The Reality Behind China’s Economic ‘Miracle’ (Part I)
Section 1: State-Owned EnterprisesSection 2: Stock Market- The ATM Machine for State Enterprises
‘Fool and Swindle the Investors’
A Market That Does Not Pay
Big Losses for Ordinary Investors
- The Party’ Land Policy
The Grand Land Grab
Violence Erupts as Farmers Evicted
Self-Immolation Protests
Meager Compensation
Section 1: State-Owned Enterprises
Unprofitable SOEs
China’s industrial structure took shape in the 1950s, based on a large-scale aid program from the Soviet Union. The Soviet model was characterized by a system of State Owned Enterprises (SOEs) in key sectors. Inefficient and still pervasive today, SOEs have been the founding components of the Chinese economy.In a one-party system, the Communist Party must control the nation’s economic lifelines, and that includes the SOEs. The management of these enterprises freely administer the state’s assets, while taking no responsibilities for their losses. The senior executives only need please their superiors who appointed them.
In December 1978, when reformers led by Deng Xiaoping launched the “Reform and Opening Up” program (改革开放), the state made some efforts to reform the SOEs. For example, it expanded the autonomy of SOE business operations, such as making production plans. It abandoned the practice of requiring the SOEs to disperse all their profits and instead began to collect income taxes. The objective was to incentivize the SOEs by allowing the retention of a certain portion of the profits. It also started to implement an accountability system that made the executives responsible for SOE profitability.
Jiang’s SOE ‘Reforms’
A new campaign to “restructure” the SOEs was mounted.Thus, officials were provided the perfect subterfuge to gobble up the state assets under the banner of “restructuring the SOEs.” Amid the process, the communist cadres used various types of chicanery to “optimize” the structure of state-owned assets or conduct “strategic restructuring” of the SOEs. Using the modern terms of “redefine,” “transfer,” “reorganize,” and “redeem,” they had found the pathway to making themselves very rich.
In November 1999 and January 2000, the city government issued two documents (no. 29 and no. 3 documents) to accelerate the SOE reform. Between April and May of 2000, the city’s three leading companies, which we will call company X (Hunan Xiangjiang Paint Group Co., Ltd.), company T (Changsha Tongda Co., Ltd.), and company H (Hunan Friendship & Apollo Co., Ltd.), sped through the process. Note that it was not necessary for these three companies to be “reformed,” as they were quite profitable industry leaders and did not belong in the group of underperforming SOEs.
A critical aspect is the “redefinition” of property rights, or the ownership of the assets. The financial statements at the end of 1999 showed that each of three companies’ total assets went well above 100 million yuan (U.S. $12 million). However, the no. 3 document provided that the company’s net assets by the end of 1983, plus the newly formed assets from funds earmarked by the state since Jan. 1, 1984, were defined as state assets, while all the properties accumulated by the company’s profits (after taxes) and other assets after Jan. 1, 1984 were redefined as the company’s private property. After this “redefinition,” state capital of company X as a share of the total assets, for example, immediately fell from 100 percent to 20.5 percent. Company X’s new total capital was about 70 million yuan (U.S. $8.5 million), among which the state capital took up only 15 million yuan (U.S. $1.8 million). Moreover, the policy allowed a 50 percent discount for a one-time buyout of the state assets. After Company X spent 5 million yuan (U.S. $0.6 million) to buy out the 10 million yuan (U.S. $1.2 million) state capital, only 5 million yuan (U.S. $0.6 million) of state capital was left, or 6 percent of the total shares. Among the rest of the shares, 14 percent went to other social organizations, also known as legal persons, and 80 percent went to individual employees. This “redefinition” ended up shrinking the size of state assets from above 100 million yuan to only 5 million, that is, more than a 95 percent reduction.
The next step was to assign the individual employees’ shares to individuals. The official policy again kicked in. Both no. 29 and no. 3 documents made provisions so that the composition of the shares should tilt toward the management and executives, enabling them to hold large numbers of the shares; policy also opposed equality of shares held by the employees. The policy encouraged the representatives of the legal person of the enterprise (usually top executives) to buy out the shares. They can pay back within three to five years (i.e., with future dividends). Or use bank short-term loans to pay for the shares. As a result, the leadership personnel of the three companies all got relatively big chunks of the shares. For example, general manager Wu of company X received one million shares (1 share is priced at 1 yuan a share). And then by a 1 to 1.88 stock split ratio, Wu got 2.88 million shares in total, much more than the average employee.
There were several problems with this “reform” process.
First, the massive undervaluation of state or public assets was even more extreme than in Russia and Eastern Europe during their period of privatization. During the very controversial Russian privatization in the 1990s, one option required that management and workers be allowed to buy no more than 51 percent of their enterprise at discounted prices. In Czechoslovakia, a more equitable method of voucher privatization was adopted, whereby citizens were given or could inexpensively buy a book of vouchers that represented potential shares in any state-owned company. In the case of company X in Changsha, 80 percent of the state assets were conveniently “redefined,” as collectively owned by the management and employees, and even lacked any provision to pay something for the assets.
Second, the management acquired the lion’s share of the company. Before the “reform,” senior management was appointed by the superior bureaucracy, and the appointments were usually unrelated to their performance. On the contrary, it was usually because they did a poor job in running the company that reform was needed. When a manager received one hundred times more shares than an ordinary employee, usually without having to purchase anything or at an artificially low price, the huge issue of fairness emerged. In addition, the policies established the wrong incentive mechanism: rewarding windfalls for bad performances. Today’s China is known for many people awash with money shopping around the world. Actually, perhaps this was how they got their first fortune.
Third, and most important of all, through the “redefinition” and giving away large numbers of shares to the management, what amounted to fraud was made legitimate and promoted by government policy. In the case of Changsha, we see clearly that it was the city government’s official documents that laid out the detailed instructions for legal appropriation of assets. Since 1995, such practices swept across the nation, as management and local officials seized on opportunities to make huge personal gains. As it was Jiang’s policy that legitimized the theft of state assets on a massive scale, the damage was much more serious and widespread than other means of corruption, which normally would lack the official sponsorship of the state.
Fourth, bringing about the right conditions for a market economy could not occur afterwards. Privatization is usually part of economic reform process that transitions into a market economy, so that the resources that fall into private hands can be put to the best use under market mechanisms. However, after the “reform” of SOEs in China, even till today, the Chinese economy is still largely a command economy by the government. Although the state enterprises are as small as one-third of the national economy, they dominate all the key industries: banking, transportation, manufacturing, and telecommunication. Private enterprises cannot borrow in the same way, if at all, what is available to the state giants. Entrepreneurship and individual creativity are severally disadvantaged in many areas, compared to the SOEs.
At the same time, the SOEs Cheng sold did not end well. Three SOEs—a pharmaceutical company, a knitting mill, and a shoe factory—were sold to Hong Kong investor Xiao Wande under the stipulation that Xiao retires the debts of the companies within a few years. After Xiao took over, he not only did not pay off the debts, but also sold the machinery and equipment and transferred the revenues to his personal accounts. Xiao was later arrested for letter of credit fraud. Many of the former employees were laid off and living on public assistance.
Earlier on, between 2003 and 2006, Wang deposited 7.03 million yuan (U.S. $0.9 million) of sales revenue into the company’s off-book account. Over the years, Wang took home 4.82 million yuan (U.S. $0.6 million). When Beijing Sanjiu Automotive Industrial Co was to be sold in 2006, these funds that Wang had siphoned off were concealed and not reported for audit. He wrote in a notebook: “Set up a few companies, and play with them using public funds. If I make money, the profit goes to me; if I lose money, let the state bear it. Everyone is doing this.”
Private Business Owners Join the Party
At the party’s 80th anniversary celebration on July 1, 2001, Jiang Zemin declared that the party should formally accept private business owners. Later that year, the party’s constitution was modified to allow businessmen to join the party. Jiang’s announcement at the height of privatization of SOEs encouraged party members to become private business owners, while showing approval for those who had gone into business. Actually, heads of SOEs and private business owners have been a major part of the richest people in China. According to a report published in 2001, one-third of China’s wealthiest people were heads of SOEs or private business owners.[5]Section 2: Stock Market
The ATM Machine for State Enterprises
China’s stock market is still dominated by state-owned enterprises. By the end of 2008, there were 1,540 non-financial corporations listed on Shanghai and Shenzhen stock exchanges, 604 or 39 percent of which were private companies, and 936 or 61 percent were state enterprises. At first glance, it appears that Chinese capital market gave the private entrepreneurs a fair share. Nearly two-fifths of the listed companies were privately owned. However, the number of companies does not tell the whole story. If we look at the eight years between 2000 and 2008, the revenue brought in by private companies listed on the China stock market was only 10 percent of the total earnings of the listed companies. The state still controlled the lion’s share of the capital market.There is a good explanation for why the state is very involved with the stock exchanges.
In September 1997, the Chinese Communist Party made it a priority to rescue the state-owned enterprises, many of which were almost bankrupt. The avowed goal was to help large and middle-sized state enterprises, operating at a loss, turn themselves around within three years. It was hoped that via reform and restructuring, these state entities would transition into modern efficient enterprises by the end of 2000.
At that time, the foremost task for Chinese stock exchanges was to provide a source of cash for state enterprises. Many ill-performing companies were packaged and listed on Shanghai or Shenzhen stock exchanges. As the amount of bad loans of those companies was too high for the state banks to cover, using stock markets to dupe ordinary stock investors became an alternative source of cash to pay down the state enterprise debts.
Guided by government policy, the state enterprises made the Chinese stock market perform like an ATM machine. The state regulators often controlled the number of the initial public offerings (IPO) of the state companies and created a shortage of stocks, so that the newly listed companies could issue stocks at a high premium. During that period, the stock market had become a finance channel for the state enterprises. The interests of millions of small investors were ignored and unprotected.
In addition, the stock market was also a money-laundering machine for the senior executives of SOEs to turn their stock holdings into cash. Due to China’s SOE “reform” policies, large numbers of the companies’ shares ended up owned by the management. These people had been holding the stock shares going back to the 1990s.
‘Fool and Swindle the Investors’
At a seminar in May 2012, Guo Shuqing, chair of China’s Securities Regulatory Commission (CSRC)—the state agency overseeing the Chinese stock market, expressed his wish for Chinese security firms. “The industry ought to toughen self-discipline, taking the most stringent measures to build up integrity, sense of accountability, and the rule of law.” Guo reminded the securities firms that “gone are the days when you fooled and swindled the investors.”[11]Guo’s words revealed a secret: the Chinese stock market had been “fooling and swindling the investors.”
By the end of 2015, there were about 2,800 companies listed on Chinese stock markets.
- Underreporting bank loan balances
- Creating non-existent or fictitious shell companies with no verifiable revenue to appear as customers
- Creating fictitious shell companies with no verifiable revenue to appear as suppliers
- Underreporting insider transactions and money transfers
- Using insider trading that is never disclosed
- Indulging in pump and dump schemes
- Stealing company’s assets by transferring to insiders leaving the shareholders with an empty shell company owning no assets
- Forging employee numbers
- Making fictitious buyout offers
- Using the company’s cash to secure the debt of companies privately owned by insiders
- Posting fake cash and fake revenue in financial statements
- Collaborating with local bank officials in China to inflate profit margins
In April 2014, CSRC issued a notice of administrative punishment of Nantex, with recognition that Nantex faked profits for five consecutive years from 2006 to 2010, with inflated profits of over 300 million yuan (U.S. $44.9 million). What made the Nantex case stand out is the fact that the actual controller of Nantex is the State-owned Assets Supervision and Administration Commission (SASAC) of Nanjing, which as stated earlier, is the government agency overseeing and managing state-owned enterprises.
Nantex’s accounting fraud involved fictitious transactions, underreporting operation costs, and underreporting bad debt reserves. It was also deceptive on its export rebates and deferred tax assets.
According to CSRC’s investigation, in each of the five years between 2006 and 2010, Nantex forged fictitious profits of 31 million yuan (U.S. $4.6 million), 42.2 million yuan (U.S. $6.3 million), 152 million yuan (U.S. $22.8 million), 60.5 million yuan (U.S. $9.1 million), and 58.6 million yuan (U.S. $8.8 million) respectively. In 2010, the inflated profit was 5,590 percent of its actual profit. At the end of 2010, due to underreporting of operation costs, Nantex overstated its profit as 42.9 million yuan (U.S. $6.4 million). Nantex also underreported bad debt reserves and exaggerated profits of 24.4 million yuan (U.S. $3.7 million). In its 2011 annual report, Nantex claimed the amount of tax rebates of 11 million yuan (U.S. $1.7 million) that did not meet the conditions of export tax rebate.
China’s stock market fraud has a long history, dating all the way back to 1990, when the Shanghai Stock Exchange and Shenzhen Stock Exchange first opened. Right from the outset they served the purpose for listed companies that needed capital. In order for the stock issuers to successfully raise money, the approving authorities are commonly acquiescent toward the malpractices and shortcomings of the listed companies. Their negligence is even evident in the applicable laws. For example, article 189 of China’s Securities Law states:
“Where an issuer fails to meet the requirements of issuance and has its issuance approved by any fraudulent means, if the securities haven’t been issued, the issuer is subject to a fine between 300,000 yuan and 600,000 yuan; if the securities have been issued, the issuer is subject to a fine between 1 percent and 5 percent of the illegally raised proceeds. The person-in-charge and other personnel directly responsible are subject to a fine between 30,000 yuan and 300,000 yuan.”
The penalty for stock fraud is only a fine up to 5 percent of the money raised, which is even less than the interest rates of some banks. The low cost of violation induces, instead of preventing, illegal practices. In the case of Nantex, which faked an inflated profit of over 300 million yuan (U.S. $44.9 million), the company was levied a fine of only 500,000 yuan (U.S. $74,900). Executives and involved personnel were each fined between 30,000 yuan (U.S. $4,500) and 300,000 yuan (U.S. $45,000). Nantex still went on as a listed company and continued to raise money from the public.
In comparison with the U.S. regarding the penalties for fraudulent financial activity in public companies, the Sarbanes-Oxley Act, passed in 2002, sets forth in Sarbanes-Oxley Section 906, that if management engages in fraudulent statements regarding the company’s finances, they can be fined up to $5 million and imprisoned up to 20 years. Congress passed this law in response to major corporate misleading financial disclosures, such as the Enron and WorldCom scandals. Soon after, many countries passed similar laws, including Canada, Germany, South Africa, Japan, France, Italy, Israel, Australia, India, and Turkey, according to the Wikipedia.
Hopefully, some day in the near future, China will have its own version of a Sarbanes-Oxley Act that will ensure truthful financial statements to potential investors. It will also have some entity comparable to the U.S. Securities and Exchange Commission (SEC), which proposes, regulates, and enforces securities rules that protect investors. Meanwhile, the reputation of Chinese companies in the overseas stock markets is that they are notorious as scammers.
In January 2013, ABC News’ “Nightline” program reported cases of scams of Chinese companies listed in U.S. stock exchanges. The ABC News investigation found that “more than 100 China-based companies have now been delisted, have left the NASDAQ and New York stock exchanges, have been denied listing, or have withdrawn applications, all following allegations of fraud or accounting irregularities.” “… But experts estimate that Americans—everyone from small investors to hedge-fund titans—have lost tens of billions of dollars in the suspect Chinese investments.”
A Market That Does Not Pay
All the players in China’s stock markets, except the investors, take full advantage of their positions, as the rules and enforcement are quite feeble. The issuers offer the stock at a high price. The underwriters, who are rewarded by the price difference between the price they pay the issuer and what they collect from investors, also usually overprice the stocks. Quite often, underwriters directly act as the shareholder of the issuer. It is the public investors whose interests remain unprotected, especially in investments with low or no dividend payments.Some companies did pay dividends, but the amount hardly compensates the investor in the Chinese stock markets. For example, in 2009, state giant PetroChina paid a pre-tax dividend of 15 Chinese cents (US 2.25 cents) per its stock share, whose price was 16.7 yuan (U.S. $2.51) at the time. The calculated rate of return of 0.898 percent was even lower than the bank interest rate.
According to statistics from Wind, a China-based financial data provider, from 1990 to 2010, Chinese A-shares—shares in mainland China-based companies that trade on Chinese stock exchanges, such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange—raised over 4.3 trillion yuan (U.S. $625 billion). The amount of dividends paid during the period was 1.8 trillion yuan (U.S. $270 billion). As the ordinary investors held less than 30 percent of the total shares, the dividends paid to them was 540 billion yuan (U.S. $81 billion). In another words, the Chinese public investors put 4.3 trillion yuan of money into stock shares, but received a dividend of only 0.54 trillion (or 540 billion) yuan over the course of 21 years. The rate of return was only 13 percent over 21 years or an APR of 0.6 percent. This is far below the compound interest rate of depositing money in an ordinary bank.
Big Losses for Ordinary Investors
Since 1992, China’s stock markets have experienced more than ten rounds of big swings. Among Chinese stock investors, losers were much more frequent than winners. The following is the performance of Chinese stock investors since 2008.[16]The 2008 A-share market was historic with a decline of over 70 percent. Shanghai Securities News conducted a 2008 survey of status of stock investors, with 25,110 investors nationwide participating. The survey showed that more than 90 percent of the investors incurred losses, and 60 percent suffered a loss of over 70 percent in the stock market. At the time of the survey, only 6 percent of the interviewees said their investments were profitable.
A Sina.com investigation, “Chinese stock investors incurred massive losses in 2013,” stated that about 65 percent of the investors were losing money in that year. Among them, 26.3 percent suffered a loss between 20 percent and 50 percent, 7.5 percent were hit hard with losses up to 80 percent. Bad stock market outcomes caused 32.2 percent of the investors to have a significantly lower living standard.
Section 3: Land Seizures, Demolitions, & Evictions
The Party’s Land Policy
In western countries, most of the land is privately owned. Additionally, the owner of a piece of land is also the owner of any construction built on the land. In communist China, the land belongs to the state. Someone owning a house cannot own the land underneath. You may be able to lease the land (typically, 70 years for residential properties), but after the period expires, the government may elect to not lease it again to you.This land tenure arrangement, however, was not always the case throughout the history of the Chinese Communist Party.
During the civil war with the Nationalists in the 1940s, the CCP forcefully seized the land from landowners and gave it to millions of landless peasants. The process was often bloody as the Party mobilized the poor peasants to kill the landowners. It provided a huge incentive for the peasants to join the Party’s armed forces to fight against the Nationalists and helped the Party win the war.
The Grand Land Grab
After the 1989 Tiananmen massacre, the Party had to resort to economic development to woo the Chinese people. In 1992, Deng Xiaoping took trips to a few southern cities to push China into a new round of economic growth. The massive expelling of farmers from their land started there.Initially, the seized land was used to build industrial parks in coastal cities so as to attract foreign investments. At the end of 1992, these parks numbered as many as 2,000, and jumped to over 6,000 in 1993. According to the Ministry of Agriculture, most of the land used for development was originally arable land.
In 1994, the party pushed forward a fiscal reform to re-divide the tax revenue between the central government and local governments so as to save the central government from fiscal crisis. Immediately the central government experienced a twofold revenue increase, while the local governments began to feel the pinch. As a result, the latter turned to leasing out the state-owned lands to use the proceeds as a revenue source.
The land lease fees as the means of local government finance brought in a multitude of benefits. First, the income went directly to the local government. Another benefit is that It entailed little cost. Normally, the cost of demolition of existing construction was low. The waves of development of real estate would boost local GDP as well as enhance officials’ resumes.
Leasing the land also provided ample opportunities for corruption.
The land grab mania immediately spiraled out of control, with its size and speed endangering the nation’s agriculture sector. The central government had to issue directives in 1997 and 1998 to freeze the use of arable lands for non-agricultural purposes. However, the restriction was shortly lifted to mitigate the economic slowdown, and the mania went on.
Along the way, the idea of industrial parks was replaced by the grander scheme of building new cities. This was the time during which China’s urbanization process experienced a transition from natural socioeconomic development to deliberately planned projects. The number of local governments’ proposals to build “international metropolitan” cities rose from 78 in 1998 to 182 in 2003. In 2008, when the 4 trillion yuan stimulus package was injected into the economy to fend off the global financial crisis, the urbanization process as a national strategy was pushed forward to a new high. 24 among the 32 provincial capital cities planned to build cities between 2014 and 2020, with a total planned area of 4,600 square kilometers. For example, Shenyang planned to build eight new districts, and Guangzhou to build nine. Not only large cities, but also hundreds of smaller cities did the same.
Within less than a quarter of the century, the Chinese authorities had enclosed 83 million mu (13.7 million acres) of arable land, expelled 127 million farmers, and eliminated at least 1.4 million villages.
Violence Erupts as Farmers Evicted
As the constitution ended private land ownership, Chinese farmers were in a weak position to refuse the land grabs from the local government. They may have tilled the land, but had no rights to own, buy, or sell the land. If someone dared to defend his dwelling on top of the land, what awaited him was usually organized violence.Land requisition was usually announced unilaterally and on short notice, without a basic consultation process. It was mandatory, and didn’t need to be agreed upon by the villagers. The only available option for the farmers was asking for as much compensation as possible; expressing opinions against the land requisition or demolition had no legal standing. The time limit was usually short: the demolition must be completed or enforced before a given date.
Coercion and violence came in a wide range of formats. The whole gamut of local judicial authorities—police, courts, and procuratorates—were mobilized and involved. Interrupting farmers by cutting off water and electricity, and blocking roads were typical tactics. Charges such as “impeding the performance of official duties,” “disturbing social order,” and “blocking construction projects” were reasons used for arrests or detentions. Sometimes, previous misdeeds such as business operations without a license, tax evasion, or even “violation of family planning,” would be dredged up as a means of forcing acquiescence.
Self-Immolation Protests
To protest the land seizures, some people chose an extreme form: self-immolation.At the time, the cases of Wen and Zhu shocked the whole nation, but failed to halt the desperation and violence resulting from China’s grand land grab. The self-immolators served as a model to copy. In 21st century China, the frequency count of farmer self-immolations to express the ultimate despair have exceeded any period in its history.
Undaunted, government officials continued their land seizures, demolitions, evictions, and unjust profit-taking.
Meager Compensation
The current Chinese law allows the compensation to range from 16 to 30 times the value of agricultural proceeds from the land. For example, if we assume 1,000 yuan (U.S. $151.9) worth of agricultural products per mu (one mu equals to 7,180 square feet) of land, the compensation can only run as high as 30,000 yuan (U.S. $4,557) per mu.According to statistics, since 1998, various types of compensation to farmers added up to 12,164 yuan (U.S. $1,848) per mu, or U.S. $0.25 per square foot, in addition to resettlement subsidies of 2,344 yuan (U.S. $356) per person. The typical land compensation to a farmer is about one or two years’ total income of an ordinary civil servant in China. In another estimate, the compensation and resettlement measures at the highest standards was only 18,000 yuan (U.S. $2,733) per person, only 1.5 times of an average urban residents’ disposable income in 2012.
In contrast to the meager compensation to the farmer or resident, the revenue gained from being replaced was worth much more. Due to the different purpose of the usage, revenue from the development of the land can differ widely. Gains from land used for industrial development can be worth hundreds of times more than agriculture production; gains from using the land for the tertiary sector development can be even worth thousands of times more.
Even with such a low standard of compensation and resettlement, the farmers were usually not able to get the full amount, often due to layers of complex rules of different level administrative authorities. The main reason for the massive number of petitions in modern day China is land-related, often attributable to local governments that withheld, deducted, and misappropriated land acquisition and resettlement compensation.
