaoping Theory, the important thought of Three Represents and the Scientific Outlook on Development as its guide to action.”21 Although the leftist thinking frequently triggered the discussion about whether the social and economic reforms were socialist or capitalist in the first 30 years of New China, the CPC and the Central government have made necessary preparations in major policies, the legal system, and public opinions to pave the way for workers to become men of

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property and advance steadily toward the goal of common prosperity. Currently, a noticeable phenomenon is that there is a wave of mass migrations of private entrepreneurs form China. According to China Private Wealth Report 2011 co-published by China Merchants Bank and Bain Capital in April 2011, among the large business owners with more than RMB100 million in investable assets, about 27% had completed investment immigration while almost half (47%) were considering submitting an application; and nearly 60% of Chinese high-net-worth individuals whose personal assets surpassed RMB10 million surveyed had either completed investment immigration, applied for investment immigration or were considering it.22 Not coincidently, in October 2011, Bank of China and Huren Research Institute released the Private Banking White Paper of 2011, and it showed that 14% of China’s wealthy had already emigrated overseas or were applying to do so, and 46% were considering moving abroad; and the percentages of people who had completed or were applying for emigration in the south, east, north, and west were 27%, 24%, 11%, and 9%, respectively, and those of people who were considering it in the four regions were 46%, 46% 50%, and 41%.23 The two reports reflected similar alertness of banks towards the loss of wealth. In fact, as early as May 24, 2011, People’s Daily published an article named “Remain Calm with the New Emigration Wave” authored by Qu Zhehan, Xu Zhifeng, and Tian Junrong. Why was there a new emigration wave? According to Ye Tan, there were mainly three reasons: Children’s education (58%), wealth security (43%), and preparation for retirement (32%). Other factors motivating investment immigration included: convenience for overseas investment or business development (16%), being easy for travel abroad (7%), to have more children (6%), and lower tax rate (6%). 24 It indicated that Chinese high-net-worth individuals were not satisfied with domestic education environment and worried about their property security and old age, whose causes were considered by Ye Tan as “three institutional defects in China.” Later, Xin Lijian added another defect — an unsound legal system, which led to businessgovernment collusion and incomplete and inaccurate information disclosure. First, based on their analysis, the educational defect is an inevitable result of the rigid education system. If the elementary education of China can still be expected to be competed internationally, its higher education has lost completely. As a result, current education in China cannot foster the elites who combine the merits from both Chinese culture and Western culture. Only by being roughly trained in China, further educated overseas, and introduced back to China, can Chinese students become the elite talents equipped with both knowledge of contemporary management concepts and market essentials.

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Second, property insecurity is the lingering shadow of the Chinese affluent class as well as a direct reflection of the lack of property rights regime in China. The wealth class is not only deterred by anti-rich movements in the Chinese history but also worried about the facts that the Ministry of Housing and Urban-Rural Development of China has outlawed the transfer of houses with limited property rights, local demolition authorities do not abide by law, the land-use right of residential building will expire after 70 years, and the Shanxi government has expelled coal mines speculators. So the rich Chinese choose investment immigration for fear that there will not be a property rights regime in China to protect their property. Third, although old-age pension schemes are not satisfactory everywhere in the world, Chinese high-net-worth individuals believe that developed countries can provide them with not only higher pensions to sustain a respectable life but also cleaner and fresher water, air, and food. This is the so-called natural environment premium. Fourth, the craze for Civil Service Examinations and the speculation fever in China reflect people’s worship of power and wealth while the unsound legal system and business-government collusion make the rich worried about the accuracy and completeness of information disclosure. Ye Tan thought that this emigration wave was a result of “the pursuit of wealth security and respectable lives on the basis of the recognition of domestic working opportunities; and certainly, immigration may not necessarily bring about respect or dignity, but immigrants could enjoy considerable freedom in thoughts and movement.” Ye said that emigration should not to be feared, “Taiwan also experienced mass migrations during its development, and when its economy picked up, many emigrants returned to Taiwan in search of personal development; and mass migrations also appeared in India and South Korea, and no fundamental harms were seen in these countries.” She added, “What should be of concern is that the majority of Chinese people, especially the elite class and the family members of corrupt officials, tend to live abroad, which reflected a huge rift between wealth and wealth protection and oversight mechanisms.” Therefore, Ye Tan drew a conclusion that “When more and more people or even over half of high-income earners have to search for security in other countries, it only indicates that the deficiencies in China’s basic system have shaken the foundation of academic freedom, fair distribution of wealth, and independence of property rights.” Her acute analysis is a wake-up call for us. Recently, mass migrations attracted more and more attention. Tao Dong commented, “Collective anxiety arises among Chinese entrepreneurs and their feeling of insecurity creeps up. This has a direct bearing to the current economic and social surroundings. China is a large country and we should not worry

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about the leaving of some people, but we must know clearly why these people decide to leave. If it is related to the defects in the country’s system, the Chinese government has to correct the wrongs immediately.” Han Zhiguo held the view that “The lack of sufficient legal protection aggravated the business environment in many places of China. The outflow of millionaires takes away a large amount of cash and if the money cannot circulate back to China due to the global economic recession, China will face the threat of economic collapse, which the Chinese government has to be alert to.” According to Feng Liguo, “Wealth outflow is a kind of voting with feet.” He explained that Deng Xiaoping encouraged “a group to get rich first and then help others achieve common prosperity, but now more than half of these who get rich first are transferring their wealth overseas, which Deng Xiaoping has never expected.” Therefore, policy-makers must first establish a system to protect the property owned by those who get rich first. Most views attributed the current mass migration to the defects in the country’s basic system, problems in economic and social mechanisms, and the lack of necessary legal protection, and demanded to build a property rights institution to protect the wealth of those who get rich first. Of course, we have no reasons to undermine our confidence in building a socialist society with Chinese characteristics just because of the temporary mass migration. But in view of many violations of the rights of capital in the Chinese history, there is a need to respect and protect the rights of capital. In 2002, the Report of the 16th National Congress of the CPC clearly announced that builders of socialism with Chinese characteristics included not only the working class, with the intellectuals as part of it, and the farmers whose incomes had ready increased, but also “emerging in the process of social changes, entrepreneurs, and technical personnel employed by non-public scientific and technological enterprises, managerial and technical staff employed by overseas-funded enterprises, the self-employed, private entrepreneurs, employees in intermediaries, freelance professionals and members of other social strata.”25 In reality, many self-employed and private entrepreneurs have heaped up a fortune and become high-net-worth individuals. But the continuity of the monopoly by state-owned enterprises, the blocking of the entry of private capital in several industries, the rent-seeking of some government departments and local officials, the suppression of private capital, and the use of torture towards private entrepreneurs as well as the illegal confiscation of their property are threats to capital security. Moreover, as China is now still at the primary stage of socialism, we have diversified capital owners, including not only owners of foreign-funded companies, Sino-foreign joint

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ventures, and domestic private companies, but also workers who became rich through their excellent work or patent inventions, managers who received stock ownership with their outstanding management skills, ordinary people who get rich through hard working and life-long accumulation, as well as individual investors who profited from investing in stocks, bonds, and real estate. It is imperative to further clarify the rights of capital, respect, protect and defend all the legitimate rights of capital owners in capital control, remove the resentment against the rich formed under the class-struggle education during the 30-year planned economy, investigate and redress unjust cases concerning the oppression of private capital, forced confession by torture towards private entrepreneurs, and illegal confiscation of personal property, and crack down on and strictly punish people who violate the rights of capital in order to provide solid ideological, theoretical, and legal bases for eliminating all wrongdoings towards the wealthy. Furthermore, the socialist society with Chinese characteristics that we are building now is one towards common prosperity. While the productive forces are highly developed, it is necessary to constantly expand the proportion of the middle-income group. Once China with a dual economic system advances beyond the primary stage of socialism and becomes a country where the middle class or medium- and high-income groups are the majority and the target of common prosperity is achieved, it still has to complete the task of respecting, protecting and defending the rights of capital. Of course, in theory, Marx pointed out that in the cooperative factories of the laborers themselves, “the antithesis between capital and labour is overcome within them, if at first only by way of making the associated labourers into their own capitalist, i.e., by enabling them to use the means of production for the employment of their own labour.” Therefore, in a socialist society where common prosperity is achieved and to constantly expand the proportion of the medium-income group becomes a characteristic of the middle class-dominated society, the antithesis between capital and labor will also be overcome as Marx has predicated. Just like in a cooperative factory, men of property will become the capitalists of their own, they will “use the means of production for the employment of their own labour.” For this reason, socialist countries should not only mobilize and give full play to the initiative of socialist workers in investment, encourage and arouse the enthusiasm and creativity of all men of property including workers to play the role of the subject of capital formation, and respect, protect, and defend all legitimate rights of the workers who own property in capital control. While leading workers towards common prosperity, socialist countries also have the responsibilities to respect and protect the rights of people to own and

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control capital in order to enable them to achieve great success in starting or operating a business. Feng Liguo posed a question concerning this mass migration: Did Deng Xiaoping expect that those people who get rich first would choose to emigrate? This is a good question. I think that the reason why the revolutionary party call for “Workers of all lands, Unite!” is by no means to make them continue being have-nots, but to lead them to achieve common prosperity by hard work and become men of property with medium or high incomes. Therefore, it is necessary for the revolutionary party to reiterate the importance of respecting and protecting the rights of people who get rich first to own capital and regard it as important as “defending the fruits of revolution.” The third and fourth generations of Chinese leaders after Deng Xiaoping have the responsibility to safeguard the fruits of revolution — ”let some people get rich first” and “common prosperity” — which Deng Xiaoping advocated and fought for the rest of his life. When I was ending this book, on November 29, 2011, the Xinhua News Agency carried a report about the Central Work Conference on Poverty Alleviation and Social Development. The Central authorities decided to raise the poverty threshold to RMB2,300 in terms of a farmer ’s annual net income, which marked a 92% rise from the RMB1,196 standard in 2009. It meant more low-income people would be qualified for government subsidies. Statistics indicated that this revision would boost the number of people deemed poor to 128 million by the end of 2011, accounting for 13.4% and 9.55% of the rural population and the country’s population, respectively. This act showed the determination of the Central government to improve people’s livelihood and achieve common prosperity. Through raising the poverty line, more low-income people would be able to share the benefits from the reforms. The objective of the Chinese government is to build a moderately prosperous society, but now the low-income group takes up around 70% of the total population, far from a country where the middle class is in the majority. China has become the second largest economy in the world and it is a collective achievement by the people all over the country, with low-income earners as a part of the contributors. How to bridge the gap between the country’s wealthy and poor classes should be a starting point for improving the income distribution policy in the near future as well as a central topic in the 18th National Congress of the CPC.

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Notes Chapter 14 1.

According to the definition from Wikipedia, an “asset-backed security” is sometimes used as an umbrella term for a type of security backed by a pool of assets, and sometimes for a particular type of that security — one backed by consumer loans or loans, leases, or receivables other than real estate. Here it is used in the first case.

2.

Liu An, “The Latest Development and Contributions of Global Derivatives Markets.”

3.

“Andrew Sheng’s an Asian View of the Global Financial Crisis.”

4.

Shi Shiwei, “Crises Provoked Changes in the Global Economic Pattern.”

5.

Gorton, “Questions and Answers about the Financial Crisis.”

6.

Zhang Yuzhe, “How Far Is Asset Securitization?”

Chapter 15 1.

Cao Erjie, “Less Uncertainties and More Cushions — Views on the ‘327 Incident’ from another

2.

Enterprise bonds are a much larger and more actively traded sector of the Chinese bond market

Perspective.” compared to corporate bonds. Enterprise bonds are bonds issued by institutions affiliated to Central Government departments, enterprises solely funded by the state, state-controlled enterprises and other large-sized, state-owned entities. Enterprise bond issuance is subject to administrative approval for a quota from the National Development and Reform Commission (NDRC). On the contrary, corporate bonds can be issued by any company. Corporate bond issuance requires verification and approval from China Securities Regulatory Commission (CSRC).

Chapter 16 1. Kuhn, Investment Banking: The Art and Science of High-Stakes Dealmaking. 2.

Jiang Zemin. “Hold High the Great Banner of Deng Xiaoping Theor y for an All-Round Advancement of the Cause of Building Socialism with Chinese Characteristics to the 21st Century.”

3.

Huang Ming was a Professor of Finance at Johnson Graduate School of Management at Cornell University and Professor of Finance at the Cheung Kong Graduate School of Business. He also serves as an Associate Editor for The American Economic Review.

Chapter 17 1.

The World Bank, “China: Long-Term Development Issues and Options.”

2.

Qin Hui, “Residency Right of the New Urban Poor.”

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Notes

3.

Xiao Ming, “National Development and Reform Commission Is Planning an Urban Agglomeration Layout of ‘Two Horizontal and Three Vertical Lines’.”

4.

Nouvelles D’Europe, “Beijing-Shanghai High-Speed Rail Brings about More than Just Speed.”

Chapter 18 1.

Marx, “The Circuit of Money Capital,” Chap.1 in The Process of Circulation of Capital, Vol.2 of

2.

Bai Qinxian, “Challenges and Inspiration from Economic Globalization and Economic

Das Capital. Financialization”; Ye Chusheng, “Economic Globalization and the Theoretical Development of Development Economics.” 3.

Guo Tongxin, “Relevant Issues on the Statistics and Proportion of the Service Industry in China.”

4.

Wang Xianzhi, “The Logistics Industry Is Burdened with Double Taxation, and the Reform of Business Tax Allows No Delay.”

5.

The English version is from the website of The Guide to P.R.C. Government Agencies, “Premier Wen Jiabao chaired a State Council executive meeting on June 8, which discussed and made plans to further increase financial investment in education and to promote healthy development of the logistics industry,” accessed April 14, 2014, http://test5.71online.com/html/fuwuye/3746.html.

Chapter 19 1.

Under the old housing system, housing was distributed directly to workers by their employers according to seniority and size of family. The workers were only expected to pay a low rent. However, the housing was owned either by the state, an enterprise, or a collective. See China Development Research Foundation, Constructing a Social Welfare System for All in China, 161.

2.

Marx and Engels, “Position of the Communists in Relation to the Various Existing Opposition Parties,” Chap. 4 in Manifesto of the Communist Party.

3.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

4. Ibid. 5.

Marx, “The Role of Credit in Capitalist Production,” Chap.27 in The Process of Capitalist

6.

Marx, “Letter from Marx to Engels on April 2, 1858,” Marx-Engels Correspondence 1858.

7.

Kasriel, “Chinese Consumers in 2020: A Look into the Future.”

8.

Hu Jintao, “Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for

Production as a Whole, Vol.3 of Das Kapital, 497–498.

New Victories in Building a Moderately Prosperous Society in all Respects.” 9. Krugman, The Conscience of a Liberal. 10.

Liu Di, “How Did Japan Create the Middle Class?”

11.

Wang Hongru, “The Income Distribution Reform Started Again.”

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Notes

12.

Chen Guangjin, “Experts from Chinese Academy of Social Science: The Income Gap Is Widening

13.

Song Xiaowu, “The Income Gap Ratio between Industries Has Expanded to 15 Times, the Highest

and the Gini Coefficient Reached 0.5.” in the World.” 14.

Hu Jintao, “Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for New Victories in Building a Moderately Prosperous Society in all Respects.”

15.

Hu Jintao, “Speech at the Meeting Commemorating the 90th Anniversary of the Founding of the

16.

Heckman, “China’s Human Capital Investment.”

17.

Chen Huai, “Real Estate Development and China’s National Conditions.”

18.

Li Xingwen, Li Song, and Zhang Xingjun, “The Total Area of China’s Arable Land Approaches the

CPC”; the English version is from http://www.kouyi.org/conference/1650.html.

1.8 Billion Mu Warning Line, and the Rural Vacant Land Exceeds 100 Million Mu.” 19.

Marx and Engels, “Proletarians and Communists,” Chap 2 in Manifesto of the Communist Party.

20.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

21.

Constitution of the Communist Party of China.

22.

China Merchants Bank and Bain Capital, China Private Wealth Report 2011, 37.

23.

Bank of China and Huren Research Institute, Private Banking White Paper of 2011.

24.

Ye Tan, “Three Institutional Defects Impelled the Migration Wave.”

25.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

229

References Chapter 14 Chinese materials: “2008: Shijie jingji yu Zhongguo jingji mianlin de xin tiaozhan” 2008：世界經濟

與中國經濟面臨的新挑戰 (New Challenges Faced by the World’s Economy

and China’s Economy). Economic Herald 經濟導刊, January 14, 2008.

Ba Shusong 巴曙松. “Jianshe geng ju tanxing, geng kang chongji de chuangxin xing jinrong shichang: Ba Shusong jiaoshou lun Meiguo ciji zhai fengbo de

jiaoxun” 建設更具彈性、更抗衝擊的創新型金融市場——巴曙松教授論美

國次級債風波的教訓 (Building a More Flexible and More Shock-Resistant

Innovative Financial Market: Lessons Learned From the U.S. Subprime Mortgage Crisis). Sina Blog of Ba Shusong 巴曙松博客, September 23, 2007.

“Ci dai weiji yi zhounian: Qingsuan Gelin sipan” 次貸危機一周年：清算格林斯潘 (The First Anniversary of Subprime Mortgage Crisis: Examine Greenspan’s Performance). Xinmin Weekly 新民週刊, April 09, 2008.

Jiang Jianqing 姜建清 , and Li Yong 李勇 . “Guanyu shangye yinhang zichan

zhengquan hua” 關於商業銀行資產證券化 (On Asset Securitization of Commercial Banks). Financial News 金融時報, November 09, 2004.

Liu An 柳岸 . “Quanqiu jinrong yanshengpin shichang de zuixin fazhan ji qi gongxian” 全球金融衍生品市場的最新發展及其貢獻 (The Latest

Development and Contributions of Global Derivatives Markets). Futures Daily 期貨日報, April 16, 2007. http://www.federalreserve.gov/

BoardDocs/Speeches/2002/200209253/default.htm (accessed January 02, 2014).

“Meiguo ci dai weiji chuandao luxian tu” 美國次貸危機傳導路線圖 (The Roadmap of U.S. Subprime Mortgage Crisis). Globe 環球, March 2008.

Qiao Xiaohui 喬曉會, Hu Caiping 胡采蘋, Jin Yan 金焱, and Liu Bo 劉波. “Huaerjie

chong su misi” 華爾街重塑迷思 (Reshape the Math of Wall Street). Caijing Magazine 財經, (18) (2010).

Research Group of Subprime Mortgage Crisis. Ci dai fengbo qishi lu 次貸風波

啟示錄 (Subprime Mortgage Crisis). Beijing: China Financial Publishing

House, 2008.

231

References

Shen Liantao (Andrew Shen) 沈聯濤. “Quanqiu jinrong tixi yu shiti jingji yijing

tuojie” 全球金融體系與實體經濟已脫節 (The Global Financial System Has Been Divorced from Real Economy). Caixin.com 財新網, May 20, 2011

Shi Hanbing 時寒冰 . “Ci dai yu jinrong paomo de zhongjie” 次債與金融泡沫 的終結 (Subprime Mortgages and the End of Financial Bubbles). South

Reviews 南風窗, April 2008.

Shi Shiwei 史世偉 . “Weiji cushi quanqiu jingji geju bianhua” 危機促使全球經

濟格局變化 (Crises Provoked Changes in the Global Economic Pattern).

China Economic Times 中國經濟時報, February 11, 2011.

Tang Shisheng 湯世生. “Cong Meiguo ciji daikuan wenti kan Zhongguo jinrong

chuangxin zhilu” 從美國次級債問題看中國金融創新之路 (To Consider

the Path of China’s Financial Innovations from U.S. Subprime Mortgage Crisis). Modern Bankers 當代金融家, March 2008.

Wang Qishan 王岐山. “Zhiyan jinrong weiji yuanzi tanlan” 直言金融危機源自貪 婪 (Financial Crisis Originated from Greedy). Address at the Celebration

of the 80th Anniversary of Bank of China London Branch. Chinanews. com 中國新聞網, May 12, 2009.

Wang Zhaoyang 王昭陽. “Ju zhe you qi wu” 居者有其屋 (Home Ownership for All). Century Weekly 新世紀, (17) (2010).

Wen Xiu 溫秀. “Yang Kaisheng tan gonghang qingyu” 楊凱生談工行晴雨 (Yang

Kaisheng Talks about the Development of Industrial and Commercial Bank of China). Caijing Magazine 財經, (30) (2008).

Wu Xuean 吳學安 . “Ci dai fengbo yubo wei liao” “次貸風波”餘波未了 (The

Aftermath of the Subprime Mortgage Crisis). China Economic Times 中國

經濟時報, April 24, 2008.

Xie Guozhong 謝國忠 . “Xia yi chang fengbao 6 yue kaishi” 下一場風暴6月開

始 (The Next Crisis Will Come in June). Caijing Magazine 財經, March 31,

2008.

Xin Qiaoli 辛喬利, and Sun Zhaodong 孫兆東. Ci dai weiji 次貸危機 (Subprime Crisis). Beijing: China Economic Publishing House, 2008.

Yin Jianfeng 殷劍峰. “Meiguo ciji anjie daikuan zhengquan fengbo pouxi” 美國 次級按揭貸款證券風波剖析 (Dissect the U.S. Subprime Mortgage Crisis).

China Securities Journal 中國證券報, August 13, 2007.

Zhang Yuzhe 張宇哲. “Zichan zhengquan hua haiyou duoyuan” 資產證券化還有多 遠 (How Far Is Asset Securitization?). Century Weekly 新世紀, (31) (2010).

Zhong Wei 鐘偉 . “Meiguo ciji zhai shichang de xianzhaung jiqi shenyuan

yingxiang” 美國次級債市場的現狀及其深遠影響 (The Status Quo and

232

References

Far-Reaching Impacts of the U.S. Subprime Mortgage Market). China Development Observation 中國發展觀察, September 28, 2007.

Zhu Xiaohuang 朱小黃. “Ci dai weiji: Huo qi ganggan shikong” 次貸危機：禍 起杠杆失控 (Subprime Mortgage Crisis: Originating from Out-of-Control

Leverage). In Lin yuan jie wang 臨淵結網 (Take Actions at the Very Last

Moment). Beijing: Economy and Management Publishing House, 2008.

English material: Shen Liantao (Andrew Shen) 沈聯濤 . “Andrew Sheng’s an Asian View of the

Global Financial Crisis.” Malaysia Finance Blog, http://malaysiafinance. blogspot.hk/2009/03/andrew-shengs-asian-view-of-global.html (accessed January 02, 2014).

Translated materials: Goodman, Laurie S., and Frank J. Fabozzi. COD de jiegou yu fenxi COD的結構與

分析 (Collateralized Debt Obligations: Structures and Analysis). Trans.

Shanghai Wincom Investment Management Co., Ltd. 上海永嘉投資管理有

限公司. Beijing: China Machine Press, 2005.

Gorton, Gary. “Guanyu ci ci quanqiu jinrong weiji de ba ge weishenme” 關於此

次全球金融危機的八個為什麼 (Questions and Answers about the Financial

Crisis). Trans. Wang Yu 王宇 . China Economic Times 中國經濟時報 , April 08, 2010.

Greenspan, Alan. “Women yongyuan buhui you wanmei de fengxian moxing”

我們永遠不會有完美的風險模型 (We Will Never Have a Perfect Model of

Risk). Oriental Morning Post 東方早報, March 16, 2008.

Soros, George. “Quanqiu mianlin 60 nian lai zui yanzhong de jinrong weiji” 全

球面臨60年來最嚴重的金融危機 (The Worst Market Crisis in 60 Years).

Trans. He Bin 賀斌. China Securities Journal 中國證券報, January 29, 2008.

Chapter 15 Chinese materials: Cao Erjie 曹爾階 . “Guanyu gufenzhi he gupiao shichang de jige lilun renshi

wenti” 關於股份制和股票市場的幾個理論認識問題 (Several Theoretical

Understandings on Joint-Stock System and Stock Markets). Review of Economic Studies 投資研究, (1) (1993).

233

References

———. “Shao yidian xuannian, duo yidian huanchong — Huan yige jiaodu tan ‘327 fengbo’ ” 少一點懸念，多一點緩衝——換一個角度談“327風波” (Less Uncertainties and More Cushions — Views on the “327 Incident” from another Perspective). Beijing Economic Daily 北京經濟報, March 12, 1995.

Liu Longheng 劉隆亨 . Xiandai jingjifa cidian 現代經濟法辭典 (A Dictionary of Modern Economic Law). Beijing: Beijing University Press, 1992.

Wang Hongzheng 王紅征 . Xiandai jinrong touzi gongju 現代金融投資工具

(Modern Investment Instruments). Beijing: Tsinghua University Press, 2005.

Zhang Huiru 張惠茹, and Li Haidong 李海東. Jinrong qihuo 金融期貨 (Financial Futures). Beijing: Science Press, 2005.

Z h e n g X u e q i n 鄭 學 勤 . “ To u j i y u t o u z i z h i b i a n ” 投 機 與 投 資 之 辨 ( T h e Distinction between Speculation and Investment). China Securities Journal

中國證券報, February 21, 2008.

Chapter 16 Chinese materials: Cao Erjie 曹爾階. “Guoyou qiye gaige he ziben yunying” 國有企業改革和資本運

營 (State-Owned Enterprise Reform and Capital Operation). Reform 改革,

(10) (1997).

———. “Touzi yinhang zai Zhongguo de gongneng dingwei” 投資銀行在中國

的功能定位 (The Functional Positioning of Investment Banks in China).

Financial News 金融時報, July 1997.

———. “Ziben yunying: Women mianlin de xin keti” 資本運營:我們面臨的新課 題 (Capital Operation: A New Challenge for Us). Financial News 金融時報,

May 1997.

Chen Yunxian 陳雲賢 . Touzi yinhang lun 投資銀行論 (Theory of Investment Banking). Beijing: Peking University Press, 1995.

Hu Shuli 胡舒立, Li Qiaoning 李巧甯, and Li Qing 李箐. “Zhuangjia Lü Liang” 莊家呂梁 (Marketmaker Lü Liang). Caijin Magazine 財經, (2001).

Huang Ming 黃明 . “Guoji tou hang liyi chongtu zhi yuan” 國際投行利益衝突 之源 (The Root Cause of the Conflict of Interest between International

Investment Banks). Century Weekly 新世紀, (17) (2010).

Li Yining 厲以寧 . Zhongguo ziben shichang fazhan de lilun yu shijian 中國資 本市場發展的理論與實踐 (The Theory and Practice of Capital Market

Development in China). Beijing: Peking University Press, 1998.

234

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Li Zibai 李子白 . Touzi yinhang xue 投資銀行學 (Investment Banking). Beijing: Tsinghua University Press, 2005.

Ruan Qingsong 阮青松. Touzi yinhang xue jingjiang 投資銀行學精講 (The Essence of Investment Banking). Dalian: Dongbei University of Finance & Economics Press, 2009.

Zhao Bingxian 趙炳賢 . Ziben yunying lun 資本運營論 (Theory on Capital Operation). Beijing: Enterprise Management Publishing House, 1997.

Translated materials: Kuhn, Robert Lawrence. Touzi yinhang xue 投資銀行學 (Investment Banking:

The Art and Science of High-Stakes Dealmaking). Trans. Li Shen 李申, et al. Beijing: Beijing Normal University Publishing Group, 1996.

Jiang Zemin 江澤民 . “Gaoju Deng Xiaoping lilun weida qizhi, ba jianshe you Zhongguo tese shehuizhuyi shiye quanmian tuixiang ershiyi shiji” 高

舉鄧小平理論偉大旗幟，把建設有中國特色社會主義事業全面推向二十一 世紀 (Hold High the Great Banner of Deng Xiaoping Theory for an All-

Round Advancement of the Cause of Building Socialism with Chinese Characteristics to the 21st Century). Report at the 15th National

Congress of the CPC. The website of Federation of American Scientists, September 12, 1997. http://www.fas.org/news/china/1997/970912-prc. htm (accessed January 28, 2014).

Chapter17 Chinese materials: Ba Shusong 巴曙松. “Bawo weiji shidai de quanqiuhua jihui” 把握後危機時代的

全球化機會 (Seize the Post-Crisis Opportunities of Globalization). China

Macroeconomic Information Network 中國宏觀經濟信息網, March 08, 2010.

———. “Jiegou tiaozheng yu jingji yunxing xin dongli” 結構調整與經濟運行

新動力 (New Impetus for Economic Adjustment and Operation). China

Macroeconomic Information Network 中國宏觀經濟信息網, March 08, 2010.

Chang Xiuze 常修澤 . “Zhongguo fenpei zhidu gaige de san ge tisheng” 中國 分配制度改革的三個提升 (The Improvements in the Reform of China’s

Distribution System). China Economic Times 中國經濟時報, March 23, 2010.

“Chanye zhuanyi, mengxiang yu xianshi” 產業轉移，想像與現實 (Industrial Transfer: Imagination and Reality). Century Weekly 新世紀, (38) (2010).

235

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Ding Wei 丁未. “Zhongguo gaotie moshi: Yige houfaxianzhi de dangdai yangben” 中國高鐵模式：一個後發先至的當代樣本 (China’s High-Speed Rail Mode: An Example of a Successful Late Comer). Economy of China 中國經濟, November 05, 2009. Gao Jianguo 高鑒國. Xin Makesi zhuyi chengshi lilun 新馬克思主義城市理論 (NeoMarxist Urban Theory). Beijing: The Commercial Press, 2006. National Bureau of Statistics of the People’s Republic of China. “Jianguo 60 nian woguo chengshi hua shuizhun tigao 5 bei duo” 建國60年我國城市化水準提 高5倍多 (China’s Urbanization Rate Increased by over 5 Times in the 60 Years of New China). Xinhua Net 新華網, September 18, 2009. Nouvelles D’Europe 歐洲時報. “Jing Hu gaotie dailai de bu jinjin shi sudu” 京滬高鐵 帶來的不僅僅是速度 (Beijing-Shanghai High-Speed Rail Brings about More than Just Speed). June 15, 2011. http://yanlun.oushinet.com/commented_ eu/20110615/7705.html (accessed March 12, 2014). Qin Hui 秦暉, “Chengshi xin pinmin de juzhu quan wenti” 城市新貧民的居住權問 題 (Residency Right of the New Urban Poor). The website of Qiushi Journal 求是理論網. http://www.qstheory.cn/jj/ztyj/fdc/201205/t20120529_160756. htm (accessed March 11, 2014). Wang Jian 王建. “Zhongguo xu jinkuai zhuanru chengshihua tiaozheng guidao” 中國須儘快轉入城市化調整軌道 (China Has to Switch to the Track of Urbanization As Soon As Possible). China Macroeconomic Information Network 中國宏觀經濟信息網, October 20, 2009. http://mcrp.macrochina. com.cn/u/2/archives/2009/1840.html (accessed March 14, 2014). Wang Xiaolu 王小魯. “Zou da chengshi luxian” 走大城市路線 (The Strategy of Developing Large Cities). China Reform 中國改革, (10) (2010). Xiao Ming 肖明, and Gu Ming 顧敏. “Gaotie gaibian Zhongguo jingji bantu” 高鐵 改變中國經濟版圖 (High-Speed Railways Changed the Economic Layout of China). 21st Century Business Herald 21世紀經濟報導, November 23, 2009. Xiao Ming 肖明. “Fa gai wei yunniang ‘er heng san zhong’ chengshi qun geju” 發改委醞釀“二橫三縱”城市群格局 (National Development and Reform Commission Is Planning an Urban Agglomeration Layout of “Two Horizontal and Three Vertical Lines”). 21st Century Business Herald 21世紀經 濟報導, October 27, 2010. Xie Yunting 謝雲挺. “Wenzhou Longgang zhen: Zhongguo diyizuo nongmin cheng zhangda hou de fannao” 溫州龍港鎮：“中國第一座農民城”長大後的煩惱 (Wenzhou Longgang Town: Troubles of the Grown-Up China’s First Farmers’ Town). China Comment 半月談, December 15, 2008. Xiong Jinchao 熊金超, and Wei Mengjia 魏夢佳. “Woguo shuaixian buru gaosu tielu

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shidai” 我國率先步入高速鐵路時代 (China Took the Lead in Entering an Age of High-Speed Rail). Xinhua Net 新華網, December 17, 2009.

Zhang Yan 張焱. “Zhongguo ying chengwei di si ci gongye geming de lingdaozhe:

Fang qinghua daxue guoqing yanjiu zhongxin jiaoshou Hu Angang” 中國

應成為第四次工業革命的領導者——訪清華大學國情研究中心教授胡鞍鋼

(China Should Pioneer the Fourth Industrial Revolution: An Interview with

Hu Angang, Professor of the Center for Chinese Studies, Tsinghua University). China Economic Times 中國經濟時報, June 09, 2011.

Zheng Wei 鄭維. “Shijie gongchang zhuanshen zhi tong” 世界工廠轉身之痛 (Pains in

the Transformation of the World’s Factory). The website of Lianhe Zaobao 聯合

早報網, June 07, 2010.

Zhang Wuchang (Steven Ng-Sheong Cheung) 張五常. Zhongguo de jingji zhidu 中國的 經濟制度 (The Economic System of China). Beijing: CITIC Press Group, 2009.

Zhou Qiren 周其仁. Tiao deng kan jian 挑燈看劍 (Burning the Midnight Oil to See the Sword). Beijing: Peking University Press, 2006.

Zhou Shuqin 周蜀秦. “Zhongguo Chengshi hua liushi nian: Guocheng, tezheng yu

zhanwang” 中國城市化六十年：過程、特徵與展望 (60-Year Urbanization in

China: Process, Characteristics and Prospects). China Ancient City 中國名城, (10)

(2009).

Zhu Yuchen 朱雨晨 , and Pan Guojian 潘國建 . “Longgang biaoben” 龍港標本 (Longgang Sample). Caijin Magazine 財經, (10) (2010).

English materials: Harvey, David. The Urbanization of Capital: Studies in the History and Theory of Capitalist Urbanization. Baltimore: John Hopkins University Press, 1985.

The World Bank, “China: Long-Term Development Issues and Options.” In A World Bank Country Economic Report. October 31, 1985. http://econ.worldbank.org/ external/default/main?pagePK=64165259&theSitePK=477872&piPK=6416542 1&menuPK=64166093&entityID=000178830_98101911363148.

Translated materials: Harvey, David. Hou xiandai de zhuangkuang: Dui wenhua bianqian zhi yuanqi de tanjiu 後現代的狀況——對文化變遷之緣起的探究 (The Condition of Postmodernity:

An Enquiry into the Origins of Cultural Change). Trans. Yan Jia 閆嘉. Beijing:

The Commercial Press, 2003.

———. Xiwang de kongjian 希望的空間 (Spaces of Hope). Trans. Hu Daping 胡大平. Nanjing: Nanjing University Press, 2006.

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Chapter 18 Chinese materials: Bai Qinxian 白欽先. “Jingji quanqiu hua he jingji jinrong hua de tiaozhan yu qishi” 經濟全球化和經濟金融化的挑戰與啟示 (Challenges and Inspiration from

Economic Globalization and Economic Financialization). Chinaacc.com 中華

會計網校, April 14, 2006.

Guo Shuqing 郭樹清. “Zhongguo jingji de neibu pingheng he waibu pingheng

wenti” 中國經濟的內部平衡和外部平衡問題 (Internal and External Balance of China’s Economy). Economic Research Journal 經濟研究, (12) (2007).

Guo Tongxin 郭同欣. “Guanyu woguo fuwu ye tongji he zhanbi de youguan wenti”

關於我國服務業統計和占比的有關問題 (Relevant Issues on the Statistics and

Proportion of the Service Industry in China). The website of National Bureau of Statistics of the People’s Republic of China, June 17, 2010. http://www.

stats.gov.cn:82/ztjc/ztfx/grdd/201006/t20100617_59066.html (accessed May 28, 2014).

Huang Yiping 黃益平. “Renminbi li guoji huobi you duoyuan?” 人民幣離國際貨幣 有多遠？ (How Far Is Renminbi from an International Currency?). Century

Weekly 新世紀, (27) (2011).

Li Keqiang 李克強. “Guanyu tiaozheng jingji jiegou cujin chixu fazhan de jige

wenti” 關於調整經濟結構促進持續發展的幾個問題 (Several Issues on the

Adjusting of Economic Structure to Promote Sustainable Development). Qiushi 求是 (Truth Seeking), (6) (2010).

Liang Da 梁達. “Woguo fuwu ye fazhan jixu tisu” 我國服務業發展亟須提速 (China’s Service Industry Is in Desperate Need of Accelerated Development). Shanghai Securities News 上海證券報, April 11, 2011.

Lu Qiwen 陸綺雯. “Riyuan shengzhi, yongyuan de tong” 日元升值永遠的痛 (Yen Appreciation Is a Forever Pain for Japan). People.cn 人民網, August 07, 2007.

Tang Chunfeng 唐淳風. “Xue Riben ‘menqi facai’ ” 學日本“悶氣發財” (Learning from Japan about How to Become Prosperous while Keeping a Low Profile). Global Times 環球時報, August 06, 2009.

Wang Jian 王建. “Xin quanqiu hua shidai yu yansheng jinrong chanpin fengxian”

新全球化時代與衍生金融產品風險 (New Era of Globalization and Risks of

Financial Derivatives). China Securities Journal 中國證券報, March 19, 2008.

Wang Xianzhi 王先知. “Wuliu ye bukan chongfu shoushui zhongfu, yingyeshui

gaige keburonghuan” 物流業不堪重複收稅重負，營業稅改革刻不容緩 (The

238

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Logistics Industry Is Burdened with Double Taxation, and the Reform of Business Tax Allows No Delay). China Times 華夏時報, May 20, 2011.

Xie Guozhong 謝國忠. “Xia yi chang fengbao 6 yue kaishi” 下一場風暴6月開始 (Next Strom Will Start in June). Caijing Magazine 財經, March 31, 2008.

Ye Chusheng 葉初升. “Jingji quanqiu hua, jingji jinrong hua yu fazhan jingji xue

lilun fazhan” 經濟全球化、經濟金融化與發展經濟學理論發展 (Economic

Globalization and the Theoretical Development of Development Economics). World Economics and Politics 世界經濟與政治, May 27, 2006.

Yu Hairong 于海榮, and Huo Kan 霍侃 . “Shier wu: Ruhe bao minsheng” “十二五”：如何保民生 (The 12th Five-Year Guideline: How to Improve

People’s Livelihood?). Century Weekly 新世紀 , (10) (2011). http://

magazine.caixin.com/2011-03-12/100235751.html (accessed May 28, 2014).

English material: Marx, Karl. The Process of Circulation of Capital. Vol.2 of Das Capital. Moscow: Progress Publishers, 1887. http://www.marxists.org/archive/marx/ works/1885-c2/ch01.htm (assessed March 25, 2014)

Translated materials: De Soto, Hernando. Ziben de mimi 資本的秘密 (The Mystery of Capital). Trans. Wang Xiaodong 王曉冬. Jiangsu: Jiangsu People’s Publishing House, 2005.

Roach, Stephen. “Meiguo de shi heng yu Zhongguo wuguan” 美國的失衡與中國

無關 (The U.S. Imbalance Has Nothing to do with China). The website of

Financial Times Chinese FT中文網, January 15, 2008. http://www.ftchinese. com/story/001016741?full=y (accessed May 28, 2014).

Chapter 19 Chinese materials: Ba Shusong 巴曙松. “Caichan xing shouru de yingyou tiaojian” 財產性收入的

應有條件 (Necessary Conditions for Increasing Property Income). China

Macroeconomic Information Network 中國宏觀經濟信息網, March 07,

2008. http://mcrp.macrochina.com.cn/u/4/archives/2008/1451.html (accessed May 28, 2014).

———. “Jiedu ‘caichan xing shouru’ de sanchong neihan” 解讀“財產性收入” 的三重內涵 (Interpreting the Three Connotations of Property Income).

239

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244

Index A-Share Market 83, 214 accounts, current 155, 160-1, 163, 165 acquisitions 51-3, 56-7, 66, 70, 86, 88-9, 93-4, 96-7, 151, 166 agglomeration, economies of 107, 130, 132-3 American International Group (AIG) 2-3 arbitrages 14-15, 22 areas, metropolitan 112, 124, 127-8, 132, 137-8, 172 asset-backed securities (ABSs) 4-6, 11-12, 15, 24 asset management 50, 148, 214 asset reorganizations 53-4, 82-3, 85, 88, 93 asset securitization 2-9, 11, 13-15, 17, 19, 21, 23-7, 145, 150-2 asset securitization market 6, 24 asset securitization products 6, 11, 14, 16, 23-4, 26 Bank of China (BOC) 49, 56, 77 Bank of Communications (BOCOM) 56-7, 77, 82 banking panics 18-19, 21 banks, merchant 50, 55-6 Beijing Enterprises Holdings Limited (BEHL) 73-4, 91-2 Beijing-Shanghai High-Speed R ailway 123-5 bond market 4, 13, 23, 60 inter-bank 23 business-government collusion 222-3 business mergers 50, 52, 56-7, 59, 62-3, 65, 93, 96, 151, 166 business tax (BT) 178-80

capital rights of 220-1, 224-5 social 66, 85, 88, 207 speculative 165-6, 172 capital adequacy ratio (CAR) 4 capital formation mechanism 4-5, 106, 108, 110, 115 capital market reform 215 capital operation 47, 49-51, 53-9, 61-7, 69-79, 81, 83, 85, 87, 89, 91-3, 95-7, 99, 148 Chicago Board of Trade (CBOT) 32, 36 Chicago Mercantile Exchange (CME) 302, 36 China Banking Regulatory Commission (CBRC) 14, 23, 60-1 China concepts stocks 73, 91 China Construction Bank (CCB) 23, 48-9, 55, 57-8, 77, 179 China Development Bank 23-4 China Financial Futures E xchange (CFFEX) 32, 39 C h i n a Hu a r o n g A s s e t M a n a g e m e n t Company 23 China Insurance Regulatory Commission (CIRC) 24 China Investment Consulting Company (CICOC) 55, 104 China Merchants Group (CMG) 68 China National Petroleum Corporation (CNPC) 82 China Securities Regulatory Commission (CSRC) 60, 217 China State Construction Engineering Corporation (CSCEC) 69 China Strategic Holdings Limited 70-2 China Telecom 75-6, 92 China Venture Capital 88-9 Chinese Academy of Social Sciences (CASS) 202-3

245

Index

Chinese high-net-worth individuals 222-3 Chinese People’s Political Consultative Conference (CPPCC) 177, 184 cities medium-sized 106, 118-19, 132, 211 small-sized 119, 128 city clusters 112, 120, 123-4, 126, 132, 136 collateralized debt obligation (CDOs) 2-3, 6-8, 11-13, 22, 25, 167 commercial mortgage-backed securities (CMBSs) 6 companies, shell 66, 68 comparative cost 132, 143, 157-8 consumer price index (CPI) 205, 213 consumer services 145-6 consumption, delayed 187, 195 contracted land 219 corporate control 71, 94-6 transfer of 94-6 credit assets 2, 5-6, 23, 167 credit default swap (CDS) 6-8, 11-13, 15, 22, 25-6, 167 credit system 45-6 debt-for-equity swap 58-9 default risk 8, 11 demographic dividend 130, 132-3 derivative products 25, 35, 98, 167 derivatives market 11-12, 32, 98-9, 148, 151-2, 157, 167 differential ground rents 130, 132-3 distribution, primary 203-4, 210-11 domestic demand 116, 122-4, 140, 171 economic financialization 150-4, 161, 166-8, 172 economic globalization 144, 149, 152-4, 156, 158, 160, 162, 165-6, 173 economies asset-dependent 158-9 real 12, 16, 36, 39, 144, 151-4, 167, 171-2

246

virtual 12, 16 emerging industries 127, 147 enterprise bonds 4, 39, 60 equity disputes 94, 96 equity financing 39, 43, 48, 67, 69, 89-90 Euro-dollar market 50-1, 151 excessive speculation 37-8, 43, 45, 52, 84, 88 exchange rates, floating 31, 140, 165 farmers income of 205, 210 per capita property income of 205 farmers-turned workers 116, 122, 130, 133, 135, 205 fictitious economy 3, 144-5, 149-53, 156-7, 159, 161, 167-8, 171-2 finance direct 53-4, 66, 151, 153, 167 indirect 24, 49, 53, 145, 153, 162 financial crisis 2, 13-14, 16-19, 76, 92, 97, 99, 115-16, 127, 163, 165-7, 170 financial interrelations ratio (FIR) 152-3 fixed exchange rate system 30-1 funds, mutual 3, 12, 14, 19-20, 35, 216-17 futures contracts 30-1, 33-4, 37, 42 f utures markets 29-33, 35-9, 41, 43, 45, 167 Gini coefficient 201-3 global currency 139-41, 143, 145, 147, 149, 151, 155, 157, 159, 161-5, 167, 169, 1713, 175, 177 global financial crisis 2, 8, 14-15, 17-19, 23, 117, 120, 122-3, 155, 162-3, 167-8, 170-1 government bonds 6, 37-8, 52, 129, 161, 171 g over n m ent i nter vent i o n 2 2 - 3 , 7 0 , 110, 173 government investment 116, 129, 181 Government National Mortgage Association (GNMA) 32

Index

gross national product (GNP) 152, 197 group, low-income 190, 204-5, 207-8, 213, 226 growth enterprise market (GEM) 77 growth rate, annual 9, 120-1, 137, 143, 181, 198, 200 hegemony, financial 162, 166-7, 171 high-speed railways 112, 123-6, 128, 130, 136-8 Hong Kong Futures Exchange (HKFE) 36 Hong Kong Securities Clearing Company (HKSCC) 36 Hong Kong Stock Exchange 36, 66-9 Hong Kong Telecom 96-7 housing system reform 188-90 human capital 94, 156, 187-8, 209-10 imbalance, international economic 154-6 immigrants, illegal 134-5 income annual household 102, 193, 197 disposable 158, 201, 213 income disparity 202-3 income distribution 188, 191-2, 194-5, 203-6, 210-11, 213, 220-1 income distribution ratio 204 income distribution system 194, 199 income gap 201-2, 205-6, 208 income inequality 203, 207 income tax individual 207 unitary 207 Industrial and Commercial Bank of China (ICBC) 23, 49, 77, 82 industrial capital 54, 110, 114-16, 131, 133, 144, 149, 156, 166, 168 industrial clusters 148 industrialization 51, 63, 106-7, 110, 117-18, 120-3, 130, 144-7, 173, 181, 202-3, 209

industries secondary 145, 147-8 tertiary 108, 126, 145-7, 173 Initial public offerings (IPOs) 39, 66, 68-9, 76, 78, 82-3, 89-90, 92 institutional investors 2, 5, 7, 11-12, 14, 17-18, 20, 22, 25, 27, 37, 79-83 insurance companies 12, 15, 50, 79, 177 intellectual services 51, 54, 62-3, 78-9, 81, 92-4, 96-7, 152 International Economic Association (IEA) 207 International Monetary Fund (IMF) 10, 154, 166 International Monetary Market (IMM) 31 investment banking 50, 52-3, 55-8, 150 mentality of 49, 56-61 investment banking industry 50-6, 96-8, 167, 179 investment banks 3, 5-7, 9-17, 19, 21-3, 25, 27, 47-59, 61-7, 69, 71, 73-9, 81-3, 89-93, 95-9 investment channels 39, 213-14 investment funds 3, 79-80, 216-17 investment immigration 222-3 investors, individual 30, 80, 216-17, 225 labor division of 75, 109, 146, 173, 178-9 materialized 195, 220 mental 185, 191 labor income 187, 195, 204, 211 land, capitalization of 219-20 land prices, a negative 114 land reform 190, 219 land transfer 205-6, 219 legal person shares 85, 94 liquidity crisis 2, 4-5 logistics industry 174-5, 180-1 Longgang Town 102-6 low-income earners 186, 209, 213, 226 management, financial 45, 49, 57, 169, 213

247

Index

manufacturing capital 149, 157, 159 cross-border transfer of 160, 171 market full-circulation 77, 83-4 parallel 84-5 market capitalization 67, 91, 154 market-oriented reform 37, 114, 144 mass migrations 222-3, 226 men of property 186, 188-90, 221, 225-6 middle-income earners 189-90, 192-3 middle-income group 190, 192-3, 203, 208-9, 211-12, 214, 221, 225 migrant workers 123, 130, 133-5, 199 modern service industry 108, 112, 145-8, 156, 173-4, 176, 179, 181 monopoly industries 205-6 mortgage-backed securities (MBSs) 2, 6, 10, 12-14, 32, 86, 94 mortgage loans 6, 8, 11

National Bureau of Statistics of China 200, 202 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 (NDRC) 60-1, 175, 206 National People’s Congress (NPC) 86, 131, 177, 188, 202 negotiated transfer 59, 84-9 New Deal 196-7 non-tradable shares, negotiated transfer of 84, 86, 88-9 olive-shaped society 107, 193-4, 197, 199 overproduction 122 parallel banking system 15, 17, 19-20, 22, 27 per capita GDP 181, 193 planned economy 38, 55, 57, 64, 71, 169, 199, 225

248

Plaza Accord 140-1, 143 price difference 42-3, 79, 83-4, 86 price elasticity 36 primary market 43, 50, 78-81, 90, 93 principle of comparative cost 132, 143, 157-8 private capital 46, 88, 95-6, 104, 113, 173, 189, 219, 221, 224-5 producer services 146-8, 179 profit maximization 64, 94-5, 114-15, 151 property income 158-9, 186, 199-201, 204-5, 211-19, 221 property rights regime 223 real estate investment trust (REIT) 6 real estate market 8, 12, 38-9, 159, 217 Reform and Opening Up 16, 49, 56-7, 59, 66, 69, 71, 102, 113, 118, 121, 126, 131, 153, 169-70 repo market 17-18, 20-2, 27 revolution financial 2, 140, 144-5 urban 109, 112-13 rural migrant workers 121-3, 127, 133-5, 198 scale, economies of 93, 109, 119, 130, 132-3, 176 scandal, 327 bond futures 36-8 secondary market 2, 24, 43, 50, 75, 78-81, 85, 88, 93, 189 securities, asset-backed 2, 4, 20, 23, 152 securities markets 15, 33, 41, 43-6, 72, 80, 93, 151, 167, 216 securitization 4-5, 19-20, 22-3, 25, 63, 145, 151, 153 securitized products 5-6 service industry 119, 145-7, 150, 156, 169, 171-3, 176-9, 181, 206 Shanghai Industrial Holding Limited (SIHL) 72-4, 91-2

Index

Sino-foreign China International Capital Corporation Limited (CICC) 53, 55-6, 58, 76, 92 socialism builders of 190-1, 224 primary stage of 192-6, 224-5 socialist market economy 25, 38, 55, 64, 71, 121, 169, 186, 203, 211 socialization 53, 145-8, 156, 173, 179, 192 special purpose vehicles (SPVs) 6 speculation 13, 40-6, 75, 78, 81-2, 85, 88, 184 state-owned enterprise reform 65, 71-2 state-owned enterprises 49, 58-9, 65, 71-2, 74, 80-3, 85, 88-9, 95, 173, 189, 206-7, 224 state-owned shares 83-9, 94-6 negotiated transfer of 85-6 state shares circulation 87 Stock Exchange of Hong Kong (SEHK) 36 stock index futures 32, 34-5, 38-9, 42 stocks, red chip 69-70, 73-5, 91 Structured investment vehicle (SIV) 15 subprime mortgage loans 8-10, 12, 14, 19, 26, 96 subprime mortgage market 9-10 subprime mortgages 8-12, 19, 97, 155, 163, 167 supply chain management 174-5, 177 surplus capital 2, 5, 54, 150 surplus labor income 195, 203-4 synergy effect 93-4

Treasury bonds 4, 11, 18, 37 unfair capital operation 60, 78, 83-9 urban agglomerations 112, 120, 125, 127-8, 136-8 urban economy 101, 103, 105-10, 113-17, 119, 121, 123, 125, 127-9, 131-5, 137 urban infrastructure capital 108, 110, 113-16 urbanization 106-7, 109-10, 112, 117, 119-24, 126, 128, 130, 133, 135-8, 171, 181, 202, 205, 211 urbanization bonus 130-1, 133-5 urbanization rate 117-18, 120-2, 137 value-added tax (VAT) 113-14, 178-9 value discovery 37, 57, 59, 78, 86, 151-2 VAT reform 179 World Bank 55-6, 58, 132, 163, 166, 175, 201

time-space compression 101, 103, 105, 107, 109-13, 115, 117, 119, 121, 123-5, 127-9, 131-3, 135, 137 trade deficit 155, 157, 161 trade surplus 140, 150, 155, 160-1 transfer-operate-transfer (TOT) 72, 115 transformation, economic str uctural 123-4, 128 Treasury bond futures 37-9

249