IMPORTANT DISCLAIMER:

THE FOLLOWING PRESENTATION REPRESENTS MY PERSONAL OPINIONS AND DOES NOT REPRESENT A COMPRHENSIVE ANALYSIS OF THE CHINESE ECONOMY. ALTHOUGH THE INFORMATION CONTAINED HAS BEEN OBTAINED FROM SOURCES BELIEVED TO BE ACCURATE I CANNOT GUARANTEE ITS ACCURACY, COMPLETENESS, OR FAIRNESS. OPINIONS INVOLVE NUMEROUS ASSUMPTIONS WHICH MAY OR MAY NOT PROVE VALID AND WHICH MAY BE CHANGED WITHOUT NOTICE.

THIS PRESENTATION IS INTENDED FOR INFORMATION PURPOSES ONLY AND DOES NOT CONSTITUE INVESTMENT ADVICE, A RECOMMENDATION, SOLICITATION, OR OFFER AND IS NOT THE BASIS FOR ANY CONTRACT TO PURCHASE OR SELL ANY SECURITY OR OTHER INSTRUMENT.

I, AS WELL AS PERSONS ASSOCIATED WITH MYSELF, MAY MAINTAIN POSITIONS IN SECURITIES, INSTRUMENTS, AND/OR MARKETS REFERRED TO BY THIS PRESENTATION.

Questions, comments, and all other inquiries should be directed to npoling@gmail.com

MacroeconomicReview GrowthDrivers MonetaryPolicy&theCurrency SocialImplications

Banking&Finance TheRoleoftheCentralBank Regulatory&MarketStructure

Party&State OutlineofPoliticalSystem ABriefHistoryofReform

Industry&theState

StructuralVulnerabilities

Summary&Conclusion

Ren Xiong (18231857)LateQingdynastypainterofthe

Shanghaischool

Sincereformbeganin1978,Chinahasachievedspectaculargrowth:

9.8%annualgrowthsince1978 Worlds2nd largesteconomyin2010 Worlds18th largesteconomyin1978

IMFpredicts: ChinaGDPUSAGDPby2016 PPP

Notabledivergencefromdevelopedworldin20082009

Consensusview Gradualistschool

ChinaisincrementallyconvergingwithWesterneconomicandpoliticalnorms

ChinawillovertaketheUSasglobalconsumerandeconomicleader

In billions of USDSource: IMF

GDP

Chinasgrowthrecordisimpressive,evenwhencomparedtootheremergingmarkets:

0

2000

4000

6000

8000

10000

12000

14000

16000

1980 1985 1990 1995 2000 2005

China

US

Euro Area

Canada

Japan

India

Brazil

Korea

Indonesia

Malaysia

Howhasthisbeenachievedsoquickly?

Source: IMF

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

ChinasShareofWorldGDP 19782010

HowhasChinagonefrombeinganeconomicbackwatertothreateningAmericansupremacyinjust30years?

HowdoesChinamanagethisseeminglyimpossiblebalance?

WeaddresseachofthesepointsinturnbeforereviewingChinasfinancialandpoliticaleconomy:

Maintain weakrenminbi RMBtopreserveexportcompetitiveness

Restrain inflation

Achieveconsistentgrowth 78%explicittarget

Chinesemacroeconomicpolicyattemptstobalance:

Open capitalaccount Necessitatedbyrelianceontrade Porouscapitalcontrols Opentoforeigndirectinvestment(FDI)withlimitedportfolioflows

Fixed exchangerateManagedpegtoUSD

Independentmonetarypolicy

Theorysuggeststhisisimpossible 1,2,3TheImpossibleTrinity

Thisbalancehasbeenachievableonlyduetothestatescoercivepoweranditsdominanceofdomesticmarkets

1 R.A.Mundell,CapitalMobilityandStabilizationPolicyunderFixedandFlexibleExchangeRates,CanadianJournalofEconomics&PoliticalScience29(1963)2 M.J.Fleming,DomesticFinancialPoliciesunderFixedandFloatingExchangeRates,InternationalMonetaryFundStaffPapers 9(1962)3 A.Rose,ExchangeRateVolatility,MonetaryPolicy,andCapitalMobility:EmpiricalEvidenceontheHolyTrinity,NBERWorkingPaper 4630(1994)

HavingYourCake Exportssubsidizedbycentralbank,thePeoplesBankofChina(PBOC)

Monetaryauthority,actsinbroadlysimilarfashiontodevelopedmarketcentralbanks

Normally,Chinaspersistenttradesurpluswouldcausetherenminbi(RMB)tostrengthenagainstthedollar(USD)

ThePBOCpreventsthetradebalancefromadjustingbyinterveninginFXmarketstomaintaintheweakRMB:

PrintsRMBtobuydollarsinopenmarketoperations Transactedasmuchas$1.8bn/dayin2007!1 Inherentlyinflationary;impactmustbecompensatedfor

Impactsterilizedbyremovingcurrencyfromcirculationby: Purchaseofforeignassets(i.e.USdebt) Direct&indirectbankreservehikes

9705 ChinaformallypeggedRMBagainstUSD

0508 Managedfloatallowsfor~20%appreciation

08 Present DefactoUSDpeg@~6.80RMB/USD globalslowdowncallsforhalttoappreciation

ABriefHistoryofChineseCurrencyManipulation

1 J.Greenwood.TheCostsandImplicationsofPBOCSterilization,CatoJournal Vol.28,No.2(2008)

Sterilizationcausessignificantlocalandinternationaleconomicdistortions Sterilizationcanonlypostponeinevitableadjustments

andEatingItToo

Themechanicsofsterilization:

ChineseexportersreceiveUSDfromUSbuyers ExportersellsUSDtoPBOC ExporterreceivesnewlycreatedRMBfromPBOCinreturn

PrintingRMBoffsetsnaturalcurrencyadjustment/balancing

PBOCaccumulatesUSDreserves,RMBsupplyincreased

ReservesparkedlargelyinUSTreasuries Lackofsufficientlylarge/liquidalternatives

Reservesdeployedincreasinglyaggressivelyviasovereignwealthfundsetc.

NewlyprintedRMBsterilized Requiresfinancialrepression:

Restrictionsonbankingsector/generalpopulace UltralowyieldingsecuritiesforcedondomesticbanksbyPBOC effectivereservehikes

ABriefHistoryofChineseCurrencyManipulation

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

0.0

2,000.0

4,000.0

6,000.0

8,000.0

10,000.0

12,000.0

14,000.0

US M2

China M2, USDUS YoY

China YoY

US&ChineseMonetaryAggregates

AsighttohumbleevenHelicopterBen

Source: Federal Reserve, PBOC

Massivefiscalstimulus 14%ofGDP!(USstimulus 6%)

ImportedUSmonetarypolicyisinappropriateforafastgrowingemergingeconomy,particularlyonewithahistoryofproblematicinflation

Freefromtheruleoflaw,Chinahasusedfinancialrepressiontolimittheinflationaryimpactofaggressivemoneyprinting:

PBOCsetsdepositandlendingratesartificially

PBOCimposeslendingquotasonbanks

PBOCissuesSTnotesandSpecialBillstobanks Lowyieldingbondsforceduponbankstoimmobilizebankassets belowmarketcoupons Defactoincreaseofbankreserverequirements 5.1%ofdomesticassetsat12/31/101

Bankreserverequirements 23.5%ofdomesticassetsat12/31/102

~30%ofbankcapitalimmobilized Inflationarypressurescontinuenonetheless

1,2 PBOC2010AnnualReport,ChinaBankingRegulatoryCommission

Explicitcostsofsterilization: Spreadbetweencostsofspecialbillsandreturnonforeignassets Sizeofspecialbillsrelativetosizeofforeignassets

1 PBOCStatistics&Figures2010

Implicitcostsofsterilization: Lendingshiftstoshadowbankingsystem

Offbalancesheetleverageandundergroundbankingsystem

Distortscapitalallocation PBOCbalancesheetexpansioncrowdsoutconsumption

Balancesheetmustgrowwitheconomytomaintainpeg 12/31/10 PBOCislevered1,180x!1

Inflationcanonlybesuppressedtemporarily: LiquidityoverhangremainsonPBOCbalancesheet Significantobstacletodeployingreservesdomestically

Ultimateadjustmentfiltersthroughvia: Domesticprices Exportsectorviaresourceprocurement

Significantbuyerofcommodities

0

500

1,000

1,500

2,000

2,500

3,000

3,500

12/1/1999 12/1/2001 12/1/2003 12/1/2005 12/1/2007 12/1/2009Billions of USDSource: China Economic Information Network, Bloomberg

ForeignExchangeReserves 19992011

CurrentPBOCGovernorZhouXiaochuan ()

At6/31/11Chinasreserveswere:3.4x2005reserves17.7x2001reserves

RaisinginterestrateslastresortforPBOCtocontrolinflation: Raisescostsofcurrencysterilization depositrate+1% costs+~5%1 Attractsspeculativecapitalflows(hotmoney) Inflictslossesonbankingsectorviabondholdings

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

Household Savings Deposits 1 Yr. RateChina 1 Yr. Lending Rate

Deposit Reserve Ratio

1 Christer Ljungwall,Christer,YiXiong,andZou Yutong.CentralBankFinancialStrengthandtheCostofSterilizationinChina.CERCWorkingPaper8(2009)

Source: PBOC, Bloomberg

Mercantilisttradepolicy/sterilizationhasledChinatoshareJapansburdenofunderwritingAmericanprofligacy Chinaisaforcedbuyer:

Source: US Treasury, billions of USD

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

US Debt, Held by Foreigners

US Debt to China

US Debt to Japan

China, % of Tot.

Japan, % of Tot.

Chinais~10%ofWorldGDPbutitsshareofglobalcommodityconsumptionismuchhigher:

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Cement Iron Ore Coal Steel Lead Zinc Alumninum Copper Nickel Pork Eggs Rice Soybeans

Source: GMO, 4/11 Quarterly Letter

ChinasresourceintensivegrowthisstretchingglobalsupplyFurthergrowthwillproveincreasinglycostlyandpressuredomesticprices

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

10/8/2006 4/8/2007 10/8/2007 4/8/2008 10/8/2008 4/8/2009 10/8/2009 4/8/2010 10/8/2010 4/8/2011

SHIBOR 3 Mo.

Deposit Rate 3 Mo.

Chinahasmadecappingpricerisesthepriorityofmacroeconomicregulationandintroducedahostoftargetedpolicies.Thesehaveworked.Weareconfidentpriceriseswillbefirmlyundercontrolthisyear.

Wen Jiabao (),6/23/11FinancialTimeseditorial

Interbankrates(SHIBOR)understatetruemarketrates anecdotalevidenceofratesinshadowbankingsystem>20%in2011

Source: PBOC, Bloomberg

-5.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008

CPI, YoY

CPI, Urban, YoY

CPI, Rural, YoY

Previousinflationarysurgesmanagedbyextraordinaryfinancialrepression(i.e.totalhaltofbanklending,sweepingcentralizationoffinancialandfiscalauthority,etc.)

Unclearifcurrentapparatusiscapableofrepeatingsuchdrasticaction

Source: PBOC, Bloomberg

LikeAsianpeers,Chinahasutilizedtheexportgrowthmodel:

Arbitrageadvantagefromlowcostlabor 2035%/GDPfromexports

Ultimateimpactislarger: Proceedsareleveredthroughstate

financialsystem&reinvesteddomestically

4050%ofGDPfromfixedassetinvestment

Primarydestinationsforfixedassetinvestment1:

Exportproductioncapacity Realestate

Significantleveragetoglobaldemand

Investmentincreasinglycompensatingforweakglobaldemand:

~70%of2008growth ~90%of2009growth2

1 MoodysAnalyticsReportChina:FixedAssetInvestment.Published6/13/2011.2 PivotCapitalManagementReport ChinasInvestmentBoom:TheGreatLeapintotheUnknown(2011),NationalBureauofStatistics

Chinalacksmeaningfulgrowthdriversoutsideofexportsandstatedriveninvestment

Exports&GrossCapitalFormation/GDP 1981 2009

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1981 1986 1991 1996 2001 2006

Gross Cap. Form. (Fixed Asset Investment)

Exports

Combined

Globaldownturnliterallypavedover:

Source: World Bank

1 HSBCGlobalResearchCurrencyWeekly,06/07/2010,p.52 DavidPearson,InChina,RealEstateFeverisRising,LosAngelesTimes,04/26/2010.Accessed8/24/11.http://articles.latimes.com/2010/apr/26/business/lafichinarealestate201004263 Pivot,p.7.Chartsexcerptedfromsamereport.

Realestateisanothersignificantdestinationforfixedassetinvestment:

HSBCestimatestotalvalueofresidentialpropertyat3.27xGDP1 Almost2xlevelinUSbeforesubprimecrisis ClosetoJapanesepeaklevelof3.8x

Japanese89GDP/Capita=14.4xChina09GDP/Capita(ConstantUSD)

Price/incomelevelstopglobalmarketsatpeakofcreditcycle

Price/Income 1520xinmajorcities,~10xinregionalcities 9xinLondon,12xinLosAngelesin2007

CompensatingforSomething? Morethan100supertall(>300m)buildingsinplanningorunderconstruction

Currentlyonly70buildings>300mglobally Significantnumberofprojectsfinancedandinitiatedbylocalgovernments Historically,projectsofthisscalehavemarkedmarkettops1:

PingAnInsurancesnewShenzenheadquarters 115floors,648m under

construction

Goldin Finance117,Tianjin 117floors,597m underconstruction.Masterplanalsocallsfor270storytowersandresidentialhighrises

1 AndrewLawrence, TheSkyscraperIndex:FaultyTowers,PropertyReportDresdnerKleinwortWassersteinResearch (1999)

TheGuangzhouUrbanPlanningBureausproposedcenterpiecefortheplannedBaietanCBD 118floors,650+m.Thedistrictwillhavemorethan10mmsq.metersoffloor

space.

ForthebenefitofAmericanreaders,ChicagosWillis(Sears)Towerisonly527mwhenits85mantennaeareincluded

DubaiX1000? Tianjinisplanninganespeciallygrandiosecentralbusinessdistrictwhichiscurrently

underconstruction:

ConstructionofPhase1ofprojectisunderway Thetoweringbuildingvisibleatcenterleftistobe~600m,whichwouldbetheworldssecondtallestifitstoodtoday

Chinaisindireneedofstructuralreform: Dependentonexporteconomy&fixedassetinvestment

Exportimpactsmalleronanetbasis,butprovidescriticalsourceofforeignexchange

Macroeconomicmanagementdistortingcapitalallocation Mountingleverageandinflation Partyremainsdominantplayerinbusinessandfinance

Stateusesmarketmechanismsselectively&onitsownterms

1 BarryEichengreen,Donghyun Park,&Kwanho Shin.WhenFastGrowingEconomiesSlowDown:InternationalEvidenceandImplicationsforChina,NBERWorkingPaper 16919(2011)4

ExperienceofotherAsiantigerssuggestsgrowthwillslowirrespectiveofinternalobstacles1 MiddleIncomeTrap Export&investmodelprecludesbalancedgrowth&formationofconsumersociety

TemptingcomparisonstoJapanbutrealitiesofChinaareevenstarker

Consensus:ChinawillrebalanceandreplaceUSasglobalconsumer

McKinsey ChineseurbanmiddleclasswithspendingpowerequivalenttoJapanesehouseholdsby2025$2.4trn

Problemsrecognized,butstructuraltransitiontakenasagiven

Reality:Chinacannot becomeaconsumernationwithoutsignificantstructuralreform

Govt.recognizesproblemsbutweddedtostatistsolutions Softinfrastructureneeded,notmorehardinfrastructure

Statemustwithdrawfromcapitalallocation Stateremainsdominantplayerinfinance&industry Stateinvestmentcrowdsoutprivateentrepreneurs Nonstatesectorstarvedofcapitalandresources

PBOCmustcurtailitsmarketoperations Economymustrebalanceawayfromexports/investment Massivebalancesheetexpansiontakesplaceofincreased

domesticspending,createsdangerousliquidityoverhang Benefitsofexportsaccruelargelytoforeigninvestorsand

stateownedenterprise

Populacehasnotsharedingainsfromgrowth: Personalincome/capitaseverelylagsGDP/Capita

growth,whichitselflagsGDPgrowth1

Wagesqueezeworsenedbyinflation/assetbubbles

2nd largesteconomy,but93rd inGDP/CapitaIMF BetweenMacedonia(92nd)&Algeria(94th) GDP/Capitaoverstatesincomeasonly~40%flows

throughtolabor

Laborssliceofthepieisshrinking2: 1997Wages/GDP:53% 2007Wages/GDP:40%

Largewealthinequality 0.4%ofChinesecontrol4050%ofwealth3 Gini coefficient:47in2010accordingtostateests.4

Understated,excludeshiddenincome Concentrationofwealthreflectsconcentrationof

poweramongstpoliticalelites

HowsuccessfulcantheChinesemiraclebewhensofewhaveenjoyeditsbenefits?

Source:WorldBankDevelopmentIndicators,19752008.

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

S. Korea Singapore Brazil Hong Kong Mexico China

2008Avg.HourlyWage

1 A.R.KhanandCarlRiskin,IncomeandInequalityinChina:Composition,DistributionandGrowthofHouseholdIncome,1988to1995,TheChinaQuarterly 154(1998)2 RichardMcGregor,TheParty (NewYork:HarperMacMillan,2010,3 VictorShih,HighWealthConcentration,PorousExchangeControl,andShockstoRelativeReturn:TheFragileStateofChinasForeignExchangeReserve,PresentationattheInstituteofNewEconomicThinking,BrettonWoods,NH(2011)4 ChenJia,CountrysWealthDividePastWarningLevel,ChinaDaily,05/12/10.Accessed08/23/11.http://www.chinadaily.com.cn/china/201005/12/content_9837073.htm

Sincetheearly90s,Chinasurbanpopulacehasbeenfavoredattheexpenseoftheirpoorer,lesseducatedruralcompatriots:

Percapitaincome1: Urban $2,000 Rural $605

Limitedjobopps. 40%ofruralpopulationun orunderemployed2

Limitedpublicservicesinruralareas Cutofffrombankcredit,reliantoninformalcredit/loansharks Functionofconcentrationofwealth/politicalpowerincities

Huoku ) rural/urbanclassregistersystemexacerbatesdivide Ruralcitizensliterallysecondclasscitizenswithrestrictedmobility Createsmarginalizedclassof150mmmigrantrurallaborers Ruralworkerscanmovetocitiestoseekjobs,butlackaccesstobasic

publicservicesduetoruralcitizenship

Oftenforcedtoworkininformallowpayingjobs SocialpositionanalogoustoillegalimmigrantsintheUS

1 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,200)251.2 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies,BloombergBusinessweek,7/10/11.3 Carsten Holz,ChinasEconomicGrowth19782025:WhatWeKnowTodayAboutChinasEconomicGrowthTomorrowHongKongUniversityofScience &Technology,2005.

Privatizationsof90sendedIronRiceBowl)socialsecuritynet SOEsusedprivatizationstojettisonlowproductivityworkerswhohadpreviouslyenjoyedguaranteedjobs&benefits

RestructuringcarriedouttoenhanceprofitabilityofretainedSOEs Createdlargegroupofunemployedwithlimitedmarketableskills/experience structurallyunemployed ~100mmterminatedworkersfrom90sstreamliningremainlargelyunemployedwardsofthestate

Localgovernmentsnowresponsibleforeducation,healthcare,andsocialsecurityafterlate80sreforms:

Createdproblematicconflictsforlocalleaderswithsignificantsocialconsequences:

Newresponsibilitieswereunfundedmandates Localofficialsperformancestillassessedbynominalgrowth

Incentivizedtofavorshorttermeconomicgrowthoverlongtermsocialinvestment

Increasingdemandsonlocalleaderspaidforthroughunsustainablefinancingpractices:

Landsalesofexpropriatedpropertyfrequentlyusedassourceofcashflow

Arbitraryseizuresofpeasantfarmland,propertyresoldtodevelopersbylocalgovernment

70mmfarmershavelosttheirlandinthiswayinthepastdecade!

Aggrievedcitizenshavelittlerecourseasthelocalgovernmentswordislaw

Seekingjusticehigherupthestatehierarchydifficultanddangerous

Healthcare 2000WorldHealthOrganizationstudyrankedChinas

healthcaresystem144th globally,behindBurundibutaheadofMongolia

~40%ofsickruralresidentsdidnotseekmedicalcareduetoitsunaffordability1

~60%ofruralresidentsrequiringhospitalizationdidnotseektreatmentduetounaffordability1

1publichealthprofessional/7,000peopleUS 1/6352

Education Statewithdreweducationfundingin90s Expensedumpedonlocalgovts.andsubsequentlypassedonto

parentsinformofincreasingschoolfees

EducationcostsgrewfasterthanCPIby10%in90s3 Inequalitycontinuestorise:4

Lackoftrainingdrivesinequalityinwages5

Illiteracyincreased64.3%between2000and2005 Equivalentto30%ofruralschoolcohortsfrom1990s6

Ruralsecondaryschooldropoutrates 43%in00037

1 Yasheng Huang,CapitalismwithChineseCharacteristics:EntrepreneurshipandtheState (NewYork:CambridgeUniversityPress,2008)251.2 JasonGale&BretOkeson.ChinaDoctorsEarning$300aMonthFlocktoDrugCompanies,BloombergBusinessweek,7/10/11.3 Carsten Holz,ChinasEconomicGrowth19782025:WhatWeKnowTodayAboutChinasEconomicGrowthTomorrowHongKongUniversityofScience &Technology,2005.4 RaviKanbur &Xiaobo Zhang,FiftyYearsofRegionalInequalityinChina:AJourneythroughCentralPlanning,Reform,andOpenness,ReviewofDevelopmentalEconomics 9(2005)5 Z.Liu,TheEffectsofEconomicReformsonWageInequality:SomeEvidencefromChina,AppliedEconomicsLetters,8,(2001)6 Huang,437 Ibid,248

Patientsawaitingtreatment

Chinesefinancespeakstothefundamentallypoorprospectsforstructuraltransitionwithoutreform

Chinasgrowthislargelyinternallyfinanced FDIislimited&largelyfocusedonexportindustries

i.e.offshoring/outsourcing

Highsavingsratefinancesinvestmentglut Saversunwillinglyunderwritegrowth BankingsectorprovidescheapcapitalforSOEs,localgovts.

Statesetsinterestratesandlimitsinvestmentoptionsforsavers

Fixeddepositrates,fixedlendingratesFixedNIM Createscheap,captivecapitalforstatebanks

Realdepositratesfrequentlynegative Alternativesforsaversrestrictedtoinvestmentin

realestateandequities encouragesspeculation

DefactotaxonChinesesavers

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

1982 1987 1992 1997 2002 2007

FDI, % of GDP

Gross savings, % of GDP

Source: PBOC, Bloomberg

1 Saez,Lawrence,BankingReforminChinaandIndia,(NewYork:PalgraveMacmillan,2004)2 CarlWalter&FrasierHowie,RedCapitalism:TheFragileFinancialFoundationofChinasExtraordinaryRise,(NewYork:JohnWiley&Sons,2011)

Inourcountryscurrentlevelofmacroeconomicdevelopment,wemustmaintainalevelofmacroeconomicgrowthofaround8%perannumandthiswillinevitablyrequireacorrespondinglevelofcapitalinvestment.Ourcountrysfinancialsystemisprimarilycharacterizedbyindirectfinancing(viabanks);thescaleofdirectfinancing(viacapitalmarkets)islimited.

YangKaisheng (),CEOofIndustrial&CommercialBankofChina

1 Saez,Lawrence,BankingReforminChinaandIndia,(NewYork:PalgraveMacmillan,2004)2 CarlWalter&FrasierHowie,RedCapitalism:TheFragileFinancialFoundationofChinasExtraordinaryRise,(NewYork:JohnWiley&Sons,2011)

CapitalRaisingActivity 1993 2009

Source: PBOC Financial Stability Report 2010

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Bonds

Bank Loans

Equity

Thesubsidizeddomesticbankingsystemfinancesalmostalleconomicactivity1:

Bankloans&bondsaccountfor~90% ofcorporatefinance2Equityfinancing immaterialForeignbanks 2%offinancialassets

1 Walter&Howie,86.

Chinasrelianceonitsstatebankingsystemisunderstatedascorporatebondsarenotmateriallydistinguishablefrombankloans :

70%heldtomaturitybystatebanks1 22of24primarydealersarestatebanks1

Underwritingbondandretainingcreditrisk effectivelyaloan

TheChineseyieldcurveisaconstructionofthestate:

Usesstatesetbank1yeardepositrateasabaseline Tradingvolumeisinsignificant yieldcurvecanbedrawnarbitrarily

Bondsissuedandsoldprimarilytogovernmentcontrolledentities Soldatbelowmarketcoupons Sellingunattractiveforholders createslossesduetobelowmarketissuance;politicallyunappealing

IllustrativeofPartysselectiveadoptionofmarketinstitutions

ThebankingsystemisChinasdefactosecondtreasury:

Capitalallocationsystemfundamentallyunchanged since70s

Partyviewsbankingsystemaspolicytoolandvehicleforpersonalenrichment

ThePartycontrolsthebankingsystem

Thebankingsystemfundsalmostalleconomicactivity

WenowwillbrieflyreviewthecurrentstateofChinesebanking:

o Capitalisoftenpoliticallydirectedandusedbylocalofficialstoaccomplishthepartyseconomictargets

o Seniorbankofficials&SOEmanagersselectedbynomenklatura system

o Partyretainsmajorityequityownership&ultimatecontrol

1 Bankannualreports,various,PBOCAnnualSurvey&Statistics2010.

CorporatebankinginChinaisdominatedby4largestatecontrolledbanksTheBig4andtheiremergingrivalBoCom:

Primarytoolsofstateinmanagingtheeconomy: Asecondtreasury despitepurportedcommercializationandpubliclistingsgovt.influenceremainssignificant

Listedwithshareofdomesticfinancialassetsasof12/31/101:

BankofChinaBOC17.0%ChinaConstructionBankCCB17.6%Industrial&CommercialBankofChinaICBC21.9%AgriculturalBankofChina ABC16.8%BankofCommunications BoCom6.4%

EmergingrivaltoBig4

Initiallyformedasstatepolicybanks,latercommercialized Politicized government.retainsmajorityownershipandcontrolsboardsofdirectors;personnelmustbegovernmentapproved

79.7%ofdomesticfinancialassets

5- Year Asset CAGR

ROA RE Loans/Total LoansOBS Commitments/

Total Loans NPL RatioTier 1

Capital

China Development Bank 21.9% 0.8% N/A N/A 0.6% N/A

Agricultural Development Bank 15.5% 0.0% N/A N/A 1.1% N/A

Export-Import Bank 44.9% N/A N/A N/A N/A N/A

Postal Savings Bank N/A N/A N/A N/A N/A N/A

Bank of China 17.2% 1.1% 29.1% 84.2% 1.2% 10.0%

China Construction Bank 18.7% 1.4% 8.9% 44.0% 1.3% 10.3%

Industrial & Commercial Bank of China 15.8% 1.3% 27.0% 54.3% 1.2% 9.7%

Agricultural Bank of China 16.7% 1.0% 26.6% 14.1% 2.3% 9.6%

Bank of Communications 22.7% 1.1% 9.8% 75.5% 1.1% 9.2%

CDB figures as of 12/31/09 (most recent), NPL figure reflects provision for loan losses as NPLs are undisclosed. Export-Import Bank figures as of 12/31/09 (most recent). Source: Bank annual reports (various), Bloomberg.

1 BankAnnualReports,PBOC.

Thecoreofthebankingsystemisroundedoutbytheexplicitlystatistpolicybanks:

Listedwithshareofdomesticfinancialassetsasof12/31/101:

ChinaDevelopmentBank CDB8.3% AgriculturalDevelopmentBankofChina ADB2.8% ChinaImportExportBank CIE1.4% ChinaPostalSavingsBankCPSBUndisclosed

Formedin1994totakeoverpolicyloansfromnewlycommercializedBig4aspartoflargerfin.sectorrestructuring

Despitestatedmission,majorityofactivityisindistinguishablefromoperationsof commercializedBig4

ChinaDevelopmentBank(CDB)

Particularlyimportantinrecentyears: LedbyRevolutionaryprinceling sonofChinasformersupremestateplanner,ChenYun

Lendingvol.onparwithMinistryofFinance 12/31/2010loanbook2XWorldBanks

Sovereignwealthfund,butmajorityofinvestmentisdomestic 70%fundedbycommercialbanks(Big4)

Shifttouniversalbankstrategyhasledstatecompetitorstosimilarlydiversifybusinesslines

IntroducednewsecuritizedproductsExemplifiesexpansionandambitionofstatecontrolledfinancials

Financierofstateegoprojects ThreeGorgesDam,ShanghaiPudong Aiport,BeijingOlympicprojects,etc.

PolicyBanksex.CPSB 12.6%oftotalfinancialassets

Big4BOCOMPolicyBanksex.CPSB92.3%oftotalfinancialassets

Concentrationhasincreasedinpastdecade Centralizationoffinanceaidsandabetspartycontrol

Ifitdoesnthaveaccesstoastableandsufficientsourceofcapital,theChinaDevelopmentBankwillbeunabletooperatenormally

Anonymous,TreasuryDepartment,CDB.Quoted01/11/10inTheEconomicObserver ()

Withaggressiveloangrowthandweakcashflowgeneration,Chinesebankingisunusuallycapitalintenseandrequiresconstantrefreshment.

>50%of0510&95%of0710newequitycapitalpaidindividends!

Thisoddityismoreexplicablewhenwerecallthatvastmajorityofbankdividendsaccruetothestate

(300,000)

(200,000)

(100,000)

0

100,000

200,000

300,000

400,000

2005 2006 2007 2008 2009 2010

Proceeds from Sale of Common Stock

Dividends Paid

Source: Bloomberg, Bank annual reports

EquityOfferings&DividendPayouts,Big4Banks,20052010

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

Dec-99 Nov-00 Nov-01 Nov-02 Nov-03 Nov-04 Nov-05 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10

Domestic Credit

GDP

Source: PBOC, Bloomberg, billions of RMB

CreditisgrowingfasterthanGDP

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

9.0%

10.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10

Total Loans of Fin. Institutions, YoY (L. Axis)

NPL Ratio (R. Axis)

Loangrowthhasslowedbutremainsdangerouslyhigh

Source: PBOC, Bloomberg

NPLsappearminimalbutareabackwardlookingindicatorinaloosecreditenvironment

Stimuluswall:banksgivengreenlightforgrowth:

Chinasstatefinancialsystemhashistoricallyfaredpoorly&hasapoortrackrecord1:

2majoreventssince1978:

Late80s/Early90s ProvincialgovernorscontrolledPBOCbranches Localofficialsovercookgrowth 20+%inflation Inflationaryspikeforcedtotalhaltofbanklending Sparkedhardlanding realestatecrashinHainan

Late90s/Early00s InducedbyAsianFinancialCrisis(AFC) UnresolvedNPLsfrompreviouscrisiscompoundedimpactofnewwaveofbadloans Govt.responseproducedcurrentmarketstructure

Historicalrecoveryratesinthe1020%rangeonbadloans Comparetorecoveries~60%atpeakofUSS&LCrisis

Suggestslackoftrueprofitmotiveinlending,likelihoodoffraudandtheftatthemargin Withoutexternalshocks(i.e.AFC)statecandelayreckoningindefinitely

Incompletereforms Previouscrisesresolvedbycreativeaccountingtoppedupwithsmallinfusionsofforex reservesandcapitalraisedfromIPOs Perceivedsuccessofbankrecaps.andsubsequentcollapseofWesternfinancialsystemhasreducedperceivedneedforreform

1 VictorShih,Factions&FinanceinChina:EliteConflictandInflation,(NewYork:CambridgeUniversityPress,2007

1 ThomasBottini,BankruptcyPerilsinChina:TheGITICTale,MultinationalBusinessReview 115(2003)

GITIC Forerunneroftodaysbankingsector? EngagedinpracticescommoninmodernChinesefinancei.e.offbalancesheetvehicles,growthofnoncorebusinesslines,politicizedlending FirstandonlyChinesefinancialallowedtofail

Lenderandsecuritiesco.effectivelycontrolledbylocalgovernment HongKonglistedsubsidiaryissuedbondsinUS

Govt.providedcomfortlettersforGITICsinternationaldeals Explicitassurancethatstatestoodbehindthebank

Enormousexpansionin90saidedbyWesternbanks OneofChinasfirstinternationalplayers

WentbustinwakeofAsianfinancialcrisis January1999 NPLratio:90.0%1 Recoveryrate:12.5%1

FirstandonlybankruptcyofmajorChinesefinancial: Assets:$2.6bn Claims:$5.6bn $4.7bn toforeigncreditors

InternationalexposurepromptedlargerconcernaboutChinassolvency Necessitatedimmediateactionandatransparentliquidationprocess:

AppointedKPMGtobuildcredibilitywithwesterners

GITICSformerheadquarters;3rd

tallestbuildinginAsiaattimeofconstruction

1 Walter&Howie

PriortoGITIC,PBOCclosedfailingbanksandmadeforeigncreditorswhole Comparativelysmallscaleoffinancialsector/limitedinternationalexposureallowedgovt.toeasilysettlethebill Reflectedinbondrisk:

8mos.beforecollapse,GITICbondsyielded240bpsoverTreasuries1

Underbankinglaw,bankswererequiredtoregisterdebtstoforeignerswithgovt. Intendedtoprotectforeigncreditors;unregistereddebtunenforceable GITICusedHongKongsubsidiariestohideoverseasdebtsDiversifiedintowidevarietyofoperatingbusinesses:

Manufacturing,textiles,hotels,etc. Originallythoughttohave66domesticand66overseassubs. 105domesticand135overseassubs.uncovered

ScaleofdebtsledtoclosuresofmanytrustcompaniesandrecentralizationofBig4undercentralgovt.

PostGITICreformssoughttorecentralizecontroloverthefinancialsystem Not aboutenhancingcapitalallocation No intentionofallowingtrulyprivatebankingorfloatinginterestrates

WhiletheprovincialGITICwasallowedtofail,Chinapursuedmoreinnovativesolutionstoresolvingthebanksunderthedirectcontrolofthecentralgovernmentinthelate90s/early00s

ParticularlyimportanttotherecapitalizationandunderpinningChinasfinancialsystemarethe4assetmanagementcos.AMCs:

Chinas4AMCs:Orient,Huarong,GreatWall,andCinda

Badbanksusedtoremoveproblemloansfrombankbalancesheets Createdtodealwithprimarilylate80s/early90s vintageNPLsthatremainedfrompastcrisis

Govt.delayedresolutionuntilexogenousshockofAFCdemandedaction40%ofpre2000loansnonperforming AMCsacquiredRMB2.4trnofbadloans

AMCsfundedbyPBOC AMCspurchaseNPLsatfacevalue 100sonthedollar AMCsresembledevelopedworldbadbanksi.e.RTCinUSS&Lcrisis,butcriticaldifference:

BanksreceivedAMCbonds anunfundedreceivable nocash intobanks Accountingsolution;banksretainexposuretobadloans

Intendedastemporaryinstitutions,theAMCs1999mandaterenewedin2009forafurther10years:

Thinlycapitalized;inevitablyinsolvent Negligiblecapitalbaseandinflatedpurchasepriceforloansmadeprofitableoperationimpossiblefromthebeginning Significantoperatingexpensesexacerbatedearthofloanrecoveries Governmenthashadtoprovidecomfortletterstoauditorstoassuresolvency

MorerecentlytheelegantAMCsystemhasbeenabandonedinfavorofdirectissuanceofunfundedreceivablesbytheMinistryofFinanceMOF

Mechanicsremainthesame:banksreceiveunfunded,evergreenIOUs

AMCbondsandsubsequentMOFreceivablesaresignificantstateliabilitiesnotreflectedinheadlinesovereigndebt figures

AMCslikeCinda haveopportunisticallyusedthelicensesoftheirseizedportfoliocompaniestoenterawidevarietyofbusinesslines,significantlyexpandingbeyondtheiroriginalmandate:

Seizedoperatingbusinessescontinueasgoingconcerns

Employ12,000people

Badbanksnowdiversifiedconglomerates

Operatinglossesworsenalreadyweakfinancialposition

Cindas operatingsubsidiariesspanlifeinsurance,P&Cinsurance,securitiesbrokerage,equipmentfinance,futurestrading,investmentmanagement,realestateinvestment,trustmanagement,propertydevelopment,construction,andevenincludeindustrialbusinesses.

AselectionofsomeofCindas publicallyacknowledgedsubsidiaries

AMCbondsandlaterMOFreceivablescompriseasignificantportion oftheBig4scapitalbase:

Big 4 Banks - Big Balance Sheet Holesin billions of RMB BOC CCB ICBC ABC

1998 MOF Bond 42.5 49.2 85.0 93.3 1999 AMC Bonds 160.0 247.0 313.0 0.0 2007 MOF Receivable 0.0 0.0 62.3 635.5 2004 PBOC Special Bills 0.8 63.4 434.8 0.0 2006 PBOC Target Bills 113.5 0.6 0.0 0.0 2007 PBOC Bills and Bank Sub-Debt 14.6 57.1 237.1 0.0 Total: 331.4 417.3 1,132.2 728.8

Total Assets: 8,748.2 9,623.0 11,785.1 8,882.6 Total Capital: 608.3 492.0 586.4 342.8 AMC Bonds/Total Capital: 26.3% 50.2% 53.4% -Source: Audited financial statements. 12/31/2009 values.

BondsrolledwithAMCmandate

EvergreenNPLs: Oldestunderlyingloansreportedlydatetolate80sandearly90s Continuedpresenceonbankbalancesheetsspeakstokickthecanapproachtorestructuring

Bankingsystemrestsonshakyfoundationofaccountingtrickery

InvestorsawareofpotentialbalancesheetholesbutbelieveinPBOC/MOFput

Confidenceinthebankingsystemreflectsinvestorconfidenceintheabilityofthestatetorecapitalizefinancialsystem largeforex reservesprovideillusorycomfort

th

ThePBOCevenhasitsownbadbankusedtohidedebts&disguiseitsprobableinsolvency:

Huida AssetManagement Createdin2005inordertoremoveproblemloansfromPBOCbalancesheet

FundedbyCinda AssetManagementCo. UtilizedduetoclosepoliticaltiestoPBOC

Opaque,nodisclosureonoperationsasportfoliohasnotbeenmarketedtooutsideinvestorsincontrasttomoretransparent1st generationAMCs

OfficialdocumentssuggestedHuida wastoacquirerealestateloansfromHainan/GuangxiandportfoliosfromtheGITICbankruptcymidlate90svintages

BeliefamongmarketparticipantsisthatHuida acquiredPBOCsoriginalAMCloanstoeasepressureoninsolventAMCs1

Thiswouldimplyaroundtripinvestmentthatwouldoffsetanddisappeariftheentitieswereconsolidated

Unaudited,offbalancesheetvehicleforPBOCandCinda UnlistedandunmentionedonCindas website;fiscalblackhole 1

1 Walter&Howie

StateCouncil

MinistryofFinance

PBOC

FinancialRegulatorySoup(NDRC,CBRC,CSRC,CIRC)

StateOwnedAssetsSupervision&Administration

Commission(SASAC)

SOEs

ChinaInvestmentCorp.(CIC)

CentralHuijinInvestment

CentralSAFEInvestment

AssetManagementCos.(Huarong,Orient,GreatWall,Cinda,Huida)

Big4andChinaDevelopmentBank

TheMinistryofFinance,operatingdirectlyundertheStateCouncil, liesattheheartofthecontemporaryChinesefinancialsystem:

ThePBOChasbeenrelegatedtosecondaryroleaftersufferingasignificanterosionofitspowerinearly/mid00s PBOCformerlycontrolledBig4&CDBviaCentralSAFEInvestment

DivisionsbetweenthePBOC&MOFreflectalternatecareerpathswithintheparty: Generalists:Rotatedbetweenministriesandlocalities Technocrats:AdvancethroughsilohierarchyofPBOC

Thecurrentownership&regulatorystructureofChinasfinancialsystemistheproductofstillbornreform:

PBOCledreformandrestructuringprocessinlate90s/early00s InstitutedAMCsystem&initiatedIPOsofBig4inHongKong

PBOCintendedtoproceedwithfurtherprivatizationandfinancialliberalization MOFactedopportunisticallytoseizecontrolofmostimportantleversofpowerbeforethePBOCsreformscouldbecompleted

MOFspoliticalascendancyeliminatedthepossibilityoffurtherlegitimatereform

WenowbrieflyreviewthepoliticalstrugglebetweenthePBOC/MOF:

RegulatoryreformhasbeenhamperedbyinternalconflictsbetweenthetreasuryMOFandthecentralbankPBOC

ThisconflictisreflectedinthecountrysduelingsovereignwealthfundsSWFs: ChinaInvestmentCorporationCIC CentralSAFEInvestmentSAFE

ThenondescriptentrancetoMOFheadquartersinBeijing

PerceivedsuccessofrestructuringviaAMCsimpededfurtherreform: Mediaoutcryaftersubsequentsalesofminoritystakesinprizedstateassetstoforeigners

9%ofCCBsoldtoBankofAmerica,5%toTemasek SingaporeanSWF Mediaconsensus:ifthebankshadalreadybeensuccessfullyrecapitalized,whyselltoforeigners?

ExacerbatedalreadyhostileelementsintheMOFandotherrivalstateministriesstemmingfromthePBOCsindependentcreationofacommercialpaperCPmarket:

PBOChadpreviouslycededregulatorypoweroverfixedincometoaStatePlanningCommission CreatingCPmarketunderminedthisauthority,generatedresentment

SuddendeathofPBOCsupporterHuangJu frompancreaticcancerin2007shiftedbalanceofpowertowardsMOF:

ProminentsupporterofJiangZemin andtheShanghaiclique,swornenemyofHu Jintao PolitburoStandingCommitteemember oneofthemostinfluentialpoliticiansinChina

HadfavoredcentralizationandsupportedPBOCinitsreform/centralizationefforts Reflectssignificantinfluenceofindividualpoliticiansindeterminingcriticalpolicyoutcomes

PartycommitteegrantedMOFapprovalin2007tofoundChinaInvestmentCorporationCIC,aSWFtorivalSAFE,thePBOCsexistingsovereignwealthfund MOFblamedPBOCforrisinginflation,accuseditofpoormanagementofreserves

ItisthroughCICthattheMOFhasenforceditsdominanceoverthePBOCandtakencontrolofthestatebanks:

CentralSAFEInvestmentsSAFE CreatedbyPBOCtotopoffBig4withforeignexchangereservesintandemw/AMCbonds

2003 $45bn toCCB/BOC 2005 $15bn inICBC

Filledremainderofgaptoolargetobepluggedbyaccountinggimmicksi.e.AMCbonds FormercontrollingshareholderofBig4,majorityrepresentationonboardsofBig4/CDBviaHuijin InvestmentHuijin

ChinaInvestmentCorporationCIC FundedbyRMB1.55trn SpecialBondsoldbyMOFtoPBOCin2007 PBOCthenforcedthesebelowmarketcouponbondsonbanks MOFusedproceedstobuy$200bn inforeignexchangereservesfromPBOC

USDreservesusedtocapitalizeCIC ~1/3ofproceedsusedforSWFinvestment RemainderusedtorecapitalizeABC/CDBandtopurchaseofHuijin andtheBig4&CDBinturnfromthePBOC

AfterCICsacquisitionofHuijin,MOFdirectlycontrolsBig4andCDB Bankingsystemisnowdirectlyownedbystatetreasury

Thepartynotonlyretainssignificantinfluenceinallocatingcapitalbutcontinuestodominateindustrybyfavoringstateownedenterpriseandinfluencingpersonnelappointments

Westernconsensus:Directionofreformsince1978hasremainedconstant Gradualreformandliberalization;increasingembraceofprivateeconomyandmarketmechanismsamidstadismantlingofStalinistcentralplanningapparatus

Reality:ManystructuralreformshavelargelybeenreversedpostTiananmen Incrementalreformhasoccurred,butefficacyislimitedbygovt.sdistrustofmarketmechanismsandbytheabilityofvestedintereststocircumventreformsatthelocallevel

Understandingthepoliticaldynamicsince1978iscriticaltounderstandingthecurrentandfuturedirectionofreform:

WebrieflyreviewthestructureoftheChinesegovernmentbeforesummarizingthedecadessincereform:

Thelastthirtyyearshavebeengreatononelevel.Theeconomyhasadvanced,butculture,society,andpoliticshavenot.Inessence,itisthesameoldsystem.

WangXiaofang,formerpartybureaucrat1

1 Hongru Liu,TheFormationoftheThinkingandReformProposalsforChinasFinancialSystemReforms,2000.

ChinahasbeenruledbytheCommunistPartyofChinasince1949: ThePartyexistsabove thelawandthegovernment:

Truelocusofpoliticalandeconomicpower Authorityofthepartysupersedesallothers

Accordingly,prominentpoliticianstypicallyholdconcurrentroleswithingovernmentandparty:

e.g.Hu Jintao isbothGeneralSecretaryoftheCommunistPartyofChinaandPresident ofthePeoplesRepublicofChina

Partyretainspowerofappointmentwhile partyagenciesi.e.CentralOrganizationDept.et.al.monitorperformanceofappointedofficials

TheHammer&SickleoftheParty

Partyledby25personPolitburo NominallyappointedbyPartyCentralCommitteebutselfperpetuatinginpractice AgendadictatedbyGeneralSecretary,decisionsachievedbyconsensus Meetsmonthly

ThePolitburoisinturndominatedbytheitsStandingCommittee: Consistsof8mostpowerfulmembersofPolitburo Chinasboardofdirectors CurrentmembershipdominatedbydisciplesofJiangZeming

Createsbiastowardsstatiststatusquo Meetsweekly

Unrestrictedbytheruleoflaw,Chinesegovernmentisinefficientandinequitable:

Chinasconstitutionisamissionstatementratherthanalegaldocument:

4versionssince49,mostrecentversionadopted~30yearsagoandmodified4timessubsequently

Unpredictablepolicyenvironmentwithfrequentlychangingrules&degreesofenforcement

Withoutchecksandbalances&effectiveenforcementmechanisms,policymaking&implementationarefrequentlyindistinguishable

Regulatorystructuresoftenreflectinternecinepoliticalconflictsi.e.MOFvs.PBOC

1 WangJingqiong.BeijingtoCloseThousandsofLiaisonOffices.ChinaDaily,01/25/2011.

Petitionerspleadforrelieffromthecorruptionoflocalofficials

Chinasgovernmentisnotafederalsystem:

Thegovernmentreliesonnegotiatedrelationshipsbetweenawiderangeofindividualpoliticians,agencies,andorganizations:

Particularlymarkedinrelationshipbetweencentralandlocalgovernments: Policyisadhocandnegotiableascentralgovt.haslimitedabilitytoenforcepolicyatlocallevel Abilityoflocalgovts.tonegotiateconcessionsfromcentralgovt.reflectedin10,000liaisonofficesi.e.localgovernmentlobbiesinBeijing TheChineseKStreet1Powerfullocalleaderscanrunjurisdictionsaspersonalfiefsi.e.ShanghaiCliquein90s,Chongqingin00s

Abusescanonlybestoppedbyconcertedeffortfromcenteri.e.corruptionscandals/scapegoating ofproblematicofficialsviaCentralCommitteeforDisciplineInspection

Nominally3branchesofgovernment:

Executive StateCouncil Sourceofpowerandauthority Composedofheadsof26statecommissionsandministriesi.e.

MinistryofFinance,MinistryofRailways,MinistryofStateSecurity,etc.

Stateministriesthoughttoemploy10mmbureaucrats Complicatedmanagementstructure localbureausreporttolocal

govts.aswellastoministry/commissionsenioroffice Furtherhindersefficientregulation/administration/

enforcementoflocalitiesbythecenter

Judicial SupremePeoplesCourt Norealindependentpower existssolelytoapplypartypolicy

tospecificcases/incidents

Legislative NationalPeoplesCongress Historicallyarubberstamplegislature,conceivedofprimarily

asanarenawhereregionaldelegatescouldlearnandunderstandthepartyline

Delegatesnowactingwithincreasingindependencei.e.abstainingfromvotes/votingindissent,butstillwithoutanyrealindependentlegislativeauthority

Theviewfromthetop

InadditiontotheStateCouncilandtheoverarchingPartysuperstructure,thereisafurtherlevelofhierarchicalgovernmentinChina localities:

Politicalcapitaloflocalofficialsdeterminesrelativeindependencefromcenterandothergovt.bodies

Officialsatonelevelcontrolthelevelimmediatelybelowthemvia: Powerofappointment Powertodraftbudgetsandlevytaxes Controlovertheallocation&redistributionofresources

Since2008,permittedtorunfiscaldeficits Localofficialsincentivizedtogenerateshorttermgrowthatallcosts Debtsalreadyest.atRMB10.7trn bycentralgovt.inJune20111,2

23provincialgovernments,furtherdividedinto: 300Prefecturesincludingnumerousprefecturelevelcitygovts. ~2,9000CountiesAvg.pop.of~500k ~650Cities furtherdisaggregatedinto:

~175,000Townships 950,000Villages CountlessDistricts,Neighborhoods,andUnitsdanwei

Eachoftheseunitsexistsinvariousforms,reflectingtheadhocandirregularstructureoflocalgovernments:

ShanghaiMunicipalGovernmentBuilding

PeoplesGrandHallinChongqing,seatofthelocalmunicipalgovernment

1 FitchWarnds OverChinaLocalGovernmentDebtBBCNews,09/08/11.Accessed09/27/11.http://www.bbc.co.uk/news/business148363862 YinNongzhing,DeputyDirectorofFinanceCommittee,NationalPeoplesCongressstatedthatRMB10trn wasaconservativeestimateoflocalgovernmentdebt.QuotedininterviewwithReuters,02/02/11.Accessed8/23/11.http://www.reuters.com/video/2011/02/02/chinafacingahiddendebtcrisis?videoId=183875158

DireneedforreforminaftermathofCulturalRevolution Economyintatters,partyscredibilityshotafterbloodbathledbyRedGuards

Chinacameclosesttoachievinglegitimatemarketorientedreforminthe80s:

ZhaoZiyang andHu Yaobang ledpragmaticreformmovement DisciplesofDengXiaoping,rosethroughCommunistYouthLeague

Everysingleimportantpoliticalreformoccurredinthe1980s1 Mandatoryretirementofofficials,reformofPartyCongress,legalreforms,etc. Effortstoincreaseadministrativeautonomyoflocalgovernments

Allowedprivatecredit &floatinginterestrates Limitedprivatebanking,statebanksbenchmarkedagainstprivatefinancials

Partybrieflyflirtedwithrelinquishingcontrolovercapitalallocation

Reformandsubsequentgrowthpredominantlyrural AreasmostaffectedbyGreatLeap/CulturalRevolutionledreform Drivenbypragmaticlocalofficialswhofrequentlywereacting

independentlyofthecenter,particularlyinthepoorestprovinces CitiesremaineddominatedbySOEsandcentralplanners

1Minxin Pei,ChinasTrappedTransition:TheLimitsofDevelopmentalAutocracy,(Boston:HarvardUniversityPress,2006)11.

Zhao(top)&Hu Architectsofreform

Town&VillageEnterprises TVEsledruralgrowthspurt: Ledbyprivateentrepreneurs,whoweregivensignificantaccesstocredit

fromlocalitiesandRuralCredit/FinanceCooperativesRCC/RFCs RCCs ~75%ofagriculturalloans,~50%ofallloanstoTVEs

DespiteWesternacademicconsensusStiglitz et.al.,successfulTVEswereprivately owned&controlled:

Output,profit,andwagesofprivateTVEs5070%higherthanstatemanagedTVEs1

Localgovts.expropriatedbestprivateassetsin90s

Economicgrowthmatchedbywelfaregainsformajorityofpopulation Ruralhouseholdincome12.2%realgrowthfrom78882

1 Qisong Lin,PrivateEnterprises:TheirEmergence,RapidGrowth,andProblems,InChinasRuralIndustry,editedbyWilliamA.Byrd.(Oxford:OxfordUniversityPress,1990)181.2 Huang117.

Nian Guangjiu foundedIdiotsSeedssunflowerseedsin1982andisrepresentativeofthedynamicentrepreneurialclassthatemergedasthestatelooseneditsgrip.

Nian wasoneofthegreatestTVEsuccessstoriesofthereformera,earninga1mmRMBprofitin1986.Inthe90shewasjailedwhilehisbusinesswasseizedandsubsequentlyrunintothegroundbytheprovincialgovernment.

ABrilliantIdiot:

Inflationarysurge&subsequentaggressivemonetarytightening,risingyouthunemploymentculminatedinTiananmen

Jarringforregimebutbroaderunrestwaslimitedduetomaterialprosperityofruralcitizensunder80sreforms

Tiananmenandsubsequentleadershipchangesledtomanyreformsbeingreversedinthe1990s Hu Yaobang forcedoutin86followingsupportofstudent

protests;hisdeathin89wasapartialtriggerforTianamen ZhouZiyang purgedforsupportingTiananmenstudents ReplacedbyJiangZeming/ZhuRhongji TheShanghaiClique

PostTiananmenlesson liberalizationmustnotentaillossofpoliticalcontrol

Focusshiftedfromruralentrepreneurshiptostatedominatedurbaneconomy

Foreigncapitalsystematicallyfavoredoverindigenousentrepreneurs1

1 Pei(2006)

Inthe90sChinaembracedstatecapitalismunderJiangZeming &ZhuRhongji Partysuperficiallyembracedsomemarketinstitutionsbutincreasinglyencroachedonenterprise

andfinancethroughsweepingcentralizationandreversalofearlierreforms

FavoredurbanSOEsandforeigncapitalistsoverindigenousentrepreneurs

Ruralandurbanincomegrowthstalled Administration/fiscalmanagementofrurallocalitiesrecentralized,lostfiscalautonomy Ruraltaxburdengrewsignificantly,subsidizedurbangrowth Ruralhouseholdincomegrewjust3.8%from8901 GDPannualized16.5%sameperiod1

Govt.bureaucracy~2xduringdecade Govt.payrollupfrom20mmintheearly90sto46mmin20042

Significantrecentralizationoffinancetocontrolinflation,favorurbanSOEs3 RFCscurbedin93,bannedin98,stronglylimitingaccesstofinanceinruralareas Post1994,RCCloansrequiredlocalandregionalapproval localautonomyrestricted Post1998,allRCCloans requiredconsentofPBOC

1 Huang,117.2 AlbertPark&Minggao Shen.JointLiabilityLendingandtheRiseandFallofChinasTownshipandVillageEnterprises.DepartmentofEconomics,UniversityofMichigan(2001)3 Shukai Zhao,Bianju Zhong DeZiangzhen Jigou [ChangingTownshipOrganizations],StateCouncilInvestigationandResearchReport 168(2004)

Chinesepeasants,yournameismisery SunDawu,ruralentrepreneurinHebei province

4th generationleaders Hu Jintao &Wen Jiabao 1st generationtoinheritruleaspickedsuccessors Reflectsincreasingbureaucratizationofparty

Recognizechallengesbutremainweddedtostatistpolicysolutions:

18th 5YearPlanreflectsthisapproach: $1.5trn ininfrastructurespendingand

targetsthedevelopmentofspecificindustrialsectors

Unfundedcommitment willlikelybefinancedbybankingsystem

Emphasisonhardinfrastructure;realproblemsoriginateinlackofsoftinfrastructurei.e.freemarkets,ruleoflaw,definedpropertyrights,etc.

Pendingtransitionto5th generation Needtomaintainstabilityandgrowth Potentiallydestabilizingpoliticaldynamic

Hxi shhuHarmonioussociety

WhatisthecurrentstateofChineseindustry?

Chinasliberalizationinthe90sproceededaccordingtotheblueprint: Letgoofthesmall,takeholdofthebig 15th PartyCongress,1997 Largecorporates remainundergovernmentcontrol

Divestedsmaller,inefficientSOEs,concentratedonrestructurednationalchampions: SmallSOEs ~20%ofsectorin97butcomprisedmajorityofoperatinglosses SmallSOEsprivatized,laidoff3040mmworkers RetainedSOEslaidoffafurther50mmworkerstoenhanceprofitability SOEsgiventaxanddebtrelief,importlicenses,accesstodomesticandforeignlistingfacilities,

andreducedoperatingrestrictions

Policyof2Guarantees Guaranteedaccesstofinancingandrawmaterialsfor234SOEs Stronglylimitedneedtoremaincompetitive

Nottrueprivatization restructuringusedtosolidifystatecontrolandenhanceprofitabilityofremainingSOEs

Partyretainsequityownershipandcontrolviacorporateboardsandpersonnelappointments Partycommittees politicalsleepercellsestablishedwithincorporationsprovidefurtherlayer

ofcontroltobeactivatedintimesofcrisis

Privatesectorsignificantlysmallerthanheadlinefigureswouldsuggest: Officialdefinitionsareproblematic:

Nonstateincludesmanycollectiveenterprisescontrolledbylocalgovernment MajorityoflistedSOEsareclassifiedasnonpublic

However,stateretainsmajority ownershipandcontrolofcorporateboards

2005OECDstudysuggestsprivatesectoris~70%ofeconomy1 Confusionregardinglegalpersonshareholdingfirms~40%ofprivatesector OECDviewsasprivate,butmajorityoflegalpersonfirmsareownedbystateanddirectly

supervisedbystatecouncil OECDlistincludessubs.ofrecognizedSOEslikePetroChina andChinaNationalPetroleum

CorporationaswellasstatechampionslikeSAICMotor

75%havezeroindividualsharecapital,45%aremerelyproductionsubsidiariesofotherSOEs2

Correctingforthis,trueprivatesectorisonlyaround40%ofeconomy2 Evenifweacceptthe70%numberatfacevalue,shareisstilllow: ComparabletoIndira Ghandis Indiawithnationalizedbankingsystemandthelicenseraj

Privatesectorprimarilyconcentratedincapitalextensiveservicesector Reflectslimitedaccesstoofficialsourcesoffinancing

1 SeanDougherty&RichardHerd,FastFallingBarriers&GrowingConcentration:TheEmergenceofaPrivateEconomyinChina, OECDEconomicsDepartmentWorkingPapers 471(2005)2 Huang3 Ibid,p.124

Majorityoflistedcos.arestateowned: Only7%of19902003listingsfromprivatecos.1 Statesectorgivenpreferentialaccesstocapitalmarkets

Mostcompetitiveoftrulyprivatecompaniesremainprivate,HKdomiciled

Manynationalchampionsdidnotexistbeforetheirpubliclistings Westerninvestmentbankersfacilitatedcreationofnationalchampionsaspartof

restructuring/consolidationofSOEsduringlate90s2

ChinaMobile particularlyegregiousexample3: Createdbyrollingupassortmentofpoorlymanagedprovincialtelcos.after1997IPO ProceedsfromNYSElistingsupplementedwithbankloans,usedtopurchasetelcos.in

6provincesownedbyitsownparent Prospectusreferredtoaproformaentitynotyetoperationallyintegrated Followedbysecondaryofferingin2000,proceedssimilarlyusedtoexpandina

further7provinces

Weakestpubliclistingsbackstoppedbystrategicinvestors Statedominatedfinancials,financialsubsidiariesofSOEs,andothergovernment

entitiesAMCs,militaryindustrials,etc.materialinvestorsinIPOs 2010ABClisting 50%ofallocationstostrategics4

Highlightsotherwiselukewarmmarketreception,partyscloseinvolvementin/backstoppingofmarketlistings

Partyretainsmajorityownership&controlofboards Partynolongerindirectcontrol,butabletoexertsignificantinfluenceindirectly

1 Huang2 Walter&Howie3 ChinaMobileProspectus(SECFormF3),filed10/04/004 Walter&Howie,178181.

1 McGregor(2011),85

Govt.haslargelywithdrawnfromdirectmanagementbutassertsequityownershipindirectlyviapersonnelappointments:

2primaryleverstocontrolappointments:

CentralOrganizationDepartmentCOD

ChinasstateHumanResourcesorganization DictatesallmeaningfulleadershipappointmentswithinPartyandenterprisesystem Thoughttocontrol70mmjobs SeniorbankmanagersmustbeapprovedbyCODaswellasPBOCandspecialbankingcommittee

CommitteeonDisciplineInspection Usedopportunisticallybycentertocontrolproblematiclocalofficials Lackstrueindependence

overseetheappointmentsofUSstategovernorsandtheirdeputies;themayorsofbigcities;headsoffederalregulatoryagencies;thechiefexecutivesof GeneralElectric, ExxonMobil, Walmart and50oddoftheremaininglargestcompanies;justicesontheSupremeCourt;theeditorsof TheNewYorkTimes, TheWallStreetJournal and TheWashingtonPost,thebossesofthetelevisionnetworksandcablestations,thepresidentsof Yale andHarvard andotherbiguniversitiesandtheheadsofthinktankssuchasthe BrookingsInstitution andthe HeritageFoundation.1

AhypotheticalAmericanequivalentoftheCODwould:

TheCODsdiscrete,featurelessBeijingheadquarterslacksanysignage

1 TheodorGroves,Yongmiao Hong,JohnMcMillan,andBarryNaughton,ChinasEvolvingManagerialLaborMarket,JourneyofPoliticalEconomy 103(4)87392(1995)

ExecutivesatSOEsarefrequentlyrotatedbetweenpostsattheCODsbehest:

AverageSOEexecutivetenure 5.5years1 Personneltransferscontravenecorporategovernancerequirementsofpubliclistings

Wherepartyandindustryintersect,legalobstaclesaremereformalities

Selectedpersonnelappointmentssince2000:

ChinaMobile,ChinaUnicom,&ChinaTelecom CEOsswitchedplaceswithoutwarningtobreakupemergingcentersofpower

Headsof3airlinesrotatedtoreducepricecompetition

Vicegov.ofPBOCmadeCEOofChinaConstructionBank

AsifJanetYellen wasgivenJamieDimons job

CNOOCschairmanappointedgovernorofHainanChairmanofHuaneng Powermadedep.gov.ofShanxiChairmanofChinalco electedtocabinetadvisorypost

54of100SOEsoncentralnomenklatura list1 Chairman/CEOsholdministerialrankandselectedbyCOD LesspowerfulStateOwnedAssetSupervision&Administration

CommissionSASACselectsCFOs/VPs EspeciallyinfluentialinBig4banks

PartyCommitteesformedwithinlargecompaniestoinsurepoliticalcorrectness/policyimplementation Committeesactiveeveninforeignbusinesses/JVs SleepercellsintroducedpostTiananmentobeactivatedduringcrises

Politicizationofmanagementcreatesproblematicconflicts:

Canabankmanagerrefusealoantoanexecutivewithgreaterstandingintheparty?

No

SOEsusedtopropupfailingcos.viastrategicinvestment3 ChinaMobile Purchased20%ofShanghaiPudong Devleopment Bankfor$5.8bn ChinaUnicom RumoredtohaveinvestedinBoCom viaopaquesubsidiary

TheRedMachine TopexecutivesatlargestSOEsreportedlyreceiveanencrypted,4digit

telephonelinetheRedMachine Communicationslinkbetweenpartyelite

Symbolicofsymbioticstate/bigbusinessrelationship

1 Walter&Howie,169.2 McGregor(2010),783 Walter&Howie 192

Theultimatestatussymbol?

Zhongnanhai,theChineseKremlin

Source:WorldBank,BloombergReflectsROEofNikkei225,DAX,CAC40,HangSeng ChinaEnterprises,KOSPI,MICEX,FTSE100,BOVESPA,SENSEX,IBEX35,S&P100,JakartaCompositefirms,exfinancials.

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

3

Y

e

a

r

A

v

e

r

a

g

e

G

D

P

G

r

o

w

t

h

3 Year Avg. Return on Equity

DespitesignificantlyhigherGDPgrowthChinesefirmslagemergingmarketpeersaswellassomedevelopedmarketsinreturnonequity

1 Madar,Daniel,BigSteel:Technology,TradeandSurvivalinaGlobalMarket,(Vancouver:UBCPress,2009)116.Assumesminimumefficientscaleat5mmt(conservative)2 WorldSteelAssociation

Chinassteelindustryisindicativeofthedangersofthestatecontrollingenterprise:

Industrydemandsscale,butincreasingfragmentation: Top5producers 1/3rd in88,only1/5th in08 Contrastswithglobalconsolidationtrend Fragmentationdrivenbymeddlingoflocalofficials

Highlyfragmentedandinefficient Economiesofscalelimitedduetostatepricecontrols Estimatedthatonly0.3%ofChinesesteelmillsareofefficientscale1

Surpluscapacityandcontinuingirrationalgrowth CapacityEUJapanRussiaUScombined2

SignificantidlecapacityOnly5%ofsteelexported

Predominantlylowgradelongproducts Limitedvalueadd,mustimporthighergradeflatproducts

Inefficientindustryaidedandabettedbypervasiveaccountingfraud

Sloppyduediligence,weakdisclosure,limitedscrutinybyunderwriters

RegulatoryreportissuedinlateMarchcriticized17banksforlistingpractices

RecentfraudsunnoticedbyhighprofileauditorsandinvestorsinthewestLongTop,ChinaMediaExpress,SinoForest,etc.

ReflectiveofundueWesternoptimism?

Bankscomplicit infrauds Cashholdingssignificantlyoverstatedby

corporate brazen,easilyfalsifiablemisrepresentations

17SOEshaverecentlyadmittedmisreportingfinancialdata1

HongKongStockExchangeacceptsChineseauditorsasoflate2009

ChinesefraudshavepassedmusterwithsomeoftheWestsmostrespectedauditorsandexchanges

1 JamesGrant,GrantsInterestRateObserver,6/3/2011,NationalAuditOffice.

1 NewYorkTimesDealbook ChineseReverseMergerCompaniesDrawLawsuits,7/26/11.Accessed8/23/11,http://dealbook.nytimes.com/2011/07/26/chinesereversemergercompaniesdrawlawsuits/

0.00

0.50

1.00

1.50

2.00

2.50

3.00

Chinese Rev. Merger Index

Russell 2000

TheInfamousChineseReverseMerger

PervasiveaccountingfraudinUSlistedChinesestocks ExchangeshavehaltedtradingpendingoutcomeofSECinvestigations Accountedforalmost50%offederalsecuritiesclassactionlawsuitsin2011YTD1

Laxaccountingstandardsfacilitatealargemarketforoffbalancesheetfinance:

EntrustedLoans Corporate/householddepositorscontributefundstotrustsmanagedbybank Proceedsloanedto3rd partyborrowers Circumventsinterestratecapsandlendingquotasimposedonbanks

Bankearningsincreasinglydrivenbyoffbalancesheetvehicles

EntrustedOBSloansest.at~8%ofalllendingin20101 OBSloansup110%YoY in20112

Reportedly40%ofentrustedloansgotopropertydevelopers3 FiguresrepresentonlyofficiallyrecognizedOBSvehicles

BogusTradeFinance Phonyinvoicesusedtoimportcommodityassetsthatcanbe

levered Favoredbypropertydevelopersmaxedoutinaboveground

domestic/offshoremarkets Alsousedtocircumventcapitalcontrols

Copperfavoredpreviously,Soyincreasinglypopular

Enormouscontingentliabilities UndrawncreditcommitmentsatBig4 RMB7.4trn 18%of

GDP!4

Loandocs.fora36mo.entrustedloanforRMB300mmtermloanwithRMB

3,000mmrevolverfortheconstructionofacoalgasificationplant.

1 PBOC2,3 HenrySanderson,OffBalanceSheetLoansDouble,BoostingBankDefaultRisk,BloombergNews,6/23/11,Accessed8/23/11.http://www.bloomberg.com/news/20110623/offbalancesheetloansdoubleboostingbankdefaultriskchinacredit.html4 JamesGrant,GrantsInterestRateObeserver 5/20/11.

Corporatecreativityinaccountingmirroredinofficialgovernmentaccounts:

Govt.economicfiguresareforreferenceonly

LiKeqiang ),heirapparenttoWen Jiabao,Chinasreigningtechnocrat

Officialgovt.debt RMB6.5trn

GovernmenthassignificantOBSdebts(2010E): UnfundedMOFreceivablesandsterilizationbillsRMB2.6trn AMCdebts,20032005RMB2.7trnNonconsolidateddebtofStateMinistriesRMB~400bnNonconsolidatedlocalgovts.(largely0809vintage)RMB~10trn PolicybankdebtRMB4.5trn

Govt.retainsultimateresponsibilityforstatefinancialsystem Govt.OBSdebtlikely34xofficiallydiscloseddebtstotaldebt:~100+%ofGDP1

1 VictorShih,LoomingProblemofLocalDebtinChina.AsianWallStreetJournal,2/10/10.

Consensusview:Govt.canrecap.financialsystemwithenormousforeignexchangereserves

Reality:Debtsvastlyunderstated,abilitytodeployforex reservesdomesticallyislimited

Investingforex reservesdomesticallywouldunwindliquidityoverhangonPBOCbalancesheet

Significantportionofreservesalreadyinvesteddomestically,includingholdingsofbankequity

Suggestsonlyafractionofreservescouldbequicklydeployedtorecapitalizethebankingsystem/arrestasystemiccrisis

Chinasfiscalpositionisacomplexwebofoffbalancesheetentitiesandunfundedcommitments

Headlinedebt/GDPgrosslyunderstatesliabilities Stateenterprisesystemdefactoliabilityofthestate

UltimateliabilitiesofChinesestatearewhollyunknowable

Enormousinequalityconcentrateswealth 1%ofChinesehouseholds0.4%ofpopulation

controlupwardsof$35trilliondependingonassumptions1

Reallocating3040%ofthiswealthoverseaswoulddrainmajorityofdomesticreserves

Negativedepositratesandlimitedchannelsfordomesticinvestmentpromotecapitalflight

Weakeningreturnsondomesticequities,realestateshouldacceleratecapitalflight

Capitalcontrolsareporous,particularlyforwealthyandpoliticallyconnected

Undergroundbanks/moneychangers Bogustradeinvoicing Increasingcurrencyliberalization

Evidencesuggestscapitalflightisalreadyunderway IncreasinginvestmentbyChinesenationalsoverseas

RealestateinUS,westernCanada,Singapore,Australia,etc.

1 Shih(2011)2 CNTV,ChinesePeopleInvestMoreinRealEstateAbroad.4/11/2011,accessed8/23/11.http://www.china.org.cn/video/201104/11/content_22330861.htm

USrealestatebrokerscourtingChineseinvestorsChinesebuyersaccountedforalmost11%ofUSreal

estatetransactionsin20112

Whileprogresshasbeenmade,Chinaeffectivelyremainsacommandandcontroleconomyatheart:

Nomorecentralplanners,butpartydistortsmostcriticalmarketprices/mechanisms

AChinabullmustbelieveinstateledcapitalallocationandthatitcanbesuccessfulonascaleunprecedentedinhumanhistory

Liberalizationismeaninglesswithout: Privateownership Privatecapitalallocation Ruleoflaw

Howisthisdifferentfromtheolddays?

ChinaismoreradicalTheStatewantstoleadeverything.Thisisthegreatestdifference

YuanWeishi,Zhongshan University1

1 McGregor(2010)78.2 CIA

IsChinasresilientgrowthsurprisinggiventhatitisprimarilydrivenbygovernmentfinancedinvestment?

Precedent:TheSovietUnionmanagedthesamefeatinthe50s6.8%compoundgrowthbyboostinginvestmentspending2

AsIfAllThisWasntEnough Chinasdemographicdividendisfading:

Populationofworkingageprojectedtoshrinkat0.1%p/afrom201520251 significantreversalofdemog.trends!

Onechildpolicyhascreatedgenderimbalance 117:100male/femaleratioin2010 40mmmorementhanwomenby20202

Increasingsocialunrest 80,000massincidentsin07,upfrom60,000in06

Norecentofficialdatabutleaksdatasuggestsasmanyas125,000incidentsin083

Recentsurgeofincidencesincludingsuicidebombings Hasledtoincreasinglyviolentcrackdowns

Harassmentofforeignjournalists,arrestsofintellectualsandactivists,resurgenceofMaoism4

Statehasincreasedallocationtostatesecurity14%inlatestbudget5

1 UNPopulationDivision,StandardChartered,TheEconomist.2 ChinaFearsBachelorFuture.BBCNewsOnline,4/5/2004.3 WaveofUnrestRocksChina.TheWallStreetJournal,6/14/2011.4 Princelings andtheGoonState.TheEconomist,4/14/2011.5 ChinasSecurityState:TheTruncheonBudget.TheEconomist,5/10/2011.

Lackofconcernforhumanrights

Extensivestatecensorship

Laxenforcementofintellectualproperty

Lackofinnovation

UnauthorizedAppleStoerinKunming

HowNowBrown(Red)Cow?

Chinahasbeforeittwoalternatepaths:1. Statusquo

Unsustainable,unfair,unbalanced,andinflationary Systemincapableofsurvivingslowglobalgrowthenvironment

Inflationwillcontinuetomount,inflamesocialtensions,andunderminepartycredibility Sheerscalecreatesupperboundtocapital/resourceintensivegrowthmodel Debtfinancedgrowth+poorcapitalallocation+lowrecoveryrates+understatedinflationrecenteconomicgrowthislikelyoverstated&perhapsaltogetherillusory

2. Structuralreform

Reformsrequiredareinherentlylongterm unlikelytoeaseimmediatepressures Wouldrequirepartytodrasticallyreshaperelationshiptostateandenterprise

Significant relinquishmentofpower&effectiveadmissionoffailurebyCCPSignificantimpediments:

Dependencyondomesticsavingsforfinancing Fundamentallyuncompetitiveindustry Entrenchedpolitical/bureaucraticincumbentsinhibitrapid/effectivereform UnresolvedliquidityoverhangonPBOCbalancesheet Significanthumancapitaldeficitfromchronicsocialunderinvestment Mountingpileofunresolvedbaddebtsstretching~20years

Stalinism Comes of AgeSlide Number 2ContentsThe Chinese Growth MiracleSlide Number 5Slide Number 6Slide Number 7What Could Go Wrong?Having Your Cake and Eating It TooUS & Chinese Monetary AggregatesKeeping a Lid on ItA Losing GameUnorthodox TighteningChina Drives Global ImbalancesChina: The Marginal BuyerDeny, Delay, DefendHistory of Problematic InflationCommunism with Capitalist CharacteristicsExports & Gross Capital Formation / GDP 1981 - 2009Export Bubble Mirrored in Real EstateCompensating for Something?Dubai X 1000?Old Dog in Need of New TricksA Tall OrderThe Wages of GrowthThe Urban/Rural DivideSocial CostsSocialism in ActionThe Great Funding Wall of ChinaBehind the WallWho Pays for All of This?Who Pays for All of This?Chinas Phony Bond MarketThe Partys ATMChinas BanksCheerleaders of GrowthPolicy BanksChurn and BurnDecreasing Marginal ReturnsPedal to the FloorHavent We Seen This Before???A Preview of Things to Come?Restructuring, Round 1Bad Bad BanksKicking the CanCinda: A Case Study in Rent SeekingBanking System is InsolventThe 5th (and Final?) Asset Management Co.The View from AboveFamily FeudThe Struggle for ControlThe MOFs Coup D'tatHow Did We Get Here?Life Under the PartyOrganized ChaosChinese Government: Graft & GroupthinkLocal YokelsThe Bureaucratic Layer CakeThe Bureaucratic Layer Cake (II)The Bureaucratic Layer Cake (III)The Reform Period 1979-1989The Reform Period 1979-1989The Tiananmen InterludeThe Resurgent State, 89-01Scientific Development, Harmonious SocietyChinas Industrial Policy StateState Owned EnterpriseNational ChampionsChinese Enterprise: The Bird in the CageThe Heavy Hand of the CODIndustry and the StateThe Costs of State InterferenceChinese Steel: Case Study in InefficiencyChinese ArithmeticChinas Latest ExportOff Balance Sheet ExplosionChinas Government is Deeply IndebtedChinas Empty War ChestCapital Flight is PossibleThe Red MachineAs If All This Wasnt EnoughHow Now Brown (Red) Cow?