Monday, October 26, 2009

Why China Isn't Ready to Lead

Dear all, my WSJ op ed from last Friday in case some of you missed it. This is not a criticism of the IMF for restructuring, but just a commentary on the irony of it all.

Property rights and contracts are still subordinate to the Party's interests.


In an era when the most developed economies are running record fiscal deficits, it is reasonable to look for new global economic leadership. Gauging solely by officially reported deficits and cash reserves, China seems an ideal candidate. Indeed, a senior International Monetary Fund bureaucrat revealed Saturday in Beijing that China may soon become the second-largest shareholder in the organization after internal restructuring.

But leadership does not depend on cash reserves alone. To lay credible claim to a bigger global role, Beijing must show it understands the rules that make a modern economy work and how to play by them. The economic downturn has only shown how far behind Beijing is in this regard. China's market institutions clearly lag those in more advanced Asian and Western countries. Parts of the government continue to blatantly disregard property rights and contracts. Rules are conveniently bent to favor powerful state entities.

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David Klein

The greatest victims of the government's disregard for property rights and contracts are domestic private entrepreneurs. Recent months saw the forced nationalization and mergers of hundreds of privately leased or owned coal mines. With the issuance of a few decrees from Beijing, domestic investors who plowed their own savings into mining lost billions. Similar examples abound in other sectors, as state agencies try to alleviate a growing overcapacity problem by forcing private firms to sell out to state-owned competitors at state-mandated prices. Because the legal system and state agencies all stand on the side of state firms, private firms have little recourse to oppose government takeovers.

Foreign investors, who used to enjoy some protection from state predatory behavior, have also fallen victim to this in the downturn. To lessen the losses of state-owned enterprises (SOEs) that entered into money-losing derivatives contracts with offshore counterparties, the State Asset Supervision and Administration Commission, the regulator for state firms, indicated to stunned bankers in Hong Kong in early September that these SOEs may not honor their contracts because the Commission never granted some SOEs the permission to enter into derivatives contracts. Not wanting to anger the government, foreign banks are now leaning toward arbitration, but a sour taste has been left in their mouths.

In a similar case, foreign investors in China's enormous distressed-asset market were surprised by a July decision by the Supreme People's Court that foreign investors who had legally purchased a nonperforming loan cannot obtain the collateral that the original guarantor pledged to a loan without the guarantor's permission and without the approval of the local foreign-exchange authorities. This decision makes it very difficult for foreign investors in distressed assets to collect on collateral that is legally bound to a given loan without surmounting numerous legal and bureaucratic hurdles.

This ruling shows China's lack of preparation even more clearly than the reneged derivatives deals. Foreign investors in distressed loans were invited by the government in the early 2000s to help digest more than 1.4 trillion yuan ($205 billion) in nonperforming loans. These investors have helped China rescue billions in distressed assets, rehabilitating many into profitable businesses. But when a well-connected state firm, Chongqing Yi De Industrial, appealed the Supreme People's Court to overturn an earlier decision in favor of the foreign creditor, the judges went against elements of its earlier rulings and ruled in favor of Yi De Industrial in July. The legal system's usual bias toward connected insiders once again seemed to have determined the outcome.

In all these examples, the Chinese government could have chosen to show the world it is willing to respect property rights, enforce contracts fairly and discipline firms that violate the rules regardless of their political connections. Instead rules were disregarded to maintain the facade of relative budgetary balance and SOE profitability, and connected insiders and large SOEs with political influence were once again told that they need not adhere to contracts. Private entrepreneurs and outsiders were reminded that the law means little without political backing.

Chinese decision makers need to realize that global economic leadership does not stem only from a large cash hoard. In the long run, a credible respect for property rights and unbiased contract enforcement will draw a larger share of global investors into the Chinese economic sphere. Until such a day arrives, China's economy will tend to attract connected rent seekers who profit from the government's willingness to bend the rules.

Mr. Shih is assistant professor of political science at Northwestern University and the author of "Factions and Finance in China: Elite Conflict and Inflation" (Cambridge University Press, 2008).

Sounds a lot like America, cf. Chrysler and GM, eminent domain and sports stadiums etc.
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