Elite Chinese Politics and Political Economy

Rob Fannion, my former roomate at Harvard, asked me about a Washington Post article that details the defense ties between Taiwan and the US. The article gives an excellent portrayal of the complex ties between the US and Taiwan, which is leading to Taiwan stalling military reforms that the US wants Taiwan to carry out. My thoughts were:

This is sad in two respects (at least). First, it shows how much the military industrial complex (yet again) dominates our defense and foreign policy. Second, it shows how much Chen is still fearful of the Taiwanese military. Under pressure from both the military and the legislature, it is hard for Chen to act. Strategically, it might be in Taiwan's interest to buy just enough weapons to continue a close relationship with the US. Basically, Taiwan's thinking is that it has no hope to defend itself against China on its own, so it needs US involvement, which requires some lobbying and arms acquisition. But it really wants to free-ride on (the threat of) a US defense if it can. If its ties with the US is too close, it might trigger an actual invasion from China or economic sanction, which it doesn't want. The whole thing is a farce.

The article can be accessed at:
http://www.washingtonpost.com/wp-dyn/articles/A38079-2003Oct29.html

Well, it's been a while since the last posting. A story on inflation finally got my interest. My friend Bill from Berkeley wrote the following speculation, followed by my reply, followed by the article:
Bill-
Cutting wages in an environment of significant inflation, when income
disparities and poverty rates have already been shooting up, is not a recipe
for political stability.

That said, I wonder how much of these price hikes are really due to increased
demand and robust growth. Might increasing uncertainty, burgeoning corruption
and graft, more and more common distribution and transportation problems, be
behind this? Also, could it just be a flight from government bonds and
inflated A-shares into durable or valuable goods that then is driving other
prices up as a by=product? Overall, it just seems to me that there is a
pessimistic explanation for all of this that looks just as probable as the
WSJ's version of skyrocketing growth and pent-up demand.

Me-
I think the raw material price hike and rapid increases in bank loans are the main culprits here. There hasn't been a huge sell-down in A share stocks, and bonds are doing okay. The raw material story is interesting. China now consumes so much raw material, especially in steel, food, and even plastic, that it is affecting world prices. This mean that China is pushing the physical limit of the world. Thus, there will be inflationary pressure even if there is redundant capacity in China to push down prices of manufactured goods. It is interesting to note that Wen and Hu are less inflation averse than Zhu. I strongly suspect that this is Hu's doing, with his "xiaokang shehui" campaign to promote higher growth in the interior regions. I suspect that the PBOC is under some political pressure to continue the current course of loose monetary policies. The PBOC itself has tried to lobby the government to retrench more, but only with limited success. You can see their frustration when they talk about the accumulating risk in the real estate market.

The WSJ Story:

October 29, 2003
ASIAN BUSINESS NEWS
Inflation Hits China
Amid Surging Demand

By KARBY LEGGETT and JAMES T. AREDDY
Staff Reporters of THE WALL STREET JOURNAL


SHANGHAI -- During a trip to his favorite supermarket this month, Yu Maomei was surprised to find the shelves for cooking oil stripped nearly bare. When he returned the next day, the 68-year-old retiree figured out what had happened: The store had raised the price of cooking oil, and some customers had stocked up in advance.

In following days, Mr. Yu found that prices for pork, rice, green vegetables and even some seafood had also jumped. "Many of the goods I need for daily life suddenly became more expensive," says Mr. Yu, in a slightly worried voice.

Long mired in a spiral of ever-lower prices, China's economy is dealing with something else these days: price inflation. In the first nine months of this year, China's benchmark consumer-price index rose 0.7%, and many economists expect it to shoot well past 1% next year. (Producer prices rose a year-on-year 1.4% in September, China reported Tuesday.) The CPI rise is still mild compared with inflation in other countries -- and a far cry from the nearly 25% inflation that spread through China's economy in the early 1990s -- but it marks the first significant inflation China has experienced since 1997, showing how the nation's booming economy is creating demand not seen in nearly a decade.

Several factors are behind the climbing prices. Demand for raw materials such as steel, cement and rubber has soared, the result of economic growth that could reach 9% this year, and surging investment across the economy. Nascent supply bottlenecks in the agricultural industry have also raised prices.

No less important, economists say, is warp-speed growth in the amount of money sloshing through China's economy -- money supply is up more than 20% this year -- a phenomenon that fuels inflation by making more money available to spend. The return of inflation is significant because it spells the end of China's five-year bout with deflation, a fall in the general price level caused in China's case by tight credit, and an oversupply of goods ranging from rice to cellphones.
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The result was a boon to shoppers, Chinese and foreign. Yet alongside the cheaper prices, a new fear emerged: of global price deflation. As China's exports filtered through the world market, so did concern that the country was spreading deflation, aggravating a problem already vexing some other countries.

Now, such fears are moving to the back burner.

Just how far inflation spreads in China has implications for a big question hanging over global financial markets: a potential revaluation of China's currency, the yuan. Washington is pressing Beijing to let the yuan strengthen, a move that would make Chinese exports less competitive. So far, Beijing has resisted.

But if prices in China continue to rise, the issue could become moot. Prolonged inflation would eventually erode the yuan's purchasing power, raising costs for Chinese manufacturers and making their exports less competitive. It would also fuel demand for cheaper raw-material and other imports, narrowing the nation's trade surplus. And as China imports more, it might help dispel its reputation as an unfair trader interested only in flooding the world with cheap exports.

"Inflation," says Yuan Gangming, a senior researcher at the Chinese Academy of Social Sciences, "would be a good way to relieve international pressure for a yuan revaluation."

Even so, economists say greater Chinese demand for foreign goods would provide little relief for foreign manufacturers of finished goods, particularly those competing against China. The reason: Many Chinese companies would likely use the nation's deep pool of low-wage labor as a way to cut prices.

For now, it's unclear to what extent inflation may grip China. Though personal incomes in the biggest cities are rising quickly -- by about 9% this year -- they are rising far more slowly in many other parts of the country, particularly the countryside. Uneven income growth hinders consumption, which has grown at almost the same 8% rate for five years.

Indeed, economists say inflationary pressure thus far is largely the result of demand for raw materials needed to build factories, roads and other infrastructure. Yet the surge in this type of investment, which accounts for 42% of China's economic growth this year, and surging bank lending -- up a year-on-year 23% in September -- is fueling concern that China's economy is becoming stretched. That in turn is prompting a debate within China's central bank over whether to cool things down by raising interest rates.

If rates rise, and demand for raw materials eases next year, China could be stuck with an old problem: vast new manufacturing capacity but fewer places to sell what the new factories make. That means prices could come down nearly as fast as they went up, Merrill Lynch economist Timothy Bond wrote this year.

Even so, most signs suggest that China has entered territory where price pressure is clearly tilted upward, not downward. Reinforcing this change is a different view of inflation among China's new leaders, particularly Premier Wen Jiabao, who appears to have decided, unlike his predecessor Zhu Rongji, that a measure of inflation is good for China. "The government is now willing to see inflation in the range of 2% to 3% a year," says Mr. Yuan, the Chinese economist.

Some foreign companies say they see opportunities to raise prices on their best products. Swiss agrochemical company Syngenta AG, for instance, recently started charging China's export-focused vegetable farmers more for crop-protection chemicals, because "they go straight for quality," says Karl Gutbrod, a Shanghai-based executive. John Mullen, regional chief executive of DHL Worldwide Express Inc., echoes that sentiment: "We're not seeing price declines at the moment," he says.

Because it can take 18 months for price increases to filter through China's relatively primitive economy, today's inflation figures reflect the pressures of early 2002. The upshot: If inflation spurts higher in coming months, Beijing may have no choice but to tighten credit, hindering its efforts to speed job growth, a top priority.

Inflationary pressure may be stronger than Beijing realizes. Though prices for finished goods continue to fall, the price of many services, such as health care and education, are rising fast.

Agriculture is another critical area. In the late 1990s, overproduction put downward pressure on China's most important farm product, grain. That has changed, leaving China on the verge of a grain shortage that is pushing up prices.

People like Mr. Yu, the retired worker in Shanghai, are already feeling the impact. With a monthly pension of just over $100, Mr. Yu says making ends meet wasn't easy when prices were falling. Now, with both food and medical costs rising, he says he is growing anxious. "Daily life is getting more difficult," says Mr. Yu, "It's a huge burden for retired workers."

Meanwhile, my friend and former roomate Rob Fannion asked me if I had any insights about the CHinese space launch. I had to disappoint him with my lack of knowledge and really kind of boredom with a fantasy of the 60s. I guess that speaks of my post-materialist bias:

I am afraid that I will have to disappoint you, since I have not much to say about the space flight. Apparently, Jiang has taken a lot of the credit for the flight, but the weird thing is that he was absent at both the launch site and the space command center. As the Chairman of the Central Military Commission, he had a perfect right to it. The speculation is that this might signify his retirement in the near future. But no one really knows.

Andy Collier of SCMP has once again sent me an article on an interview with Liu Mingkang, the head of the Central Banking Regulatory Commission. And my comment on the article was this:

I also read the Liu Mingkang story with interest, but I have heard it all before from Zhou Xiaochuan. If you compare what Liu said to what Zhou said six years ago, you won't find that much variation. Interest rate liberalization, for example, has been kicked around since the late 80s. In fact, Xie Ping was one of the first proponents for liberalization within the PBOC. (don't quote me on this, but his loud mouth has resulted in him being in the same position for almost ten years now). I think they will continue to make micro-steps toward liberalization, but nothing major. I think diversifying ownership of the Big Four will be very contentious. A couple of things on the list that will probably go forward are allowing foreigners to hold more shares in city commercial banks. The city commercials are now in very poor shape, so I am sure they wouldn't mind injecting some fresh capital in some of them. Also, they will try to consolidate the RCCs, but that will involve a nasty fight with the local governments. Also, I am not sure if the PBOC really wants to find out how badly off some of the RCCs are doing. I also find Liu's estimate of new NPL being in the 2-3% range wildly optimistic. While there is no doubt that NPL ratio among new loans is lower than in the early 90s (most of the NPLs were generated in the 90s, not a "historical problem" as they claim). But I would be surprised if the true figure is lower than 10%.


The article:

Chinese Regulator Promises
To Turn Around Ailing Banks

By KATHY CHEN
Staff Reporter of THE WALL STREET JOURNAL


BEIJING -- The top bank regulator in China vowed to turn around the bulk of the nation's debt-laden banks in five to seven years and, calling on foreign investors to help, said Beijing plans to raise the stake they can acquire in Chinese banks to 25% from 15%.

In his first interview with a foreign newspaper since taking office in March, Liu Mingkang said Wednesday that China's recently anointed leadership under Communist Party chief Hu Jintao is committed to speeding up reform of the debt-burdened financial sector. He said Beijing has a broad plan in the works that includes diversifying the ownership structure of the nation's four big state-run commercial banks, further liberalizing interest rates "in the near future," and passing a tough bank-supervisory law as early as December.

Prolonging bank reforms "will increase sharply the cost and burden" to the financial system, said Mr. Liu, who heads the recently established China Banking Regulatory Commission. "China's new leaders realize this, and they said they have got to quicken the pace."


Mr. Liu said China plans to start by reforming and restructuring the big state-run banks and tens of thousands of rural credit unions, which together account for nearly three-fourths of the country's total financial assets. He said he hopes foreign investors can help reform China's shareholding banks by taking stakes in those banks. "All the banks will have to diversify their ownership and attract new blood," he said, predicting a turnaround for these banks "in five or seven years."

Mr. Liu, a professional banker who has a business degree from the City University of London, has his work cut out for him. A decade into a bank-reform program, Beijing has spent nearly $200 billion during the past five years to fix the bad-loan problem, a legacy of decades of government-mandated financing for state-owned enterprises. But the nation's banks remain buried under $375 billion in bad debt, by the government's own estimate. Many economic analysts say the problem is far larger.

And financial fraud is on the rise, even as foreign banks such as Citigroup Inc. and HSBC Holdings PLC are gearing up for a push into China. Under its agreement with the World Trade Organization, China has promised to give foreign banks free access in December 2006.

One major problem is the supreme role that Communist Party officials play in managing banks, from the largest state-owned lenders down to thousands of tiny rural banks owned by local governments. On personnel appointments, many lending decisions and even annual deposit quotas, China's bankers report not to an independent board of directors or shareholders, but to party bosses in Beijing. The result, bankers and industry experts say, is a system often void of accountability.

Identifying Risk

Mr. Liu and his staff of regulators are trying to change all that by stressing to banks the importance of identifying risk and by backing up their supervision of the sector with teeth. "The new government has asked us to have a brand new approach to monitoring risk and supervision," he said.

The commission, which in March was split off from the central bank to take over regulation and supervision of the banking sector, has authority to block banks from opening new branches or expanding if they don't meet the agency's standards. It also has power to fire top managers and impose penalties and fines for violations of rules.

Regulators hope to strengthen their enforcement authority with the expected passage by year-end of the country's first bank-supervisory law, which would give the agency powers such as the right to foreclose on properties. A draft law is under debate and would require approval by the national legislature's standing committee.

Other reforms in the works or under way include:

. Consolidation of China's 35,500 rural credit cooperatives to about 2,000 in the next two or three years. Mr. Liu said the sector would be open to private investment, with foreign investment possible in prosperous coastal regions.

. Further liberalization of interest rates "very soon." Small rural banks already enjoy authority to adjust their rates to match the risk; bigger banks are restricted to a narrower band. But Mr. Liu conceded that more flexibility is needed. Banking regulators are finalizing a rate liberalization plan.

. An increase to 25% in the stake that foreign investors may take in Chinese banks. Mr. Liu said foreign investors, including banks, insurance companies, and funds, could play a role in helping Chinese banks improve their corporate governance and management structures. Besides investing in China's shareholding banks and more than 100 city commercial banks, foreign investors might be allowed to become strategic investors in the state-run commercial banks, he said.

. Approval of Citibank's application to issue a yuan-denominated credit card with Shanghai-based Pudong Development Bank, in which the Citigroup unit has a 4.62% stake. Most cards issued by Chinese banks are some form of debit card, and this would be the first true credit card to be offered to Chinese consumers by a Sino-foreign venture.

. Fulfillment of a pledge China made to the WTO to allow foreign banks to provide Chinese-currency services to domestic corporate customers by Dec. 6, and to lift all barriers on foreign banks to the Chinese market by Dec. 1, 2006.


Speaking in fluent English in an office building on loan from the central bank, Mr. Liu conceded that China has a long way to go in creating a modern banking system, and that the speed of reducing nonperforming loans has been slow. But he sought to strike an optimistic note on the changes that Chinese banks are undertaking. He estimated that banks' ratio of new nonperforming loans totaled between 2% and 3% of all new loans during the past three years, a figure that he says is "within our control. In a transitional economy like China's, I'm confident as long as we can keep overall nonperforming loans to between 5% and 6%."

Potential Bubble?

Some Chinese and foreign economists have voiced concerns in recent months that China's economy may be overheating, driven by a wave of easy bank credit, and that a potential bubble may be forming in the red-hot property sector. Mr. Liu agreed that new lending has picked up -- the amount of loans outstanding rose 23% as of the end of August compared with the same period last year -- but he said he is comfortable with the trend.

He said faster loan growth has been necessary to fuel economic growth after severe acute respiratory syndrome temporarily shut down parts of the country earlier this year and amid Beijing's ambitious plans to overhaul the ailing state sector.

"With an expansion of lending, you can never draw the conclusion, 'Is it a good thing or a bad thing?'" he said. "If you can see an improvement of quality, then we will welcome it."

Write to Kathy Chen at kathy.chen@wsj.com

Bill Hurst's comment on the city issue:

Shenyang in particular has no chance of becoming a zhixishi. It is in too
muhc of a mess for the center to want to take it on and it is not all that
importnat as a hub or economic center. Dalian will almost definitely be
elevated I think for the reasons Victor noted. Also, Qingdao/Yantai will
probably go as well to give the center direct control over the Bohai Gulf
openning and all the FDI flowing into that zone from Korea and Japan. Wuhan
could also go since ti is such a crucial transport hub for central China. One
issue with both Wuhan and Shenyang, though, is what cities could become the
capitals of Liaoning and Hubei. It'd be great to see Benxi get a turn at
being a provincial capital, but I have to think that Anshan would be the city
in line for the post (if it were not subsumed in either the Shenyang or Dalian
municipalities).

On why Dalian and Shenyang are on the list of possible cities to be elevated to the provincial level:

Bill Hurst: Interesting. I am actually surprised that Guangzhou is not on the list - if I
were Hu it definitely would be. Also surpirses from my angle are Shenyang and Wuhan. All the others make sense.

Matt Rudolph: i'm with bill on this. why both shenyang and dalian? this list reminds me
a bit of the first list for PBOC branches.

Me: The Shenyang/ Dalian issue is interesting. I think much of it hinges on how Bo Xilai (governor of Liaoning, where both of these cities are located) wants to play it. I suspect that he will push for elevating Dalian. First, Dalian is basically the PR of Bo, so an elevation would give many of his followers a promotion. Also, it is economically doing pretty well, so it would be a nice offering to the center in anticipation of his promotion to the central government, which I don't doubt is his ultimate aim. The appearance of Shenyang on the list might be just that, for the sake of appearance. That is, if everyone expects Bo to push for Dalian, he might have proposed Shenyang to give an appearance of fairness.

Kunchin Lin of Berkeley has this very interesting insight on the issue of elevating cities to the provincial level (see postings below):

We should've expected this. Furthermore, I've three
insights from my interview with a NPC member in 2002:

1) This is Jiang Zemin's move.

2) The next step is to redistribute. One key means to accomplish that is to TAKE AWAY the extrabudgetary authorities of the cities. If we see this move in the next year, the "recentralization" argument would be hugely strengthened and Jiang would've scored a big victory that he was unable to accomplish under his own regime.

3) The NPC will be involved in designing the
procedural aspects of the fiscal redistribution.
Poorer provinces will gang up on the coastal gold
pots.

My reply:

I don't doubt what you say, but why would Jiang back something that will piss off a lot of local officials? And why get the NPC involved in this. If the idea is to get Western provinces to gang up on Jiangsu, it seems like it is a move by Hu and Wen, who have close connections with the West.

Andy Collier, of SCMP, also asked me about his article on Xia Bin (attached below), the State Council's expert on banking reform. Wow, I really wasted a lot of time today. My comment was this:

On Xia Bin's comment, I think he is both right and wrong. He is right in that ownership restructuring will not help bank performance. Some of the joint stock banks have a lot of NPL, although they are only partially owned by the state and are much newer. In fact, I am doing a study comparing the credit risks of the different types of banks. We find that city commercial banks, which are also joint-stock banks, perform the worst out of all the different types of banks. I suspect that part of the reason why city commercial banks do so terribly is that they are completely at the mercy of the local government, which leads to a lot of intervention. Big Four state banks, on the other hand, because they now enjoy State Council and Central Finance Work Committee protection after 1998, can say no to the local government. Although they can't say no to the central government, they get partially compensated for carrying out central policies. Thus, making them into weaker bureaucratic entities actually makes little sense and will worsen their performance. But Xia Bin's suggestion of making top managers independent of the state will have a similar effect. No one will take someone without a bureaucratic rank seriously. It might actually lead to more local intervention in the banks, not less.

The article:

Andrew K. Collier in Beijing

The head of the financial research arm of China's State Council said the state banks should focus on eliminating bad loans before they move to the next stage of selling shares to the public. "If we want to have public offerings, we have to resolve the problems of the non-performing loans. Without resolving NPLs, how can we do offerings," said Xia Bin, director general of the Financial Research Institute of the Development Research Center (DRC) of the State Council. Speaking at a financial seminar yesterday, Mr. Xia also recommended that state bank presidents should relinquish their government titles to avoid confusion and he called for China to hire more foreigners to become bank executives. "The Big Four presidents are advisors on the Ministerial level. The presidents and director generals should eliminate their official titles," he said. In addition, "I advocate recruiting people overseas to become presidents of branches." While Mr. Xia doesn't set policy, his institute provides analysis to the country's top leaders in financial reform. He made his comments at a seminar sponsored by the Asian Development Bank and attended by key policymakers from the state banks, the People's Bank of China, the China Banking Regulatory Commission, and other financial institutions. The seminar occurred just as Beijing is holding its annual Party Congress, which is expected to result in announcements about new plans for reforming the economic system, including stronger rules protecting private property. PBOC officials said many of the questions about the direction of China's banking reform "would be resolved" in statements made after the close of the Party Congress, which ends Tuesday. At the seminar, Mr. Xia and other officials commented on a paper sponsored by the ADB by Professor Giovanni Ferri, a former World Bank official now at the University of Bari in Italy.
Professor Ferri argued that a gradual move to "mixed governance" - a combination of state owners and shareholders - would improve corporate governance at the banks and slowly reduce the banks' huge non-performing loans. The former World Bank official also said the Government should establish a State Banking Holding company to provide a "filter" between the banks and the government. However, Mr. Xia and other officials said reducing state control won't eliminate bad debt. Instead, the problem is that government officials, mainly in the rural areas, intervene in making loans that end up being unprofitable. Until this and other larger political issues are overcome, NPLs will continue to plague the banking system. "A large amount of NPLs are caused by external factors outside of the banking system" that cannot be eliminated until major macroeconomic issues are resolved, said Xie Ping, director general of the Research Department of the People's Bank of China.
Mr. Xie said analysis of 300 bank branches shows that 20 per cent of the NPLs are caused by bad corporate governance, while "a large amount of the rest is due to poor performance or loss-making enterprises."
Nor does mixed ownership guarantee good corporate governance. The biggest owner in one bank in Hainan has only 5 per cent of the shares "but it is very hard to make them repay debts," the DRC's Mr. Xia said. Similarly, companies like Petrochina and Sinopec have highly efficient financial operations even though they are majority controlled by the state, he noted. Despite its high non performing loans in China, companies like the Bank of China with branches in Hong Kong have generated excellent profits due to Hong Kong's sound regulatory system, Mr. Xia said. Others agreed on a "go slow" approach to public floatation of the state banks. "Ownership diversification should not be the single goal of the banking sector," said Ruizhang Jian, vice president of the Industrial and Commercial Bank of China. The government must balance the need to lower NPLs with the potential for protests by laid-off workers, said another finance official. "If there are too many NPLs, it will be a big problem for the stability of the banking system. However, if we push too hard, it can cause a lot of unrest in the local level, particularly in the Northeast," said Wang Haijun, executive director of the China Cinda Asset Management Corp. (CINDA).
He said CINDA has faced a "big headache" selling NPLs. Investors point to Southeast Asian countries in the 1997 financial crisis that sold assets at 5 cents on the dollar and demand similar deals from China. "I say China is different because China's economy is not in crisis," Mr. Wang said. Although CINDA is receiving cash recovery on the NPLs at a rate of 20 per cent, "I doubt we can in the short-term solve the NPL problem." The PBOC's Mr. Xie said China can "grow" out of the NPL problem. If China can maintain high growth over five to ten years, and keep the increase in NPLs to 5 per cent a year, "we will see a fast decrease in NPLs." Meanwhile, foreign banks will not be a significant factor in the resolving the problems in the banking sector. "The role of foreign banks in China is not so visible," he said.

Andy Collier, of SCMP, asked me about the Third Plenum. My comment was this:

On the plenum, I see nothing new on the editorial issued after the plenum. In fact, there are some disturbing trends for banking reform. In the editorial, financial reform is buried in the middle of the 7th paragraph, right after the phrases that the government should do all it can to support Western development and the revitalization of the Northeast. Although this trend began toward the end of the Zhu Administration, it signals that there will unlikely be any significant progress in financial reform in the near future. The government seems much more focused on redistributing resources to Western China, SOE reforms, and rural development, than in institutional changes. Moreover, this documents signals to local officials that priorities like SOE reform, increasing rural income, and Western developments are now higher than financial reform, which will likely increase political pressure on banks to lend to these policy goals. The only step forward I read was the phrase giving private enterprises equal rights and equal access to market, but that has been achieved in many places already.

Okay, so someone on Chinapol said that the story I told is an old one, which I agree:

I completely agree with you that this is an old story. Nonetheless, it is interesting to speculate on why the central government chooses this moment to raise the issue again. This is something I would've expected to occur under Zhu Rongji, not Wen Jiabao. Also, given the political tension between Jiang's people and Hu Jintao these days, one would think that both sides need as much provincial support as possible and would be less likely to embark on the quest to harm local interests. From the article, it seems the negotiations are still at a pretty preliminary stage, so we will see if anything actually happens.

One of my colleagues pointed out this very interesting article, and my response was:

This is very interesting development indeed. One implication of this move is to deny provincial government the revenue generated in these big cities. The end result might be even less transfer payment from the big cities to the poor rural areas of these provinces. I am sure the central government will partially compensate through subsidies, but only partially. So, the central government and the city government are both proponents, while the provincial government is the opponent. Sichuan fought Chongqing’s elevation every step of the way, but nomenklatura power won out in the end. The brilliance of this move is that the elevation would give every official in that city an automatic one grade promotion, which no doubt generates a strong support coalition ex ante. One interesting thing about the list is the exclusion of Guangzhou. When I was in China, I heard about the possible elevation of Guangzhou. I guess the Guangdong government would rather lose Shenzhen than Guangzhou.

The article:

This seems like it could be a very important development. Can anyone comment on the views of this from Beijing, the cities that want to apply, or the provinces that might lose them? And what about the consequences -- has Chongqing really done better because it's free from Sichuan, and has Sichuan suffered?

---------------

China ponders raising status of large cities
By James Kynge in Beijing
Published: October 13 2003 20:06 | Last Updated: October 13 2003 20:06

China has begun to consider raising the administrative status of several large cities by putting them under the direct control of Beijing - a scheme that would aim to reverse the ebb of state power away from the central government, officials said.

The proposal, if adopted, would have the potential to boost the economies of the cities selected to become zhixiashi, or province-level cities, and reveal one aspect of an emerging t op-level plan to reform China's administrative system, officials said.

Approval for new zhixiashi would be unlikely before a meeting of the National People's Congress next March at the earliest. "There are plenty of cities that have requested to be turn ed into zhixiashi but the government has not yet made its decision on this idea yet," said an official at the ministry of civil affairs.

The list of cities that have either put forward their candidacy or been considered by the central government is long. Nanjing, the capital of the central province of Jiangsu; Shenzhe n, a "special economic zone" bordering Hong Kong; Shenyang, capital of the north-eastern province of Liaoning; Dalian, the second city in Liaoning; Qingdao, the most prosperous city in the eastern province of Shandong; and Wuhan, capital of the central province of Hu bei, have all been mentioned.

If the government decides to go ahead with the proposal to elevate the status of some cities, only one or two of the candidates may be chosen in the initial stages, officials said.

Beijing's consideration of the plan and the lobbying by individual cities is being conducted in strict secrecy. Officials in each of the candidate cities denied all knowledge of the proposal but none said that their city would not be interested in becoming a zhixiashi.

The main reason for elevating cities to the status of zhixiashi was to streamline an increasingly clogged chain of command between the central government and the provinces. In s everal cases provincial governments follow an agenda that is either separate from that of Beijing, or inimical to Beijing's interests.

"Some of these provincial governments are corrupt from the top to the bottom," said the policy adviser. "They are more like mafias than anything else."

The last of China's four existing zhixiashi - Beijing, Shanghai, Tianjin and Chongqing - was Chong- qing, a city area of more than 30m people in western China.

In the six years since it was approved, the extra freedom bequeathed it has helped Chongqing's economy expand sevenfold, its tax revenue rise 2.9 times, and its fixed asset investment grow three times.

There was a discussion between myself and Bill Hurst, a graduate student at UC Berkeley about why we haven't heard anything about the Third Plenum in the official press. A leading scholar of Chinese politics, however, told us on Chinapol that this was perfectly normally. Oh well, we will find out soon enough:

Bill Hurst:
We'll see what comes out of the plenum in the end. What I do find
interesting, though, is that all the major newspapers as well as CCTV and
other outlets have remained almost completely silent on any details of the
meeting. I wonder if this means something big is in the works or if it is
just the media following Hu's instructions to pay less attention to top
leaders' every move?

Me:
That was exactly my thought. Why the hell haven't they publicized anything. It is true that plena are usually given less fanfare than the Party Congresses, but this still seems strange. Well, if we don't see anything tomorrow, i think something is up. Most likely, a debate on what to tell the public. Also, on the RMRB website, there were two articles on the plenum written a few days ago before the start of the plenum. In them, "experts" gave their opinion on what would be discussed at the plenum. The wording just seems strange.
This suggests some degree of uncertainty about the agenda of the plenum.

Bill:
Timing the meeting with the space launch may also mean something. But the
only really big thing I can imagine coming out of this is that maybe Jiang is
out from the CMC, or maybe they have decided to actually float the RMB, or
maybe they are going to actually fund the "dibao" and formally bankrupt all
the SOEs that are bankrupt in all but name. All of these would be important,
but they just do not rise to the same level as the reforms int he wake of the
1978 3rd plenum. If there is something more significant than these changes, I
just cannot guess what it might be.

SO, someone found my commentary on the WSJ to be too optimistic. He pointed out that such rapid expansion in loans will lead to substantial increases in non-performing loans. I did come off as optimistic without really meaning to. Here is my reply:

There is no doubt that current lending practices will give the Chinese government a lot of grieve in the future. I myself am quite pessimistic about the long-term viability of the Chinese banking system. Having said that, there are some recent developments that might delay the impending crisis for a few more years. Although consumer lending is quite reckless these days, the credit risk has actually declined compared to the mid-90s. Just by spreading their risk to many small borrowers versus a few large SOEs, banks’ credit risk decreases. Moreover, the foreign exchange reserve has grown by leaps an bounds, which also bolsters depositors’ confidence in the liquidity of the system. I agree with you that the Chinese system is one giant confidence scheme. I just think that there is still enough confidence to go around.

My commentaries on the latest WSJ on Chinese banks:

Excerpts of the Article:
October 3, 2003

Surge in Lending In China Stokes Economic Worries;
Spending, Investment Sprees Point To Overheating;
Bad Debts Rise

By KATHY CHEN and KARBY LEGGETT
Staff Reporters of THE WALL STREET JOURNAL

SHANGHAI -- Liu Yijun is 27 years old and works as a real-estate agent. He and his wife, a supermarket purchasing agent, together make about $8,000 a year. On that modest income, this year they've bought a new Mazda for more than $19,000 and a new apartment priced at almost $91,000.

How did they do it? "Bank loans changed our life," Mr. Liu says.

China is awash in easy credit these days, spurring a national spending and investment spree in everything from residential property to wine, cars, steel and shopping malls. Banks' liberal lending policies -- Mr. Liu and his wife, for instance, financed at rates between 5% and 6% -- have boosted lifestyles and helped fuel China's white-hot economic growth. Gross domestic product hit $1.236 trillion last year, up 50% from 1996, according to the International Monetary Fund. The average annual growth rate during that period was nearly 7%.

Warning Signs

However, there are signs that the world's fastest-growing economy may be in danger of overheating. Pessimists point to overproduction in steel and a possible asset bubble developing in property. They worry that economic growth can't be sustained at its current pace. What's more, economists estimate that of China's nearly $2 trillion in outstanding loans, between $500 billion and $750 billion aren't expected to be repaid. Those amounts are in line with Japan's bad-loan problem.

For now, there is little danger that the economy or even the antiquated, state-run banking system will collapse. China's banks remain government-owned and are backed by what amounts to a sovereign pledge to keep them afloat. Indeed, the banks have been carrying a huge load of bad loans for years, and have rarely experienced runs because of the country's closed banking system and China's traditionally trusting bank customers. In recent years, Beijing has been taking steps to overhaul the banks and reduce their bad debts, including setting up some companies to take over bad loans. Still, with many Chinese banks once again handing out loans rather indiscriminately, a new set of bad loans could emerge on their books, setting back China's financial reforms. And their problems could become harder to fix as the country prepares to open its doors to foreign competition..........

My commentary, the usual two-hand commentary:

The fear raised by the article is partially justified. Consumer loans and real estate construction loans are still a relatively small percentage of total loans outstanding. According to 2002 PBOC figures, short-term construction loans are only 2% of total loans outstanding. However, its growth in 2002 was a spectacular 45%. I don’t have access to consumer loan data, but I suspect it is the same story, namely high growth but still only a small slice of the big picture. Of course, much of the recent growth in lending to real estate is masked under the category of “long term loans,” which grew by 20% in 2002, a pretty significant growth. However, a lot of the long-term loans went toward major government construction projects, such as the Three Gorges Dam and the new project to divert water from the South to the North. Also, loans to industrial enterprises, mostly SOEs, also grew by a healthy 15%. The bottom line is that even if disaster strikes in the real estate market, it won’t destabilize the banking sector that much. Of course, it will hit different kinds of banks differently. The Big Four state banks will be relatively okay, while the joint-stock banks (like Shanghai Pudong and Guangdong Development) will be hit much harder. The Chinese has certainly dealt with a similar situation in 1993.

The bigger risk is a long-term liquidity risk, stemming as much from real estate loans as from government construction projects. Essentially, growth of “long-term loans” has consistently outstripped growth of lending overall, which means an increasing portion of Chinese banks’ portfolios are trapped in long-term assets. Meanwhile, most deposits (or debt) are short-term. Again, the Chinese has successfully managed this situation, but if there is an exogenous shock to the economy, like the return of SARS, it might trigger a banking panic. Overall, the situation is not as dire as the article suggests, but the trend is not encouraging.

Well, what do you know, my commentaries to China Pol about the silting of the Three Gorges Dam actually got picked up by the reporter at Globe and Mail. Here is the result: China announces abrupt increase in water at dam


By GEOFFREY YORK
Wednesday, October 1, 2003 - Page A18

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BEIJING -- In a sign of unexpected problems at the massive Three Gorges Dam, the Chinese government has announced a sudden rise in the level of the stagnant reservoir above the dam, causing more environmental damage and forcing more people to abandon their homes.

The reservoir had reached a height of 135 metres after the controversial dam went into operation in June. It was scheduled to remain at that level until 2006, when it would rise a further 21 metres. Instead, the Chinese authorities have announced that the reservoir will rise a further four metres by the end of October, almost three years ahead of schedule.

The terse announcement gave no detailed explanation for the sudden change of plan. "It's very strange; nobody knows why," said Dai Qing, a prominent Chinese environmentalist who has opposed the Three Gorges project for years.

She predicted that the higher reservoir level will cause a worrisome increase in pollution along the Yangtze River, where the $25-billion (U.S.) project has become the world's biggest dam and biggest construction project.

Many polluted sites on the riverbank have not yet been cleaned up because the reservoir was supposed to remain at 135 metres for the next three years, but now those will be flooded. Environmentalists have said that the dam is creating the world's largest cesspool.

According to Chinese media reports, the higher reservoir level will also force the relocation of an additional 1,300 people who live along the Yangtze. More than 500,000 people have already been obliged to move to higher ground as the dam began operations.

"The news will come as a shock to people living in the new submersion zone along the banks of the reservoir," said a commentary in Three Gorges Probe, a Toronto-based environmental newsletter that monitors the dam project.

The residents "will be required to move at painfully short notice," the article added. "Many had assumed they still had two or three years to make the necessary practical and psychological preparations for their displacement."

Victor Shih, a political scientist at Northwestern University in Illinois who has studied the financing of the dam project, said the most likely explanation for the unexpected rise is the silting process, which he says is occurring much more rapidly than predicted.

He said the dam's estimated cost has more than doubled, while the silting is expected to reduce the amount of power it generates. The dam and reservoir are being raised to ensure that the project remains financially viable, he said, since Chinese lenders have invested so much money in it.

Today, I saw this weird website called secretchina.com, which has all this gossip about elite Chinese politics.It's probably a Falungong site. But there is an interesting article that claims that Jiang Zemin will step down from the Central Military Commission at the Third Plenum this month. I frankly find this unlikely since Hu Jintao failed to unseat Huang Ju during the Shanghai investigations. The article did cite one piece of intriguing evidence. During the national day celebrations, Hu Jintao talked about the Three Representatives on a speech on September 29th to the Politburo, but did not mention it on the September 30th speech to propaganda cadres. That is just weird. Maybe this website has some special connection. We will see soon enough.

Kunchin Lin has agreed to be named in these discussions (thank you KC). He recently sent me this question:

Yeah, well, we know that "intra-party democracy" is
likely a means to the end of political struggle
between Hu and Jiang. So Victor, according to your
argument in dissertation, both Hu and Jiang are
"Party" factions that shouldn't affect banking
decisions and main policy
(decentralization-recentralization) directions right?

and my answer was:

Okay, I know I am not supposed to make exceptions to an argument, but here I am. I think that on average, there are these two tendencies in the Party with respect to monetary policies. But things go a bit crazy when there is intense factional struggle. For example, when Deng was fighting Hua, he cooperated with Chen Yun until Hua was completely defeated. Then, Deng and Chen returned to their fight over monetary centralization. I think the intense struggle between Hu and Jiang now is causing the formation of another temporary alliance between Hu and Wen. In these sorts of alliance, the Party leader basically receives political support from the technocrat in exchange for support for more centralization policies. My prediction is that once Jiang (or Hu) is defeated, there will be more tension between Wen and the survivor on the Party side.

Some general discussion:

It is not surprising that China has not carried out banking reform. No sane politician in that position would. Why change anything if there is so much money to go around. A prime case of this under very different institutional conditions is Japan. I only raise it as a puzzle in this dissertation to contrast against the whole Naughton optimism and the prevailing wisdom that insulated bureaucrats would automatically carry out reform. I also think you are on to something by comparing "money rent" with "oil rent." In a way, both are sort of "natural endowments," if you assume that savings rate is given by nature rather than by policies. Also, like an oil state, the banking system is really used to distribute rent to officials at every level to maintain their loyalty. This is why corruption in the grain procurement system is rarely investigated.

Your question of what would happen if savings somehow collapse is very intriguing. First, if China run into an Argentinean situation, its monetary sovereignty will be taken away by the IMF. China knows this, and it is partially motivating it to carry out incremental reforms. If an IMF takeover occurs, I think actually the Party people and the bureaucrats will unite to try to regain control of the banks. Both sides gain enormous amount of rent under the current system, although now the central bureaucrats benefit a bit more. I think they can solve the collective action problem in this case. Besides, if the IMF takes over the financial system, the CCP is in a world of trouble. It will have to stop subsidizing SOEs, agricultural procurement (which really is a way to subsidize rural cadres), and major construction projects, all of which distribute rent to CCP cadres. Without this rent, there is really no incentive for local officials to stay loyal to the Party.

I would not disagree with your point about 1994. I didn't have very good material for what happened in 1994, and I look forward to reading your perspective on it. My point is simply that Zhu probably established himself as a credible politician in that period, whereas he was just a technocrat before that point. This does not mean that he was omnipotent after that. He made many compromises in 1994 in order to push through the tax reform, which faced fierce opposition in many quarters. I think there will have to be a much deeper account of what happened in that year when the sources become available.

My comment on 4/3/03 when there was intense discussion on the possible formation of the Central Banking Regulatory Commission:

My point about Zhou is that he would prefer not to split the power of the
PBOC, as he is now Governor. In fact, the PBOC and the the nascent CBRC
people are still fighting over who will control various piece. One item
of contention is whether trust and investment companies should fall under
the supervision of the CBRC or the PBOC.

CBRC has an advantage in that the party secretary, Yan Haiwang, is a
close protege of Wen Jiabao. Part of the reason why CBRC was created in
the first place was to give Yan a firmer institutional power base. The
old CFWC, which will soon be abolished, only shared appointment power with
the Organization Department, and had little formal power otherwise. CBRC
will firmly place supervision power in the hands of Yan Haiwang.

I think CBRC will have similar bureaucratic status as CSRC and CIRC.

More discussion on the nature of elite politics:

I also played with institutional ideas (of course,
that's what american political scientists do first), but the case of Zhao
Ziyang really argues against that. Even after he became Premier,
nominally the head of the State Council, he continued to champion the
cause of the local government and not speaking that much "Beijing hua."
The other interesting case is Jiang Zemin, who behaved like a central
bureaucrat before 1992. He later learned the trick and played to the
provinces. It is not clear whether he became more supportive of the
provinces because of his position or because he gained many followers in
teh provinces.

As for your second point, I agree that that investment hunger is always
there, and the central government was perfectly willing to waste money on
construction and large SOEs. However, it made a difference whether the
central government or the local government controlled financial policies.
When local government had it, they competed with each other to expand
money supply (similar logic as sending up "satellites" during the Great
Leap), which caused inflation. The central planners still waste money,
but they solve the collective action problem and can control money supply
expansion.

My discussion with a CCP insider about whether there were two different types of officials in the CCP: Party cadres and central bureaucrats:

I would be interested in hearing what you mean by "deeper reason" for why
HU and Zhao favored the provinces more. INthe case of Zhao, I think he was
also trying to curry favor with Deng by giving money to Yang
Shangkun's province. Hu was known to travel to provinces and give them
various benefits. In fact, that was one of the complaints against him,
that he often intervened in economic affairs. I would be interested in
hearing why you think those two favored the local level so much.

As for Chen Yun, he did in fact have proteges at the provinces, in Jiangsu
and Shanghai. Li Zemin, the party secretary of Jiangsu for a long time,
was Chen's close follower, as was Jiang Zemin. However, there was no
clear indication that Chen did them any major favor in terms of more
investment, at least not to the extent that Zhao and Hu did. The fact
that Shanghai and Jiangsu got much less loans than Guangdong did during
the 80s attests to that. I also ran a regression and found that members
of the bureaucratic factions tend to give no favors to their followers in
the provinces.

My comment on 3/6/03 when we found out that the SETC was disbanded:

Wow, huge. I can't believe they will downgrade SETC just like that. They
keep saying that reform is for efficiency, but getting rid of their
rivals' powerbase is closer to the truth, at least this time. Well, Zeng
Peiyan won in a big way in consolidating huge amount of power in his hand.
My question is: The Asset Management Commission will draw cadres from
which existing organizations? I suppose many SETC cadres will end up in
SAMC, e.g. LI Rongrong (?), but quite a few MOF officials will end up in
SAMC as well. Also, will they manage the banks, as well as normal SOEs?

There are both up and down sides to giving SOE management power to SAMC.
Currently, MOF cares only about how much money SOEs give to the MOF every
year, so it hounds SOEs for money allthe time. THis is a problem with
banks, which would rather use the money to write off loans. BUt, SAMC will
presumably have an ambiguous mission of getting a return from SOEs and
making them viable in the long-term. If they honestly carry out their
mission, that would be fine, but the mission for "long-term viability"
will create room for rent-seeking, much aswhat the SETC did in the past
administration. Oh well, what can you do; it's China.