China's latest revolution

By David Shirreff

China is going through nothing less than a financial revolution. Banks which for years were the sleeping limbs of a totalitarian giant are waking up to a new life of exposure to international markets and competition among themselves. Trading companies are being forced to fight for business. Farmers have become business tycoons and factories are selling bonds and shares.

All this is still very new. But western-style bankers, including the Japanese, have been quick to seek relationships with these new players, or potential players, in the international financial markets.

Provinces are starting to manage their own investments and to seek their own sources of foreign funds. Foreign currency is pouring into coastal regions, wreaking havoc with exchange controls, but bringing a taste of luxury and self-betterment to a deprived people. The revolution, which started in the late 1970s, hotted up last year and now threatens to reach boiling point.

Properly handled, the plethora of new financial forces could be the powerhouse behind China’s economic and social reforms. The next few months will show that better. They will reveal new Chinese names in the international capital markets; new names taking tentative steps in trading interbank deposits. And there could be the last appearance of that old bugbear – the question of unredeemed Chinese imperial bonds.

Only two institutions, representing 1 billion people and a landmass of 9.6 million square kilometres, are reasonably well known. They are Bank of China, a commercial bank which also manages China’s $16 billion reserves, and the China International Trust and Investment Corporation (CITIC), which acts as the government's merchant bank, attracting foreign investment and investing in material resources abroad. Bank of China is 73 years old, CITIC only five, but in some areas, as the powers-that-be intended, they are starting to compete.

"It's not rivalry with Bank of China," said CITIC executive director Jing Shuping. “China is so big. We're complementary to each other. Our sense of competition is simply a motivation for each to improve efficiency and management."

However, a battle royal is developing for leadership in China's investment programme, and especially for the highest profile in the international capital markets. CITIC stole a march on the Bank of China in January 1982 by being the first Chinese organization to issue a foreign bond since the 1949 revolution – a ¥10 billion private placement in Japan. The province of Fujian (the Fujian Investment and Enterprise Corporation – FIEC) did the next placement of ¥5 billion in August 1983. But Bank of China floated the first public bond issue last November, a ¥20 billion samurai led by Nomura Securities. CITIC was quick to follow with a ¥30 billion samurai led by Daiwa Securities in January this year.

So far the honours are even. Bank of China was planning to do a second samurai issue in March. But CITIC's chairman, Rong Yiren, China's best-known former capitalist, upstaged the Bank of China by announcing that CITIC would be doing a Deutschemark private placement.

Issuing in Japan is one thing. Issuing in Germany is quite another. Japan's embarrassing war record in China precludes the Japanese from raking up the past. But holders of $120 million (nominal) former imperial Chinese bonds in Europe and the US have no such qualms. Even after a court judgment in their favour in the US the Chinese cannot be certain that these bond-holders won't still try to torpedo a new Chinese bond issue anywhere in the western world.

Last year CITIC was prepared to run the lesser risk of such a thing happening to a DM private placement. The torpedo came not from imperial bond-holders but from the Bank of China. "It was a question of who should go first," said a German banker.

In November the Bank of China rejected the German placement in favour of doing a public issue in Japan. By February this year, when China was looking at the Deutschemark again, the market had died. And in March both CITIC and Bank of China were still waiting for a window.

"One thing's certain," said a German banker, "a Chinese issue at this moment couldn't fail to be a success. So many banks want the relationship that they would take the bonds even if they couldn't sell them."

That might be the picture in Germany – for the moment, it isn't so rosy in London or the US.

The Bank of England has stated categorically that it won't allow a Chinese borrower to do a sterling bulldog issue. In the US there are two cases in New York and an appeal still pending in Alabama against China's alleged default on imperial bonds.

In October last year the judge in the Alabama case ruled that his court had no jurisdiction over a question of sovereign immunity – since before a 1976 agreement there was no limitation on sovereign immunity in the US law and the Huguang Railway bonds in question were issued in 1911. The plaintiffs lodged an appeal but it is unlikely they will continue expensive legal action with little hope of success. A similar case in Pittsburgh last year, suing for $1 billion, was dismissed by the judge on the same grounds and won't be appealed against. In New York there are two cases before the same judge. They are entitled Karl Marx and Company against the People's Republic of China. If legal precedent is the guide then these cases will be dismissed too.

Eugene Theroux, a partner with lawyers Baker & Mackenzie, who acted for the Chinese government in the Alabama case, commented in March: "My advice to holders of these bonds is to hang them on the wall." Rumours that the Bank of China has been seeking to buy up outstanding bonds drove up prices temporarily. But the rumours haven't been substantiated by anyone contacted by Euromoney.

If a Eurodollar bond were issued in London there might be some objections from the Chinese Bondholders' Committee of the Council of The Corporation of Foreign Bondholders, a committee set up in 1935 by the then governor of the Bank of England. But verbal objections might be all the council could achieve. "The obstacle to legal action," said council director Michael Gough, "is the existence of sovereign immunity. US sovereign immunity isn't as liberal as ours." What then could the council do? "We've always tried to proceed by negotiation," continued Gough. "There's still a request in by our government to the Chinese government to honour these bonds." What sort of concrete action could the council take? "For example," said Gough, "when Pemex first issued a sterling bond, we got the lead manager to mention in the offer document that there were some Mexican bonds in default, which had been issued by a rebel government. We would like that done in the Chinese case." The Chinese question is the council's most important grievance, ahead of those against Bulgaria and East Germany. The nominal amount outstanding is £61 million ($71 million) with £150 million ($175 million) in arrears of interest.

Despite rumours to the contrary, the Chinese attitude is an absolute rejection of these claims. They say they won't honour the bonds of a government which used the proceeds to oppress and tyrannize its people. "We won't be held responsible for the debts of the previous government," explained CITIC executive director Jing Shuping. "As the People’s Republic of China we honour whatever we say. Even in very difficult times, even when the Russians withdrew, we paid them every cent. The PRC keeps its word. If the international capital markets don’t accept this it’s their loss. We can raise money in Japan, and there are so many other markets, like Hong Kong and Singapore.”

Since 1949 China has honoured its word. Since 1979 Chinese borrowers have been able to raise bank loans in the international markets. The Bank of China (London branch) is happily issuing CDs in the London market. "It's a tap issue," said BoC’s deputy general manager in London, KC Wu. "We don't push it as a major source of funds." Bank of China has the capability to do the same in Hong Kong. "We could issue CDs in US or Hong Kong dollars,” said BoC Hong Kong's senior deputy general manager Shan-Kwei Fong, but we rely on our deposits.” Bank of China has 12 sub-branches and 12 sister banks in Hong Kong, and one sister bank in Macao, providing a total of 390 retail outlets. It's estimated to have about 20% of the Hong Kong retail deposit market.

So how soon could Bank of China or CITIC make a yankee bond or Eurobond issue? Investment bankers are already visiting Beijing to talk about it. Most are confident that an issue could go ahead without snags. One niggling fear is that a troublemaker could buy one of the new bonds and attempt to call a cross-default before the proceeds were transferred to the borrower. Bank lawyers in Germany examined this possibility and were apparently satisfied such interference wouldn't succeed. 

"But the Chinese want their first issue to be a 100% success," said a German banker. "Even if the interference wouldn't succeed, they want to avoid a scandal." Bank of China doesn't want to be lumped together as a lending risk with its heavily-borrowed neighbours South Korea, Taiwan or the Philippines. With some justification it claims more affinity with the best capital-hungry sovereign risks – Sweden, France, even Japan.

With the legal issues finally buried, Chinese paper would be heavily in demand. It would have scarcity value backed by an economy which is being developed along principles applauded by western analysts.

Moreover, Bank of China, the most likely issuer, is a respected player in the Eurobond market, particularly in floating rate notes. "They are regular buyers and sellers," said one market maker. Bank of China, London, has 20 dealers in securities, money market instruments, precious metals and foreign exchange "We're definitely not a market maker," said deputy general manager Wu. We’re rather conservative." But recently the Bank of China has been increasingly active as a co-manager of international bond issues. It has favoured bank issues particularly floating exchange rate notes. That experience will stand it in good stead when it becomes an issuer itself. "Bank of China would be most wise to do a floating rate issue," said a French banker. "Most of the paper is picked up by banks so there's less risk of an investor problem."

Bank of China's samurai issue earned an AAA rating from the Japan Bond Research Institute. CITIC’s was rated AA mainly because it is less well known. The risk in both cases must be regarded as the Chinese government. Any other bond issuers in the near future would probably offer an underlying Bank of China guarantee. Given that guarantee, there are 12 other potential issuers wanting their image groomed and their name spread about the international capital markets.

Of those 12, two are banks, Industrial and Commercial Bank of China, the biggest in terms of its balance sheet, and China Investment Bank, a small institution formed to handle some of the World Bank loans to China. Up to now both banks have simply handed their foreign exchange business to the Bank of China. But from the beginning of this year ICBC has been allowed to do its own foreign exchange deposit business in Beijing, Shanghai, Guangzhou and the four special economic zones. Both CIB and ICBC have also been authorized to raise funds abroad. The Agricultural Bank can do foreign exchange business but up to now hasn't been authorized to raise funds abroad.

However, the biggest growth area in China's foreign borrowing is likely to be at the provincial level, through the regional international trust and investment corporations (the ITICs). There are 10 of them, all established on the lines of CITIC but owned by provinces and municipalities instead of the central government. Fujian Investment and Enterprise Corporation (FIEC) has already done a yen private placement. The others most likely to raise funds abroad in the near future are Beijing International Trust and Investment Corporation (BITIC), Guangdong International Trust and Investment Corporation (GITIC), and Shanghai International Trust Company (SITCO). "We've got up to $60 million worth of credit lines from foreign banks," said BITIC's vice president Lin Zhongshu. "Now we're planning to issue a bond, probably a samurai, and probably this year at a good time – at the moment the interest rate is low but the exchange rate is a problem. To save time on documentation we'd prefer to issue under a Bank of China guarantee."

SITCO's plans aren't so advanced. "We're going to issue bonds in future if we need to," said SITCO's spokesman Wei Ji-Zeng. SITCO appears to be more of a net investor abroad: "We do interest-rate swap operations with Japanese banks," said Wei. He was referring to gensaki investments, buying a Japanese bond combined with a bond futures contract with a Japanese bank. But SITCO will be instrumental in raising money abroad for some of Shanghai's major infrastructural projects. There is the mass transit railway scheme, which will cost about $750 million and various port development schemes.

GITIC is close to the Hong Kong market. Its origin is the Guangdong Overseas Chinese Investment Corporation, founded in 1955 with overseas Chinese shareholders and nationalized in 1966. The overseas Chinese still have a small stake in GITIC and that will be enlarged by a new stock issue in Hong Kong, denominated in US or Hong Kong dollars. Standard Chartered, which was one of the banks that handled the original stock issue in the 1950s, will be involved. GITIC had a branch in Guangzhou city, called the Guangzhou International Trust and Investment Corporation, which is now an independent company. That may also seek capital abroad but the name could cause confusion. The other ITICs are less talked about but they all represent either special economic zones where there should be big demand for capital, or provinces and municipalities the size of European countries. They will eventually come to market much like the municipalities, provinces and states in Canada and Australia.

But will the China of the future be anything like Canada, Australia or Japan? This year, hosts of articles in the western media have greeted what they see as the rise of capitalism in China. Have they got it right or are they just misreading the signs?

Recently the Chinese leadership has done little to refute the notion that communism is dead and capitalism is being born again. Socialism with Chinese characteristics is the vague but pragmatic term coined to replace Marxist-Leninist slogans. A westerner is tempted to rub his hands with glee, saying: "I told you so, ours is the only system that works."

But the fact that there are one billion Chinese mustn't be forgotten. Getting even a tenth of them off their bicycles and into saloon cars is an impossible task. The traffic problem, already bad, would choke the major cities. China Daily, the country's popular English language newspaper, carries a constant stream of stories about individuals who have bettered themselves: the pair of brothers who bought a private plane for crop-spraying; the man who farms scorpions and sells their precious venom; the farmers' cooperative which has set up a film company. This is the positive, encouraging side of an increasingly laissez-faire society. 

But what about the negative side? Over the last 17 years China has fought to rescue its population from near starvation. Today no one dies of starvation even though some regions, such as Tibet, are far from self-sufficient. But in western terms few people have enough food. Nearly everyone in China knows hunger – at home, at school, at university. Even the privileged white-collar workers, the cadres, welcome an official banquet as a way of getting a square meal. Given that background, with no social security and scanty free medicine, to be out of a job is a disaster. To be dismissed from a job is a family disgrace. In the United Kingdom, 3 million out of 60 million people are unemployed. The same ratio in China would mean 50 million people out of a job. Thatcherism would not work.

For this reason, the idea of rampant capitalism in China will never be realized. It will be a controlled experiment applied only to segments of the economy. There are no suitable outside models but an approximation might be French dirigisme combined with the oligolithic business set-up in Japan.

Capitalism may not quite be born again, but there are some capitalists. Rural reform has allowed farmers to specialize and to sell some of their produce in a free market. Many of them have accumulated cash and having satisfied their immediate needs are looking for opportunities to invest. The phenomenon of rich farmers and poor townsfolk is a reversal of the situation a few years ago. It's a welcome redress for former injustices but might create social imbalance and tremendous urban unrest in the long term. Factory management is being shaken up and the bonus system has been introduced. But bonuses can't go to workers in obsolete, unprofitable industries. There are many such industries in Shanghai, a city of 12 million people. Rejuvenating industries takes longer than emancipating farmers. Civil servants on fixed salaries aren't benefiting from the shake-up in industry and commerce, and the unofficial flow of wealth into official pockets is being dammed up. Before, the system was bolstered by 35 million privileged communist party members – now the party elite is being replaced by a meritocracy, even a plutocracy. And the plutocrats are coming in from the countryside. It is revolution in its purest form.

Much of what is happening today has happened previously in Chinese history. In the 19th century a China which had been closed to the outside world was opened up to international commerce. Trade was concentrated on a number of free ports on the eastern seaboard – like today's special economic zones and the 14 coastal cities. The result was an opium war and, after 1949, the expunging of almost all foreign influences.

There's a slight difference today. The broad masses of the Chinese people have never had a chance to help mould their society; a mechanism is being introduced whereby they might. That mechanism is a market for the free flow of goods, capital other resources. It's the mechanism of a non-violent revolution.