Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise

Q & A with the authors of Red Capitalism, Revised edition

Red Capitalism was recently named one of The Economist's books of the year. Have you been surprised by the success of the book?
Yes. We knew the story of bank reform and the larger picture it painted about how China is run was an important story but we were very surprised by how well received it was. We were able to give a narrative to the reform program in China which people could understand just as China was starting to suffer from and appreciate the impact of its huge stimulus program which it launched in response to the collapse of the global economy in 2008.

Since publication what are the most notable changes you have seen in the China market?
The most notable change is the attitude and sentiment of foreign investors and commentators. A few years ago the sentiment towards China was very positive. The large stimulus plan was seen as huge positive for China and those urging caution were lone voices. Now the sentiment has shifted significantly. The weakness of the banking system is much better understood as is the huge amount of debt that has been built up over the past few years in the pursuit of high growth rates. This change of sentiment is clearly shown by the stock prices with all the Chinese bank stocks falling significantly in 2011.

What was wrong with the stimulus program? Didn't it produce economic growth?
In late 2008 as the global economy collapsed Chinese companies had to lay off workers, and lots of them. It was reported that 20 million workers were laid off in the export sector as demand for Chinese exports collapsed. In response to that the Chinese leaders turned on the credit taps via the banks and flooded the economy with money. Local governments were encouraged to get people working and a vast amount of that money went into infrastructure projects: roads, office blocks, sports stadiums and such like. The local government couldn't borrow directly from the banks so they set up Local Government Financing Vehicles, LGFVs, to borrow on their behalf. These LGFVs entities have borrowed at least 11 trillion RMB and many of the projects they built are not economically viable i.e. they won't produce any revenue. The net result is that growth initially came through the construction but now that the loans are coming due there is no revenue to pay the debts off! The stimulus wasn't wrong; it just was that much of the funds went into projects which could never pay back the loans needed to build them.

But even if China has wasted some of the stimulus isn't China a rich country now? Surely they can use part of their 3 trillion US$ of foreign reserves to pay down these debts?
China is still in many ways a poor country and can't afford to waste much of its hard earned wealth on bailing out its banks or building worthless infrastructure or vanity projects. Money that is spent on wasted projects is money that can't build schools or hospitals. The bank bailout of a decade ago has still not been fully accounted for and yet a new bad debt crisis is brewing. The foreign reserves give a false appearance of wealth. They are very important for a large trading economy which China is to facilitate trade but they cannot be used or brought back to China without stoking inflation pressures.

What must China do to avoid bad debt problems in the future?
The first step has to be to better price money. Basically savers in China get very low interest rates and the large State owned enterprise get cheap credit which is then used on unproductive projects. The hard working China saver is paying for the mismanagement of the State owned enterprises. But changing this system is very tough. It would mean the government can no longer set interest rates, it would ideally mean that capital controls are also substantially loosened and that State owned enterprises are no longer guaranteed access to cheap funding. Changing any of these things would be a bold step for the government and given the cautious nature of political decisions in China this will take a very long time to do. Until then China's economy will boom and bust but with Chinese characteristics!

2012 will see a change in the leadership of China, will new leaders help re-start reform?
Nothing can be ruled out but many of the problems within China cannot be solved with a simple change of faces. Many of the problems are structural and there are now so many powerful and politically connected players whose primary goal is to maintain the status quo that even the strongest of reformers will struggle to bring real change. Even if reformers gain the upper hand the global environment will be very tough for the next few years which will encourage a very cautious approach from China.