The Capital Market in China : A 60-Year Review [1 ed.] 9781623200596, 9781623200046

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Contents Chapter 14 Asset Securitization: A Treasury of Investment Banks

Chapter 15 Futures Markets Chapter 16 The Investment Banking Mentality and Capital Operation at Investment Banks

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47

Chapter 17 Time-Space Compression Leads to the Urban Era: Capital Accumulation and the Urban Economy

101

Chapter 18 Financial Globalization: Opportunities and Challenges for the Renminbi as a Global Currency

139

Chapter 19 Socialist Workers and Capital

183

Notes

227

References

231

Index

245

14

Chapter

Asset Securitization: A Treasury of Investment Banks

The Capital Market in China: A 60-Year Review Volume 3

Prologue: The Origin of U.S. Mortgage-Backed Securities and Lewis S. Ranieri The earliest asset securitization originated from mortgage-backed securities (MBSs) in the United States in 1968. At that time, banks were not allowed to operate across state lines in the United States, and home mortgage loans issued by banks totally relied on the deposits of local residents and enterprises. The term of some loans was as long as 30 years, but the major source of these loans was one-year fixed deposits. For one thing, there was a discrepancy between deposit term and loan term. For another, the interest rate stayed high due to inflation while the prosperity of direct financing in the capital market diluted bank loans and deposits, and the role of banks as intermediaries was also gradually weakened. In order to get rid of the risk mismatch between “shortterm deposits and long-term loans,” banks created portfolios of home mortgage loans, on the basis of which banks issued bonds to institutional investors. Through this practice, the financing channel of banks and the liquidity of credit assets were suddenly expanded. Thus, home mortgage loans owned a secondary market and banks increased their capacity in supporting house purchasing. It was the U.S. MBSs that raised the curtain on asset securitization. Since then, all kinds of asset-backed securities and securitized derivative products and unregulated off-exchange trading came out. MBSs not only eased the liquidity crisis, but also provided a new way out for surplus capital. Human society finished its final leap of the financial revolution by moving from an age of money to an age of capital. Among the derivatives of securitization issues, the one attracting the most attention was collateralized debt obligation (CDO), which was created by bundling a batch of MBSs and also one of the “chief culprits” in this global financial crisis. Wang Zhaoyang termed CDOs as “bundled mortgage bonds” and gave a full description of the history of the packaged mortgage bonds in his article “Home Ownership for All” published in New Century. In March 2008, when talking about the global financial crisis, Nobel Prize laureate in Economics Robert Mundell included Lewis S. Ranieri in his list of the “five goats who contributed to the financial crisis of 2008,” together with former U.S. president Bill Clinton, former American International Group (AIG) head Hank Greenberg, Ben Bernanke, and Henry Paulson. The now obscure Lewis S. Ranieri was once the head of the mortgage department at Salomon Brothers in the 1970s. According to Wang Zhaoyang, the earliest version of bundled bonds dated back to 1977. And Lewis was irrefutably believed to be the founding

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father of bundled bonds. Wang Zhaoyang had taken two securities training classes of Lewis on mortgage bonds. Wang wrote in the article: In my mind, he (Lewis) did not mention much about housing and mortgage but focused on explicating the concept of “fungible.” In English, the adjective “fungible” is very rarely used, meaning repeatable, quantifiable, and substitutable. Generally speaking, families and houses cannot be easily replaced. But, every American dreams that one day he or she should and is able to own his or her own house. It can be said that housing is at the center of the American dream. In accordance with the universally applicable principle of fungibility, all collective and material dreams can be extended, combined, repeated, quantified, and exchanged. To put it simply, the brilliant concept coined by Lewis S. Ranieri means to convert the future expectation for house ownership of Americans into floating securities that can be traded in a large scale on the market. The operating principle of bundled mortgage bonds is as simple and obvious as the red suspenders Lewis likes to wear: A lends money to B and receives an IOU in return; if A lends money to 10 people at the same time, A will get 10 IOUs; based on loan terms, interest rate curve, and credit ratings, A packs the 10 IOUs into two portfolios which will be sold to bank C at a discount; then, Bank C will further group 30 portfolios (including 300 IOUs) it has gathered from different people or institutions into six series and resell these series to Citibank; Citibank will repackage those series into new bundles of IOUs with new terms before selling them to AIG; following that, those IOU packages will probably be sold to three different hedge funds. This cycle continuously repeated itself. Eventually, the subprime mortgage crisis broke out 20 years later, shaking the whole world. The so-called toxic assets which filled the accounts of transnational banks and investment funds were no other than bundled mortgage bonds, or CDOs created and promoted by Lewis. This creation was widely imitated by others later on. Unfortunately, besides the economist Robert Mundell, others rarely spoke of Lewis S. Ranieri and his prominent contribution to the financial history of human beings. But anyway, asset securitization is the most important innovation in international financial history. Asset securitization together with mutual funds constitutes two pillars in the development of the 20th century’s international capital market and fictitious economy. At present, China is at its primary stage of asset securitization and it still has a broad space for future development.

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The Capital Market in China: A 60-Year Review Volume 3

Innovations of Asset Securitization in the Capital Formation Mechanism Asset securitization usually refers to raising funds by issuing securities backed by assets in the capital market with the future cash inflows of the underlying assets as guarantees. It re-injects liquidity into assets with future income through securitization, thereby revitalizing the global financial industry and greatly enriching the capital culture. The United States started MBSs in 1968. This new type of securities played an important role in solving the liquidity crisis of residential mortgage loans and turned out to be one of the significant financial innovations in the late 20th century. Then, in the 1980s, asset-backed securities1 (ABSs) were also gradually developed. In 1985, automobile loan-backed securities began to be issued and these securities played a part in promoting the prosperity of the European and American car markets. In 1988, banks released securities backed by credit card receivables. Shortly after that, financial securities backed by student loans, leases, and business credit were launched successively in 1993, and this trend was gradually extended to the securitization of enterprise account receivables. In 1995, the International Finance Corporation (IFC) under the World Bank Group, issued USD400-million non-recourse securities, using its long-term assets in South American and other developing countries as collateral. This was application of asset securitization to large- and medium-sized capital construction projects by taking the future earnings of these projects as collateral. It immediately sped up asset liquidity while lowering financial risks and enlarging available loan volume. In particular, it should be mentioned that in the implementation of the Basel Accords in each country, financial institutions increasingly attached great importance to capital adequacy ratio (CAR) and strove to get rid of redundant assets and corresponding liabilities. This, in turn, stimulated the rapid development of asset securitization in Europe, the United States, and other Western countries. In addition, the ABS, as a new kind of financial instrument, swept over Europe and U.S. with the reputation of “silver-edged bonds,” which not only attracted a huge amount of capital, but also offered new investment opportunities. Statistics showed that the value of U.S. outstanding MBSs and ABSs was USD5.3 trillion and USD1.7 trillion, respectively. If combined, the total amount of the above two bonds could reach USD7 trillion, which accounted for 32% of the USD22-trillion U.S. debt market, surpassing treasury bonds and enterprise bonds to make the largest share in the U.S. bond market.

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In 2005, the circulation of ABSs in the U.S. exceeded USD1 trillion. The housing mortgage loans amounted to USD2.46 trillion in 2006 and USD6 trillion in 2007, equivalent to 30% of all assets (USD20 trillion) owned by commercial banks. By definition, asset securitization means to transfer assets that can generate stable future cash inflows into negotiable securities in the capital market through structural design, credit enhancement, and other technical means. Asset securitization is said to be an important innovation in the capital formation mechanism mainly because: First of all, by restructuring illiquid assets which can produce stable future cash flow, it converts these assets into securities which can be sold and circulated in the capital market. By doing so, it revitalizes frozen assets and mitigates the liquidity crisis. Next, the development of asset securitization offers a wide range of financial products and this contributes to the healthy growth of the capital market. Meanwhile, commercial banks can translate long-term stocks of credit assets into negotiable securities, thus realizing the return of commercial banks’ functions. Third, asset securitization provides an important means for solving market fragmentation and expanding the scale of the capital market. It also broadens the channels of capital formation and creates new opportunities for the integration between banks and capital markets. Through issuing securitized products, banks are able to obtain capital from the capital market. And by investing in securitized products, insurance firms, fund management companies, and other institutional investors will get their money involved in the capital market, which effectively changes the fragmented state between capital markets, and banking and insurance markets. Fourth, asset securitization disperses financial risks. The ABS is constructed based on future income streams that arise from the use of the underlying assets and adopts bankruptcy remote, credit enhancements, and many other technical means in the structural design and distribution process. It, therefore, contains relatively low risks. Moreover, through securitization, risks from bank loans will be spread and transferred to investors, and, as a result, the problem of risks being overly concentrated in the banking sector is eased. The main investors of ABS products are large-scale institutional investors, who are relatively rational in their investments. This will enable a comparatively stable secondary market for securitized products. In this way, the market of securitized products can form a large pool of funds, leading to a lowering of the average risk of the capital market and a reduction of the overall market volatility. Last, asset securitization provides a new way out for surplus capital. After

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the United States first launched MBSs, the market of securitized products grew very quickly. In 1990, the total market value of ABS and MBS surpassed that of the enterprise bond market, and then outstripped the U.S. treasury bond market in 1998. In 2003, the issue amount of U.S. ABSs and MBSs totaled USD2.72 trillion, almost equal to half of that of the debt market (USD5.67 trillion). In the U.S. asset securitization market, the MBS market was over three times the size of the ABS market. Fannie Mae and Freddie Mac, two large governmentsponsored mortgage finance lenders, offered USD4 trillion in mortgage loans which accounted for more than 75% of national individual housing loans. These two lenders were the major participants in the asset securitization market.

A Great Variety of Financial Derivatives of Asset Securitization Products The further development of asset securitization was realized by the financial innovations made by investment banks on ABS. Accordingly, a great variety of financial derivatives came into being. In this section, I will focus on CDO and credit default swap (CDS). At this point, asset securitization became a cornucopia of wealth for investment banks. The financing mechanism for those financial derivatives is: Banks will sell mortgage loans to major investment banks, and then these investment banks will form special purpose vehicles (SPVs), namely to set up new institutions with multiple housing mortgage loans as asset pools, in order to raise funds by issuing securities in the market. Consequently, mortgage lenders will no longer bear the risks from granting loans. The underlying assets of CDO usually are credit assets or bonds. The earliest CDO was issued by an American company, Drexel Burnham Lambert, in 1987. A decade later, the CDO became one of the most rapidly developed asset securitization products. The CDO is a kind of securitization issues created by the investment banks on Wall Street by reliance on the cash flow of SPVs. For example, a variety of asset securitization products, such as housing and car mortgage loans and real estate investment trust (REIT) will be packaged into different kinds of CDOs. To be exact, the CDO involves the financing and refinancing activities, during which issuers will create a pool of diversified debt instruments and then offer marketable securities backed by the pool. The debt instruments that support CDOs include not only high-yield bonds and corporate bonds or government bonds in emerging markets, but also traditional ABSs, residential mortgage-backed securities (RMBSs), commercial mortgagebacked securities (CMBSs), and other securitized products. This kind of pool

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of assets usually bundles mortgage loans of different types and from different areas into a package, and then based on the credit quality of cash flow, the package is “sliced” into discrete “tranches” that can be sold to the public and institutional investors in the form of pledged securities. The tranches in a CDO package vary substantially in their risk profile and are usually categorized as senior, mezzanine, and equity, according to their degree of perceived credit risk. Each category corresponds to different risks and rates of return. The senior tranches are the safest one because they have first priority on the collateral in the event of a default but offer the lowest coupon rates (interest rates) compared to the remaining two tranches. And mezzanine tranches are generally safer than equity tranches. There will be a credit sought for all but equity tranches. For senior tranches, at least an A rating is typically sought. For mezzanine tranches, a rating of BBB but no less than B is sought. Since equity tranches receive the residual cash flow, no rating is sought for this type of tranches. They may receive the highest return but also assume the largest default risk. Typically, senior tranches constitute the lion’s share, mezzanine notes take up 5%–15%, and equity notes represent 2%–15%. Conservative hedge funds, commercial banks, and pension funds would like to purchase the CDOs with the highest quality, while speculators and some security issuers prefer equity tranches. From a professional perspective, the CDO is an innovative structured financial product. Xia Xiaojun noted in the “Translator ’s Words” in the book Collateralized Debt Obligations: Structures and Analysis that CDOs can be interpreted as structured CDOs. Because “from investors’ points of view, the CDO refers to some sequential securities that are collateralized by the same pool of assets; they offer different rates of return following the principle of riskreturn tradeoff, make interest and principal payments in sequence based on seniority, and will be tracked by rating agencies during the whole process. The word ‘structured’ is used to emphasize the characteristic of CDO backed by debt obligations instead of that of debt obligations serving as collateral for the CDO, albeit sometimes debt obligations also should conform to the principle of diversified portfolios when used as collateral.” The number of CDO products presented an exponential growth trend in recent years. Statistics revealed that aggregate global CDO issuance totaled USD157 billion in 2004, expanded to USD272 billion in 2005, and finally went to USD549 billion in 2006. In the first half of 2007, CDO issuance already reached USD314 billion. From 2004 to 2007, the figure further grew to roughly USD1.3 trillion. Financial innovations emerged one after another in the market. After the CDO had swept the world, some investment banks created CDS on the basis of CDO. The CDS is considered an insurance product which hedges against

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the default risk of certain assets (mostly bonds, such as CDOs). In 1995, JP Morgan invented CDS with the aim of transferring the credit exposure of corporate bonds and loans in the balance sheet to the market. Through CDS, the credit risk between two parties will be shifted and restructured. Subsequently, International Swaps and Derivatives Association (ISDA) developed it into a standard form in 1998. The combination between CDS and CDO made things even more complicated. As long as buyers of CDS pay a certain amount of deposits, like insurance premiums, they will receive credit protection in the event of defaults by the counterpart. It is equivalent to shifting the default risk of fixed-income securities to the sellers of CDSs by using those over-the-counter (OCT) instruments.

The Securitization of Subprime Mortgage Loans and the Causes of the Subsequent Crisis Asset securitization, as a financial innovation, not only promoted the prosperity of financial markets, but also brought about financial risks. The U.S. subprime mortgage rose in the early years of the new century and after the short period of prosperity it exploded into a global financial crisis in 2007. After the United States suffered the September 11 attacks, the Federal Reserve Board Chairman Alan Greenspan initiated 11 interest rate cuts since September for fear of an economic slowdown. This was the most drastic round of interest cuts ever since 1981. In June 2003, the federal funds rate was reduced from 6.5% to 1%, the lowest level in the last 50 years. This rate cut gave rise to excessive liquidity surges and stimulated economic growth. In the third quarter of 2003, the growth rate of the country’s GDP reached 9.7 %, the highest since 1990. The low interest rate boosted the thriving U.S. real estate market and, in particular, offered excellent opportunities for the growth of subprime mortgage loans. Those loans were considered “subprime” relative to high-quality mortgage loans. The U.S. mortgage loans were generally rated in accordance with borrowers’ credit: 1. Prime mortgage loans are home loans given to superior customers who can earn stable incomes, assume a reasonable debt burden, and receive a higher credit rating (with a credit score of 660 or above); and those people mainly choose traditional 30-year or 15-year fixed-rate mortgages; 2. The mortgage loans between the safest and riskiest ones are called Alt-A mortgages; 3. The subprime lending category targets borrowers who have non-existent credit histories, low ability to repay loans, and a credit score below 620. The interest rate cuts stimulated the growth of subprime mortgages. In

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the United States, there were approximately six million poor people and new immigrants who did not have favorable credit ratings and nearly half of them had no proof of regular income. Under normal circumstances, clients like those can hardly obtain loans from banks. However, after the interest rate cuts in 2001, excess liquidity forced banks and lending institutions to risk expanding the subprime mortgage market to these over six million originally unqualified borrowers in pursuit of a high return on capital. Lenders lowered the threshold of the subprime mortgage market and opened a door for people who failed to meet the requirements of ordinary mortgages, for example, borrowers who had a loan-to-value (LTV) ratio above 85% or a payment-to-income ratio over 55%. Moreover, lending institutions constantly came up with new tricks to encourage subprime mortgage loans. Some proposed 3-year, 5-year, and 7-year adjustable rate mortgages, namely, these loans charge a low interest rate in the first few years and will readjust the rate based on the market interest rate after a stated period of time; some replaced the fixed interest rate with a floating one in order to adapt to the declining trend of interest rates; and others invented a 2/28 mortgage, whose interest rate is fixed for the first two years and then adjusted for the next 28 years (the interest rate is generally three percentage points higher than that of prime mortgages, around 9%–10%). Subprime mortgage loans brought about two effects. One was the stimulation of the purchasing of houses. This benefited low-income families the most. The U.S. homeownership rate was 64% in 1995 and it rose to approximately 69% in 2006. According to the statistics released by the U.S. Federal Reserve, between 1995 and 2004, the homeownership rate of low-income families increased by six percentage points while that of the high-income group only grew by four percentage points. The other contribution of subprime mortgages was that it pushed up house prices in the United States. Since early 2002, the annual growth rate of house prices exceeded 10%. By the end of 2005, the annual growth rate was as high as around 17%, which pumped real estate bubbles to the bursting point. Under the circumstances of constant interest rate cuts and rising home prices, loan borrowers were able to use the increased value of mortgaged houses to raise the loan amount in order to repay their old debts. Thanks to the continuous reduction of interest rates, the U.S. housing market boomed. Since the interest rate of subprime mortgages was at least two to three percentage points higher than that of ordinary mortgages, it helped to expand the size of the subprime mortgage market. The U.S. subprime mortgage loans only amounted to USD138 billion in 2000 and USD160 billion in 2001. Additionally, subprime mortgages and Alt-A mortgages accounted for less than 15% of the total mortgage loans in 2003. However, the value of the two kinds of

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loans rapidly grew to USD600 billion in 2006, representing 24.39% of the nation’s total mortgage amount. According to data from the International Monetary Fund (IMF), the figure soared to USD1.1–1.2 trillion in 2007, taking up one fifth of the value of the whole mortgage market and 6% of commercial bank assets in the United States. Unfortunately, interest rate cuts did not last long. Since June 2004, the U.S. Federal Reserve imposed a new monetary policy to cope with the excess liquidity and successively raised the interest rate 17 times. Up to June 2006, the federal funds rate more than quadrupled from 1% to 5.25%. The prime lending rate rose from 4% to 8.25%, which led to a sharp rise in the mortgage rate in the subprime mortgage market. Moreover, the policy of “interest rate readjustment” forced a surge in monthly payments, which in turn increased the repayment pressure on borrowers. From 2007 onward, among subprime mortgage loans issued between 2004 and 2006, 59% adjusted their monthly installment by increasing more than one fourth and 19% by over one half. This significantly increased the repayment pressure on borrowers and the default rate surged massively. Worse still, the interest rate hike pierced the real estate bubbles. The U.S. house prices soon plunged from a high level in 2005 and showed negative growth after the second quarter of 2006. Collateral declined in value while the repayment pressure of borrowers increased dramatically. House buyers of subprime mortgages who had planned to pay off their debts by relying on future house appreciation had to give up their real estate. In 2006, approximately 15% of all adjustable rate mortgages were overdue and this rate was five percentage points higher than that of fixed-rate mortgages. The number of defaulters increased constantly. According to a survey, there were 180,000 households whose houses were repossessed by lenders due to defaults on mortgages in July 2006 and this number almost doubled compared to the number in the same period of 2005. In 2008, around 2.2 million subprime mortgage borrowers had their homes repossessed by banks. Based on IMF statistics, the total value of American subprime mortgage loans was somewhere between USD1.1 trillion and USD1.2 trillion. As for the bad debts of those loans, it was estimated by Goldman Sachs that the total amount was about USD400 billion, only accounting for 2.6% of the country’s USD15 trillion GDP in 2006. In a developed financial market like that of the United States, this proportion did not seem to be a serious one when judging the size of the subprime mortgage loan. Then, why did the bust of the subprime mortgage market evolve into a global financial tsunami? A reason was that the financial market of the United States was very well developed. MBSs grew quickly in the United States and excess liquidity sped up financial innovations. Investment banks launched subprime mortgage-backed

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securities and their derivatives. These were structured finance products created by using subprime mortgages as the underlying assets. At first, investment banks packed up subprime mortgages into ABSs and sold these to investors with a very attractive fixed income. Later, housing and car mortgage loans and many other kinds of asset securitization products were packaged into various CDOs. For example, mortgaged securities backed by cars and houses with similar credit ratings would be bundled into one CDO. Then, multiple CDOs would be translated into CDSs. The CDS is originally an insurance product used to hedge against the default risk of bond holdings, but it has evolved into a new speculative product in the derivatives market. In the traditional securities market, if an investor buys bonds of a company, he will bear the default risk of the company. But, credit derivatives are designed to transfer the risks of investors in the form of multiple portfolios that will be sold and circulated in the market. Different from traditional bonds which are sold independently, credit derivative securities pool together mortgage loans of different types and from different areas into packages, and then sell them off to individual and institutional investors in various forms of pledged securities. This type of transaction can go on and on indefinitely. After a series of actions, the originally high-risk subprime mortgage-backed debts can carve out a portion to be rated as AAA. The interest rate of subprime mortgages is generally two or three percentage points higher than that of ordinary mortgages. In times of declining interest rates, the return from mortgage-backed debts is much more generous than the return from ordinary government bonds. The high rate of return, however, made investors forget about the underlying risks. Thus, those loans were greatly welcomed by institutional investors. After 2001, the return on the U.S. Treasury bonds was lowered and the stock market performed badly. Large investors around the world, especially hedge funds, snapped up securities backed by subprime mortgages and most of their investments were made in portfolios with the highest risks and returns. Under the circumstances of declining interest rates and rising house prices, these high-risk bonds and their derivatives not only received high ratings but also were able to generate high returns. Through effective operations of various loan products and derivative securities, those high-risk loans were securitized into subprime debts which further developed into CDOs and CDSs. In this way, the high risks embedded in high returns were spread around the world. Therefore, Alan Greenspan said in the article “World Finance and Risk Management” in 2002 that the rapid advances in the financial derivatives market “have significantly lowered the costs of, and expanded the opportunities for, hedging risks. These increasingly complex financial instruments have been especial contributors, particularly over the past couple of stressful years, to the development of a far more

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flexible, efficient, and resilient financial system than existed just a quarter-century ago.”2 It should be said that the U.S. economy recovered quickly from the bursting of the Internet Bubble in 2000 and the 9/11 terrorist attacks, mainly because of the prosperity of the real estate market and the rise of the financial derivatives market. And it was the powerful hedging function of all kinds of derivatives that realized the risk transfer of the U.S. real economy. The financial products, derivatives, and financial innovation of America are the most advanced in the world. Lenders of subprime mortgage loans issued MBSs and ABSs repeatedly on the basis of the USD1.1–USD1.2 trillion in subprime mortgages. Then, based on the above securities, investment banks invented CDO, CDS, and derivatives — such as the ABX index — to be purchased by hedge funds, mutual funds, commercial banks, insurance companies, investment firms, and other institutional investors. Additionally, CDSs and ABX indices often bypassed formal exchanges and were traded over-the-counter, so they were basically not subject to market regulation. In this way, debts and risks were almost shifted out and expanded unlimitedly by virtue of the amplification mechanism of the derivatives market, and thus the transaction size of the subprime debt market was amplified tens of times. Those hedge funds and mutual funds generally employed highly leveraged tools in investment with a leverage ratio above 10 times and most of their funds were borrowed from the financial market. With the MBSs, CDOs, and CDSs being constantly transferred, investors from all around the world held a portion of the U.S. subprime mortgage backed securities and their derivatives. It was exactly because of the overflow of those bonds and their derivatives that the risks were shifted to the whole world. It was reported that by the end of 2006, those U.S. subprime mortgage bonds were basically held by five kinds of financial institutions. In general, banks accounted for 31%, asset management companies took up 22%, hedge funds represented 10%, insurance companies constituted 19%, and pension funds held 18%. However, the derivatives market was also a double-edged sword. While promoting the high prosperity of the virtual economy, the derivatives market also inflated bubbles, and raised and accumulated the systemic risks of its own. As the interest rate rose between 2004 and 2006 and house prices fell in the subsequent years, investors who expected to get a high return by investing in high-risk securities found their hopes a damp squib. A minor fluctuation in the financial field will be magnified multiple times to induce a global panic. This can significantly increase the negative impact of the subprime crisis. Take the CDS, a derivative of the U.S. subprime debt, as an example. The CDS was an innovative financial product designed to mitigate risks. Its sellers only charged a few percent of the value of the bonds they guaranteed as a margin. If the

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bonds depreciate substantially, the sellers will suffer several times the loss of the margin. For instance, a holder of a certain MBS purchases a CDS as a protection against risks with an annual margin rate of 2%. Once the bond becomes worthless, the seller of CDS will lose 100% of the security value, or 50 times of the margin; and if the bond falls by 50%, the loss will be 25 times the margin. In this financial crisis, many CDOs and the asset pools of many other securities received a high rating from rating agencies and therefore sellers of CDS dare make transactions at a low margin rate. However, the outburst of this real estate crisis and the existence of such a large number of low-quality subprime mortgage loans reflected that the margin rate was ridiculously low. Besides, the CDS is the same with other financial futures in that investors can speculate on the credit of sellers. As speculators can purchase CDSs without holding any corresponding debt instruments, the number of CDS was in fact larger than that of bonds in market transactions. Consequently, the CDS market swelled from USD900 billion in 2000 to USD45.5 trillion in 2007, equivalent to two times the size of the U.S. stock market. Those swaps which were originally used to reduce risks in reality contributed to speculation and risks. That was very ironic. In April 2007, the second-biggest subprime mortgage lender in the United States — New Century Financial Corporation — filed for bankruptcy. The U.S. subprime mortgage crisis began to emerge. In July 2007, a number of well-known international rating companies downgraded the ratings of more than 1,000 MBSs in the United States, which aroused market panic. On August 1, 2007, Bear Stearns announced the collapse of two hedge funds which invested in subprime mortgage-backed securities (the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund). Subsequently, American Home Mortgage Investment Corporation filed for bankruptcy protection. On August 15, the stock price of Countrywide Financial Corporation, the nation’s largest mortgage lender, started to slump. At that time, the market was not totally pessimistic. However, when Citigroup and Merrill Lynch disclosed their 2007 performances, Citigroup recorded the worst loss in its 196year history, far beyond Wall Street’s pessimistic expectations, and the deficit in the fourth quarter of Merrill Lynch was three times larger than the market exception. Since the number of bad loans had increased in those companies, banks demanded additional margins, which increased the risks of capital chain rupture. Since then, the subprime mortgage crisis quickly spread across the United States and even the global market, leading to a sharp plunge in major capital markets around the world, including stock markets, bond markets, and oil futures markets. Later, the liquidation of giant hedge funds or investment banks triggered market turmoil.

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The problem of subprime mortgage loans spread to securities backed by these mortgages, which in turn exerted an impact on mutual funds, hedge funds, investment banks, commercial banks, and other kinds of financial institutions. On the face of it, commercial banks did not hold a large amount of subprime mortgage-backed securities, but hedge funds probably mortgaged that kind of security to get bank loans which were most likely used to purchase MBSs again. In addition, asset securitization products and relevant derivatives are large in quantity. The trade volume of those securities by institutional investors in the repurchase market reached several trillion dollars. This was unexpected considering the past condition of scattered individual depositors and smallscale interbank markets. However, once institutional investors start a bank run, the disaster is sure to be devastating.

Asset Securitization and Further Analysis of the Global Financial Crisis How should we look at this global financial crisis? Greenspan called this financial crisis originating from the U.S. as a “oncein-a-century credit tsunami.” George Soros commented that it was “the worst financial crisis since the 1930s.” For me, to understand this global financial meltdown, we need to judge it from the perspective of economic globalization. Soros attributed this “worst financial crisis” to “market fundamentalism” which assumes that the financial market mechanism can balance and correct itself. Soros’ words were very educational. When he was interviewed by Caijing Magazine in August 2010, Soros said that what had caused the financial imbalance was a “super bubble.” This imbalance lasted a very long period of time — 28 years — and it spanned 1980 to 2008. He added that the problem was the excessive leverage of the financial sector, as well as that of the real estate sector. The culprit of this global financial crisis was asset securitization and its derivatives, especially the unregulated OTC transactions of derivatives, which were termed by Warren Buffett as “financial weapons of mass destruction.” Andrew Sheng, the former Chairman of the Securities and Futures Commission of Hong Kong and Chief Adviser to the China Banking Regulatory Commission, believed that “it was the four arbitrages in the modern economy that gave rise to “the three greatest inventions” in modern finance, leading to “the greatest problem” in today’s world.

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Asset Securitization: A Treasury of Investment Banks

Through a macro-level analysis, Andrew Sheng attributed this global financial crisis to four types of arbitrages in the contemporary economy. According to him, the four arbitrages3 are: 1. Wage arbitrage. The newly increased market-oriented economies after the Cold War contributed three billion workers to the global market and paved the way for 20-year low inflation. 2. Financial arbitrage. The cheap money policy of the yen gave birth to the global carry trade of the yen and also significantly promoted worldwide leverage operations and derivative transactions; 3. Knowledge arbitrage. Large numbers of financial engineers sprang up; and 4. Regulatory arbitrage. The regulations on the global market were relaxed. It was under such circumstances that the macroscopical trend of globalization was created. Until the end of the 20th century, with the development of financial engineering, to create and pursue profits became the main power of financial innovations. Accordingly, the “three greatest inventions” in modern finance had brought today’s world “the greatest problem.” Those three greatest inventions are: 1. Structured investment vehicle (SIV). An SIV enables the high-risk products invested in by financial institutions to be kept off the balance-sheet, escaping restrictions through regulation (in the U.S., the size of the traditional regulated banking system and the parallel banking system totaled USD20 trillion); 2. ABS. It packages bank loans into securities to be sold again in the market (the U.S. ABS amounted to USD700 billion in 2000 and grew to USD2.4 trillion in 2007, which indicated that banks transferred many of their debts to the securities market); 4 3. CDS. It improves the quality of the underlying assets of ABS by being underwritten by insurance companies (the CDS market soared from USD900 billion in 2000 to USD45.5 trillion in 2007, almost two times the size of the U.S. stock market). I think that “the three greatest inventions” having brought about “the greatest problem” for the modern finance, as presented by Andrew Sheng, was indeed a clever and concise summary of this crisis. What pushed the “three greatest inventions” to the limit were leverage operations by commercial and investment banks, and, as a result, all financial institutions and borrowers were stuck with high leverage. John Mack, the former head of Morgan Stanley, said frankly: “The over-leveraged transaction in Wall Street is really one of our faults. We have borrowed too many debts and taken high risks, and thus we are accountable for this crisis.” Certainly, the financial system also acted as an accomplice in this incident. The United States promulgated in 1999 the Financial Services Modernization Act, which overturned the separation between commercial banking and securities businesses practiced for over half a century and implemented mixed operation

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The Capital Market in China: A 60-Year Review Volume 3

by integrating commercial banks and investment banks into the transactions of asset securitization products and their derivatives. The last straw that broke the camel’s back was modern high technology. The advance of computers and modern information technology not only enabled remote transactions and instant settlement in the financial field and real economy, but also made the issuance of loans overly rely on computer models by applying a modern credit scoring system and automated underwriting system. Consequently, banks dare issue subprime housing mortgage loans to borrowers with poor credit in order to earn high returns by creating highrisk innovative financial products based on default rates and quantitative models. On the basis of this, various kinds of financial innovations in the capital market and virtual economy developed asset securitization and constantly created different types of financial derivatives. Worse still, investment banks expanded asset securitization products and their derivatives in a huge quantity, resulting in the disconnection of the capital market and virtual economy from the real economy. This led to the collapse of Wall Street and three large investment banks — Merrill Lynch, Lehman Brothers, and Bear Stearns — in this crisis. If we delve into the root of this financial crisis, one of the causes was greed. On May 11, 2009, when Wang Qishan, Vice Premier of the State Council, said during the dinner party of the 80th Anniversary of Bank of China London Branch in the presence of hundreds of bankers that the origin of the financial crisis was that financial professionals were too greedy to remember the basic rules of the financial field: 1. risks or safety; 2. liquidity; 3. profitability. Among these rules, risks ranked first. “When thinking it over, we will know that this crisis broke out after many years of accumulation. If in those years we had borne in mind these three rules, I believe this crisis could have been avoided. But unfortunately, it is easier said than done and the smarter the person is, the more quickly he forgets about these rules. In the face of great temptation, it is human nature to forget ancient wisdom and the three basic rules of finance.” Wang Qishan said that he learned these principles from his friends in London after the start of the Reform and Opening Up era. “My teachers are the friends in Wall Street and the City of London, so I always remember these three rules. When considering financial issues, I put risks at the first place all the time, whether working for a commercial bank, trust company, investment bank, the Central bank, or a local government. I told many entrepreneurs, not necessarily those in the financial field, that you must pay attention to risks and liquidity, and only under these two premises, can you pursue benefits. Now, as we are talking about a people-oriented scientific outlook on development, security is the primary need of humans and the demand for security precedes that for food and clothing from the perspective of the overall development of mankind. That is my understanding. Unfortunately, lots of people forgot these three rules, thus

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Asset Securitization: A Treasury of Investment Banks

triggering this huge disaster.” The blunt words of Wang Qishan silenced naysayers.

Of course, in addition to greed, poor supervision was also another cause.

Veteran business reporter Charlie Gasparino commented: “Greed and poor

regulation stifled the financial system.” It was truly an incisive conclusion to this crisis.

In the memoirs of U.S. Treasury Secretary Henry Paulson — On the Brink, he

remarked: “Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age. It is rife with duplication, gaping holes, and counterproductive competition among regulators.”

In addition, John Mack from Morgan Stanley believed that regulators had

not done a very good job in keeping abreast with the times and failed to grasp

and understand the changes in the market, which added more complexity to the problem. Soros directly criticized the regulators of the U.S. by stating that

“regulators are more flawed than markets. Why are they imperfect? Because they

are bureaucratic and they respond slower than markets. They are also easily subject to political influences.”

Alan Greenspan is to blame for the poor supervision in the financial field.

The underlying reason is that during his 20-year tenure as Chairman of the U.S.

Federal Reserve, Greenspan always advocated an overly lenient system towards financial innovations and firmly opposed the government’s strengthening of

financial supervision on OTC derivatives. According to the statistics of the Bank for International Settlements (BIS), by the end of 2007, the total notional principal

of derivatives traded on the exchange amounted to approximately USD40 trillion while the notional principal of OTC derivatives totaled USD596 trillion, almost 15 times the former. The unregulated OTC derivatives ran rampant, eventually leading to the breakdown of Wall Street and the outbreak of the global financial crisis.

Questions and Answers on the Global Financial Crisis Gary Gorton, a professor of finance at the Wharton School, University of

Pennsylvania, when analyzing the differences between this financial crisis and previous ones, mentioned that this crisis was mainly caused by the bank runs by institutional investors on the repurchase market (repo market) and the existence of a parallel banking system in addition to the regulated traditional banking system, and that the panic of 2007 was due to a run by institutional investors on the repo

market which was not insured by deposit insurance.5 His eight major viewpoints are explained below.

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The Capital Market in China: A 60-Year Review Volume 3

1. What was the root cause of this financial crisis? The root cause of this global financial crisis was a banking panic which started on August 9, 2007. There have been multiple banking panics in the history of the United States in which a large number of depositors rush en masse to their banks and demand their money back — literally, “runs on banks.” Banking means creating short-term trading or transaction securities backed by longer term assets. The fundamental business of banking creates a vulnerability to panic. But, panic can be prevented with intelligent policies. What happened in August 2007 involved a different form of bank liability, mainly taking place in repo transactions and repo markets, concerning trillions of dollars. The participants of the repo market were not regular people but firms and institutional investors, so, this panic was not like the previous panics in American history in that it was not a mass run on banks by individual depositors, but instead was a run by firms and institutional investors on financial firms.

2. Why was there a banking panic? As explained, the panic of 2007 was not centered on demand deposits, but on the repo market which is not covered by the U.S. deposit insurance system. As the economy transforms with growth, banking also changes. But, at a deep level the basic form of bank liability has the same structure, whether it is private bank notes, demand deposits, or sale and repurchase agreements. Bank liabilities are designed to be safe; they are short term, redeemable, and backed by collateral. But, they have always been vulnerable to mass withdrawals. During the Free Banking Era before the Civil War, the dominant form of money was privately issued bank notes backed by state bonds. Bank notes were also redeemable on demand and demand deposits were one of the important sources of bank capital. There were banking panics because sometimes the collateral (the state bonds) was of questionable value. During the Civil War, the government took over the money business; national bank notes (greenbacks) were backed by U.S. Treasury bonds and there were no longer private bank notes. But, banking panics continued because of the inherent nature of demand deposits. Until 1933 when the deposit insurance was enacted into law, it basically ended panics due to demand deposits (checking accounts). The time from 1934 to 2007 was a quiet period in the U.S. banking sector. This time the panic was in the sale and repo market. In the last 25 years or so, there was another significant change: a change in the form of quantity of bank liabilities. At root this change had to do with the traditional banking

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Asset Securitization: A Treasury of Investment Banks

system becoming unprofitable in the 1980s. During that decade, traditional banks lost market share to money market mutual funds (which replaced demand deposits) and junk bonds (which took market share from lending), to name the two most important changes. From then on, the U.S. banking industry began large-scale securitization and repurchase businesses.

3. Was the amount of subprime mortgages a cause for the panic? The outstanding amount of subprime bonds was not large enough to cause a systemic financial crisis by itself. In 2006, subprime debt stood at about USD1.2 trillion outstanding, of which roughly 82% was rated AAA and to date has very small amounts of realized losses. In the United States, the total size of the traditional and parallel banking systems is about USD20 trillion. In contrast, the USD1.2 trillion of subprime mortgage loans cannot explain the global financial crisis. In addition, the U.S. subprime mortgages started to deteriorate in January 2007 and the banking panic occurred eight months later in August 2007. That is to say, subprime lending began to deteriorate significantly well before the panic, and thus it was not a true reason for the panic.

4. How did the “parallel banking system” develop? After the 1980s, holding loans on the balance sheets of commercial banks was not profitable. This is why the parallel or shadow banking system developed. If an industry is not profitable, the owners will exit the industry by not investing. Here, “exit” means that the regulated banking sector will shrink. One form of exit is for banks to not hold loans but to sell the loans; securitization is the selling of portfolios of loans. The traditional banking sector shrank, and a whole new banking sector developed — the parallel banking system. A major part of it was securitization and the market size was very huge. If comparing the non-mortgage securitization issuance amounts with the amount of all of U.S. corporate debt issuance, we can see that the scale of the former exceeded that of the latter starting in 2004.

5. How to understand the relationship between the traditional banking system and the parallel banking system? The two banking systems are intimately connected, and the parallel banking system is essentially how the traditional, regulated, banking system is funded. It means that without the securitization markets the traditional banking system is not going to function in the modern financial system. The traditional,

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The Capital Market in China: A 60-Year Review Volume 3

regulated banking system makes loans to consumers and corporations, but where do the traditional banks get the money? Portfolios of the loans are sold as bonds, to the various securitization vehicles in the parallel banking system. Like the traditional banks, these vehicles are intermediaries who in turn are financed by pension companies, annuities, mutual funds, and other institutional investors.

6. Who were the investors of the repo market and how large was the market? Some economists believe the so-called “originate–to-distribute” concept which stresses that securitizations should not end up on bank balance sheets. There is no basis for this idea. These asset-backed bonds were needed as collateral for a form of depository banking. Institutional investors have demands for checking accounts. But, for them there are no safe banking accounts because deposit insurance is limited. So, where does an institutional investor go to deposit money? The institutional investor wants to earn interest, have immediate access to the money, and be assured that the deposit is safe. The answer is that the institutional investor goes to the repo market. Suppose the institutional investor is Mr. Smith, he has USD500 million in cash that will be used to buy securities, but not right now. Right now Mr. Smith wants a safe place to earn interest, but such a place where the money will be available in case the opportunity for buying securities arises. Smith goes to Bear Stearns and “deposits” the USD500 million overnight for interest. What makes this deposit safe? The safety comes from the collateral that Bear Stearns provides. Bear Stearns holds some asset-backed securities that are earning London Interbank Offered Rate (LIBOR) plus 6%. They have a market value of USD500 million. These bonds are provided to Mr. Smith as collateral. Mr. Smith takes physical possession of these bonds. Since the transaction is overnight, Mr. Smith can get his money back the next morning, or he can agree to “roll” the trade. Mr. Smith earns, say, 3%. If Bear Stearns borrows at 3% and lends at 6%, in order to conduct this banking business, Bear Stearns needs collateral (that earns 6% in the example) — just like in the Free Banking Era, banks needed state bonds as collateral. In the last 25 years or so, the money under management in pension funds and institutional investors, and money in corporate treasuries, has grown enormously, creating a demand for the sale and repurchase businesses. How big was the repo market? I roughly guess that it is at least USD12 trillion, the size of the total assets in the regulated banking sector.

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Asset Securitization: A Treasury of Investment Banks

7. What does the panic have to do with repo? There is another aspect to repo that is important: haircuts. In the repo example I gave above, Mr. Smith deposited USD500 million of cash with Bear Stearns and received as collateral USD500 million in bonds, valued at market value. Here, Smith does not care if Bear Stearns becomes insolvent because Smith in that event can unilaterally terminate the transaction and sell the bonds to get the USD500 million. Imagine that Mr. Smith said to Bear: “I will deposit only USD400 million and I want USD500 million (market value) of bonds as collateral.” This would be a 20% haircut. In this case, Mr. Smith is protected against a USD100 million decline in the value of the bonds, should Bear Stearns become insolvent and should Mr. Smith want to sell the bonds. Note that a haircut requires the bank to raise money. In the above example, suppose the haircut was zero to start with, but then it becomes positive, say that it rises to 20%. This is essentially a withdrawal from the bank of USD100 million. Bear turns over USD500 million of bonds to Mr. Smith, but only receives USD400 million. How does Bear Stearns finance the other USD100 million? We will come to this shortly. Prior to the panic, haircuts on all assets were zero. An increase in the haircuts is a withdrawal from the bank. Massive withdrawals are a banking panic. The evidence is that the increase in haircuts for securitized bonds (and other structured bonds) frequently occurred starting in August 2007. We do not know how much was withdrawn because we do not know the actual size of the repo market. But, to get a sense of the magnitude, suppose the repo market was USD12 trillion. If repo haircuts rose from zero to an average of 20%, the banking system would need to come up with USD2 trillion, an impossible task.

8. Where did the losses come from? Faced with the task of raising money to meet the withdrawals, banks had to sell assets. But, there were no investors willing to make sufficiently large new investments, on the order of USD2 trillion. In order to minimize losses, banks chose to sell bonds that they thought would not drop in price a great deal. For example, they sold AAA-rated corporate bonds. These kinds of forced sales are called “fire sales” — sales that must be made to raise money, even if the sale causes the price to fall because so much is offered for sale. Normally, AAA-rated corporate bonds would trade at higher prices (lower spreads) than, say, AA-rated bonds. However, during crises when

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The Capital Market in China: A 60-Year Review Volume 3

multiple banks race to make fire sales of highly rated securities, AAA-rated corporate bonds may fetch less capital than AA-rated corporate bonds. The underlying reason is that in the face of a bank run, banks holding AAA-rated corporate bonds have no choice but to sell these bonds at an extremely low price in order to avoid bankruptcy, which will result in substantial losses. In the above, Professor Gary Gorton analyzed the root causes of this crisis, mainly including securitization and its huge amounts of derivatives, and the parallel banking system. The panic arose as a result of bank runs of institutional investors in the repo market, which is not insured. More importantly, securitization and its derivatives have developed so big as to have trillions of dollars that once massive institutional investors withdraw their deposits, it will lead to not only the fall of the banks but also panic in the whole repo market. Before the crisis, trillions of dollars were traded in the repo market, too big for anyone to save. To sum up, it is because of the four arbitrages and three inventions in the modern economy creating “the greatest problem” and “financial weapons of mass destruction” plus the excessive leverage in the financial system that this crisis is not an ordinary banking cirsis, but a large mistake made by investment banks on the basis of subprime lending, CDO, and CDS. It is reflected in a mass run on banks by firms and institutional investors, instead of individual depositors, in the repo market. As was reported following the bankruptcy of Lehman Brothers, around USD1.6 trillion of trading positions of its partners (equivalent to 14% of the trading positions in London Stock Exchange and 12% of the fixed income in New York Stock Exchange) was frozen, immediately triggering off liquidity shortages in a large number of European financial institutions. Meanwhile, it also caused a state of extreme panic in the market: Everyone may go bankrupt, and who will be the next? It can be disputed whether the U.S. government should or should not allow Lehman Brothers to fall, but in the face of an astronomical figure of USD1.6 trillion, just as exTreasury Secretary Henry Paulson expressed on numerous occasions, “he and the American government have tried their best.” At that time no one would take over the falling company, and to persuade Congress to use the money of taxpayers to rescue Lehman was an impossible task. Considering Soros’s words that the past financial imbalance was a “super bubble” and the past full of a few large crises, I believe that ever since President Franklin Delano Roosevelt introduced government invention in economic adjustment, government intervention, like the girl who opened Pandora’s Box, became an indispensable factor in economic operation. From then on, the eruption of the crisis evolved from four stages of prosperity, recession,

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Asset Securitization: A Treasury of Investment Banks

depression, and recovery to five stages of prosperity, recession, government intervention, depression, and recovery. This government intervention is sometimes reflected in a deficit budget and at others a relaxation in liquidity requirements in the monetary policy. To put it more exactly, it is to use a bubble to replace and rescue another bubble. Therefore, under government intervention, to substitute one bubble for another bubble will probably be a regular way to solve future crises.

To Speed Up Asset Securitization in China China first tried asset securitization in the early 1990s. The earliest successful case was Sanya real estate investment securities of Hainan in 1992. Then the Zhuhai highway fee realized securitization in 1996. China Ocean Shipping (Group) Company (COSCO) completed accounts receivables securitization in 1997 and China International Marine Containers Group also realized USD80 million accounts receivables securitization in 2000. China Huarong Asset Management Company securitized its non-performing assets in 2003 and Industrial and Commercial Bank of China (ICBC) securitized the toxic assets of the Ningbo branch in 2004. In April 2005, the People’s Bank of China and China Banking Regulatory Commission (CBRC) jointly published the Measures for the Pilot Administration of the Securitization of Credit Assets. It indicated that asset securitization had entered into a development stage of standard operation. On December 15, 2005, China Development Bank issued RMB4.18 billion credit asset-backed securities and China Construction Bank launched individual housing mortgage loan securitization goods of RMB3.02 billion. This formally opened the inter-bank bond market and signified the start of the asset securitization pilot in China. The development of China’s asset securitization was always not smooth. According to the report made by Century Weekly, over the three years up to November 2008, there were 19 credit asset-backed securities launched in the interbank bond market and they raised RMB66.8 billion in total. By comparison, the size of the bond market amounted to RMB19 trillion during the same period.6 In the Western countries with mature market economies, asset securitization products usually occupied more than 20% of the bond market. The Central bank had planned to expand the pilot project to include RMB60 billion, but the global financial crisis in 2008 disrupted the expectation. The State Council was cautious about the launch of financial products related to securitization and real estate, so the second round of pilot projects of asset securitization was postponed.

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The Capital Market in China: A 60-Year Review Volume 3

Another problem faced by China’s asset securitization was that the market responded coldly towards the previous released asset securitization products. The two batches of products issued by China Development Bank were not actively traded and showed poor liquidity in the secondary market. In 2007, the scheduled issuance of RMB8-billion ABSs by China Development Bank was aborted due to a failure to meet the minimal subscription amount. Why was the market not enthusiastic about the pilot projects of asset securitization? In addition to the reasons of inadequate information disclosure, poor rating credibility, and insufficient liquidity, according to industry insiders, it was because the maturity was too short and the scale was very small. The maturity period of the first two batches of asset securitization products was generally within three years whereas the international average was between three to ten years or even longer. The size of a single asset securitization product in China usually amounted to just RMB2–3 billion. The industry insiders believed that only with a single product with at least RMB10 billion could liquidity be seen. If a product has a market size smaller than several trillions of renminbi, it can hardly be treated as a major investment product to attract large investors and the issuing institution has no motivation to establish the corresponding internal rating system. The industry insiders added that the restriction on investors entering the asset securitization market was another reason. The composition of asset securitization investors is simple and risks are centered on the banking system. China Insurance Regulatory Commission (CIRC) has not yet permitted the release of asset securitization products issued by national social security funds and insurance firms. After the global financial tsunami, some people simply believed that asset securitization was very dangerous and the management skills of China’s banking industry were not good enough to handle the asset securitization related businesses. Obviously, it is an excessive worry. I agree with Yang Kaisheng, who said “China should not only engage in asset securitization, but also accelerate this process,” for four reasons. First, currently indirect finance still dominates the domestic market and the annual loan increase of more than 10% brings about enormous funding pressure on commercial banks. To divert excess credit assets to the capital market through asset securitization will be an important channel to maintain an optimized CAR. Second, asset securitization offers more financial products and investment tools for investors besides savings and stocks. Third, asset securitization will change the over-concentration of financial risks on banks by dispersing risks.

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Asset Securitization: A Treasury of Investment Banks

Fourth, only when the development of asset securitization and its derivatives is accelerated, can a comprehensive set of fair and impartial institutional structures of the capital market and a relevant talent reserve be built, and experience and lessons be accumulated and learned. It is important to emphasize that the popularity of asset securitization and its derivative products, such as CDO and CDS, in Europe and the United States did not happen overnight. It needs not only commercial banks, investment banks, securities firms, accounting firms, law firms, credit rating agencies, regulatory bodies, institutional investors, and many other professional institutions, but also a large number of accountants, economists, lawyers, actuaries, tax and regulatory personnel, and other professionals. A series of laws, regulations, systems, and experience supporting the capital culture is also necessary. All of these rely on step-by-step evolution and long-term accumulation in market operation. And institutions and professionals who engage in financial innovation also need long-term practices in the market and a constant cash flow in order to support their survival and development and accumulate their professional competence and credibility. At the beginning of the 1990s, when China decided to switch to a socialist market economy, it realized that there was a shortage of hundreds of thousands of lawyers, accountants, and tax personnel. After nearly 20 years of construction and development, the capital market has finally built such a structure and size as we see today. If China wants to develop asset securitization and its derivatives to keep pace with the times, it is necessary to double or triple the size of today’s capital market, financial institutions, and talent pool. This is particularly because asset securitization and its derivatives are highly diversified financial products, unlike savings, state bonds, and stocks which are simple standard products. Not only are assets selected to be collateral diversified, but also the types of ABS products for investors are abundant, be they conservative, risky, or in between, and static or dynamic. It demands heavily professional skills of talents in financial institutions. Here, to borrow the expression used by Xia Xiaojun in “Translator’s Words” in the book Collateralized Debt Obligations: Structures and Analysis, “asset securitization and its derivatives are like a universal converter which converts assets of different natures and from different regions through securitization into investment targets that appeal to international investors with different investment appetites and at the same time raises capital in the market by selling diverse portfolios in order to serve separate purposes.” It should be pointed out that in the last five years, investment banks, rating agencies, and relevant institutions in Western countries continuously searched for business opportunities in the operation of the mathematical model of the default rate,

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The Capital Market in China: A 60-Year Review Volume 3

which involved almost all high-end mathematical talents. Many of China’s universities responded slowly to this trend, however. They have just set up an advanced mathematics course in the past two years, but to coincide with the global financial tsunami. Even U.S. President Barack Obama said that the financial sector would make up a smaller part of the U.S. economy in the future, and “it just won’t be half of our economy.... We don’t want every single college grad with mathematical aptitude to become a derivatives trader.” President Obama continued to express that some of the job-seekers who would normally go to the financial sector would shift to other areas of the economy, such as engineering. Analyzed further, the U.S. subprime mortgage crisis cannot be attributed to asset securitization itself, for three vital reasons. First of all, new types of securitization products created through financial innovation developed too quickly. Under the conditions of a declining interest rate and rising house prices, a series of relevant institutions and staff were so optimistic and confident that subprime mortgage loans were not appropriately sliced into tranches and often rated too high. They did not take precautions against risks from interest rates and house prices, and also left some gaps in regulation. Besides, when the interest rate rose and the house price dropped, rating agencies did not downgrade the ratings of asset securitization products correspondingly. The facts that multi-layer securities had accumulated excess risks, the hedging strategy of CDS was too optimistic and simple, and the low margin rate of CDS encouraged high sepeculation, contributed to the rise of bubbles from asset securitization and its derivatives. The second important reason is that the high leverage ratio and high correlation of modern financial markets and financial products created new features in the risk emergence and transmission of the modern financial system. The crisis deriving from U.S. subprime debt and its derivatives made it clear that even if it is in America where its financial regulatory system was ahead of other countries and regions, there may be a defect in the arrangement and supervision of high risks and high leverage ratio of certain innovative financial products (such as CDS). Consequently, in the later period of the crisis, the five top-level investment banks in the United States all returned to traditional banks, apart from those being insolvent and merged, and adopted normal risk control measures and proper leverage ratios. For a country like China where its financial development lagged behind, when launching pilot projects and opening innovative financial products with a high-leverage ratio, relevant authorities should be more cautious, try to balance opportunities and risks, and must strictly enforce supervision.

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Asset Securitization: A Treasury of Investment Banks

Lastly, governments should draw a lesson from the U.S. crisis in terms of the changes caused by asset securitization and its derivatives in the financial field, and implement targeted supervision towards institutional investors, repo markets, and the parallel banking system.

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Chapter

Futures Markets

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Pioneers of Financial Futures — Milton Friedman and Leo Melamed How did futures markets develop? The world was on the gold standard for currency until the Second World War. After the war and until the 1970s, the Bretton Woods System was in place under the lead of the United States, where the currency issuance of various countries was pegged to the U.S. dollar while the U.S. dollar was pegged to gold. From the late 1950s onward, overwhelmed by the Korean War and Vietnam War, America was running a large trade deficit for years on end. The balance of international payments deteriorated and foreign countries were also causing the gold reserves to be massively depleted by the exchange of U.S. dollars for gold. In August 1970, when the U.S gold reserve could no longer sustain the increasing overflow of dollars, President Richard Nixon abandoned the commitment to the gold standard by ending the trade of gold at the fixed price of USD35 per ounce and announced the suspension of dollar convertibility to gold. The fixed exchange rate system began to totter. In 1971, Professor Milton Friedman from the University of Chicago expressed the view that the pound sterling was overvalued and that shorting the British currency could be profitable. But banks only offered future cover to financial institutions trading foreign exchanges in the forward market but not to individual investors. And no bank in Chicago dare follow Friedman’s predication to sell the pound short. Meanwhile, Leo Melamed, Chairman of the Chicago Mercantile Exchange (CME), concluded, after long-term observation, that there would be only two fates for the British pound: Either it would be devalued or it would retain its value due to the British government. Melamed discussed his ideas with Friedman who agreed to Melamed’s speculation. At that time, futures markets in Chicago were only engaged in trading commodities, and there was no market in financial futures. The two men predicated that the fixed exchange rate system was going to be disintegrated and Melamed hoped to make use of the symmetry of futures contracts for short and long positions in the Chicago futures market to create a new financial product based on foreign exchanges in the CEM. He planned to experiment with financial futures contracts and establish an exchange market that would be accessible to everyone and that would be the currency futures market. U.S President Nixon closed the gold window as part of the New Economic Policy (NEP) on August 15, 1971. In December of the same year, a group of

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Futures Markets

10 countries (G10) signed the Smithsonian Agreement at the Smithsonian Institution in Washington, D.C., and announced a 7.89% devaluation of the dollar in relation to gold and a wider band of ±2.25% for other currencies to move relative to their central rate against the U.S. dollar. The pegged exchange rate system finally wobbled. On December 20, 1971, Melamed officially announced the plan of establishing a futures market in foreign currency, namely the International Monetary Market (IMM). The IMM launched trading in seven futures contracts, including British pounds, Canadian dollars, Deutsche marks, Italian lira, Japanese yen, Mexican pesos, and Swiss francs. Melamed was elected Chairman of the newly established IMM. On May 16, 1972, the IMM officially began operations. It marked the beginning of financial futures innovations and opened a page in the century-long history of the futures industry. In the following years, Melamed and the CME introduced many new financial futures, such as Treasury bill futures and Eurodollars futures, and launched stock index futures in 1982. That is why the financial sector believes that Milton Friedman and Leo Melamed are the pioneers of financial futures. In 1986, University of Chicago Professor Merton Miller, 1990 Nobel laureate in Economics, nominated financial futures as “the most significant innovation in the last 20 years.” The financial futures market was the fastest growing market in the late 20th century. From 1976 to 1986, the annual turnover of financial futures rose from USD37 million to USD216 million. In 1996, the daily volume of foreign exchange futures in only the CME averaged USD12 billion. In 2003, the global trading of futures totaled USD74.9 billion, 25 times the world’s GDP. Financial futures, as a financial derivative, provide stock indices, interest rates, and exchange rates with a kind of financial instrument and mechanism to hedge against and transfer risks, which at the same time enriches the capital culture.

Features and Functions of Futures Markets The international futures market started to develop after the 1970s. At that time, the Bretton Woods system came to an end, the United States abandoned the convertibility of the dollar into gold, and the system of fixed exchange rates was replaced by one of floating exchange rates. As a result, the currencies of each country fluctuated violently, which made averting risks from foreign exchanges, interest rates, and stock prices a top priority. The CME successfully set up the IMM in 1972 and launched trading in seven currency futures: British pounds,

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Canadian dollars, Deutsche marks, Italian lira, Japanese yen, Mexican pesos, and Swiss francs. This signified the beginning of the innovative development of financial futures. In 1975, the Chicago Board of Trade (CBOT) created the first interest rate futures contract, one based on Government National Mortgage Association (GNMA) mortgage-backed securities. In January 1976, the CME launched a three-month U.S. Treasury bill future, which later proved to be the most active short-term interest rate futures throughout the 1970s. Although the financial futures markets started relatively later than commodity futures, the turnover of financial futures took up more than 90% of the whole futures market. Financial futures became an important ingredient of not only the futures market but also the financial market. In 2009, global futures and options trading hit 17.7 billion contracts, among which futures and options of stock index and equity accounted for 67%, exceeding the total volume of other financial and commodity futures, including interest rates, foreign exchanges, energy, agricultural products, and metal. According to the survey on 79 derivatives exchanges worldwide made by the U.S. Futures Industry Association (FIA), the global volume of futures and options increased rapidly to reach 22.3 billion contracts, a year-onyear increase of 25.65%. The commodity futures market of China recorded 1.52 billion contracts, representing 50.95% of the global commodity futures and options volume, a growth of 4.32 percentage points compared to the previous year. The stock index futures was first launched by the Kansas City Board of Trade (KCBT) in 1982 and since then, the stock index future was promoted to the whole world and quickly became a leading product in the derivatives markets. In East Asia, the earliest example is the Hong Kong Hang Seng Index (HSI) futures, which was born in May 1986. After that, Japan’s Nikkei 225 index futures, South Korea’s KOSP1200 index futures, and Taiwan’s TAIEX futures were introduced successively. China Financial Futures Exchange (CFFEX) was established in 2006 and it began to trade stock index futures in April 2010. The most positive influence from trading stock index futures is to have changed the existing perception of investors and substituted the strategy of profiting in one direction (either selling or buying) with short-term trading strategies. Financial futures activities place heavy emphasis on standard operation and involve the trading of standard financial or commodity futures contracts according to a set of strict rules in futures markets. The financial futures market is a system combining high complexity and high risks. All players in the market should not only be alert to market opportunities, but also pay attention to regulated operations and risk control. The main features of financial futures transactions are as follows.

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1. Financial futures refer to the futures contracts with financial instruments as the subject matter. The trading object is intangible and virtual financial products, namely securities, and it excludes physical commodities that materially exist. 2. Financial futures are traded with standardized contracts. There are strict standards on the type of currency, transaction amount, delivery date, transaction date, and other contract terms. 3. The delivery period is also standardized. In most cases, the delivery period is three months, six months, nine months, or twelve months, and futures contracts will last no more than two years. Delivery date within each delivery period is determined by the underlying asset. 4. Financial futures adopt an open outcry system to decide the price of contract. Under high transparency and credibility, futures markets are very effective. 5. Futures markets, like securities markets, implement a membership system. Trading members are at the same time members of clearing, who have to pay a margin deposit in order to secure the safety of transactions and reduce credit risks. Additionally, the main functions and roles of financial futures markets are displayed in the following aspects. The first is the price discovery, which means the futures markets can offer price information on a variety of financial instruments. The futures market has very good liquidity, and once there is a shift in market expectation, the futures market will soon respond. In particular, since the price of financial futures reflects people’s forecast and expectation for the changes in market supply and demand and exchange rates and is very sensitive to market fluctuations, it can pass on the information to spot markets as an important reference, and thus affect the spot price to strike a balance. Second, financial futures markets have the function of risk transfer. The introduction of financial futures offers a channel to hedge against risks for the market. The risk transfer function of financial futures is realized through hedging. The fundamental principle of hedging is to buy or sell certain financial instruments in the cash market while at the same time sell or buy the same financial instruments in the futures market in the hopes of offsetting losses in spot goods by gains from the futures. The factors that affect the price fluctuations in the cash and futures markets are the same and the two markets move in the identical direction, so taking equal but opposite positions in the cash and futures markets can compensate losses with profits and hedge against

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risks. For example, when there is a rise in exchange rate, investors can enter into an opposite contract to mitigate or eliminate the risk from the future cash market. Take another example, if investors hold stocks which have a direct bearing on stock indices, they can prevent a loss from a future stock price drop by selling a stock index futures contract. And by matching the short position in stock index futures with the long position in stocks, risks from overall positions will be reduced and losses from one position can be offset by gains from the other position. During the hedging, risks are diversified and risks are transferred from those who do not want to bear risks to those who are willing to take risks. Of course, this transfer of risk can be realized only when there are people who would like to assume risks. These people are speculators. Large numbers of speculators activate the financial futures market and expand the scale of futures trading. Third, financial futures markets also function like a lever, creating investment opportunities for speculators. Risks and benefits coexist in the financial futures market. The transactions of financial futures are a kind of margin trading and the percentage of margin is relatively low. Exchanges will decide whether to initiate a margin call or to allow excess margin withdrawal according to the changes of market prices. As a result, financial futures have a high leverage ratio, which means that with a small investment, investors can manage capital several times the size of the margin. Any minor changes in the futures price can translate into a huge gain or loss. This makes it possible to allow hedgers to avoid or transfer price risks while providing speculators with opportunities to make risky investments and gain the corresponding returns. The high leverage feature of the financial futures market encourages speculators to run high risk to make investment and enter into futures contracts in exchange for high returns amid price fluctuations. When trading exchange rate, interest rate, and stock index futures, speculators only have to post a certain amount of margin to control the futures value tens of times. Fourth, the financial futures market offers new trading products and investment opportunities. Interest rate swaps, currency swaps, and equity index futures all can be used as arbitrage tools. For example, when the price of equity index futures deviates significantly from the reasonable price, arbitrage activities around equity index futures will arise. If investors only target the average returns of the stock market or future gains of a certain type of stocks (such as technology stocks) but lack sufficient capital to purchase all these stocks in the spot market, they can still track the market index or technology sector index and share profits by turning to buy stock index futures with a little money. In addition, stock index futures have a short duration (typically three

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months) and high liquidity, which is beneficial to rapidly changing the asset structure and reasonably allocate resources by investors. Surely, financial common sense tells us that every financial future is in nature a zero-sum game. When some people make a profit, there will definitely be some others who lose money. With stock index futures, if investors sell short when the price is high, they can avoid losses or even make gains. But for the whole market, there must be another group of investors who suffer great losses. Despite that, these financial derivatives play a unique role in discovering value, minimizing risks, creating opportunities, and balancing benefits, which are indeed irreplaceable by other financial instruments. It is no wonder people say that without financial futures, there will be no perfect financial market. Financial futures provide a new measure of risk management in regard of exchange rate, interest rate, and stock investment. By investing in stock index futures, investors are able to not only limit the risk of investment portfolios to a reasonable range, but also grasp investment opportunities and accurately implement investment strategies. Take funds as an example, when the market is experiencing a short-term downturn, funds can choose to exit by buying index futures rather than giving up their long-term holdings of stocks. Similarly, when there is a new direction in investment, funds can grasp the opportunity by purchasing futures and then take time to choose individual stocks. It is precisely because the function of index futures in actively managing risks was gradually accepted by the market that index futures businesses developed very quickly in overseas markets in the last 20 years. Almost all stock markets with a certain scale have listed index futures products with some contracts exceeding the stock market in transaction volume. Robert Merton once said that to not do futures was the biggest venture. That sounds very reasonable. As China’s stock market showed in the previous period, without a derivative product like the financial future, it seemed that investors were encouraged to push up the market and risks were exposed freely. After index futures were launched in 2010, there was a checking force in the market and before the market went up too high, the force would work to balance the price. The “unilateral market” and “short-term bull and long-term bear market” talked about by people in the past few years were reflections of a lack of hedging. Financial futures brought about a new way of risk management, and thus enabled financial institutions which had a very strict requirement for risk control dare put more capital in the market. Throughout the development of foreign stock index futures markets, the ones who used index futures the most were fund managers (such as those of mutual funds, pension funds, and insurance funds). Apart from fund managers, other major market participants

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include underwriters, market makers, and stock issuing companies. Certainly, there are also some disadvantages. For a stock whose estimate value is high, it is possible to gain a profit by short selling the stock. This, in turn, will bring a shock to the stock market. Cao Heping from Peking University put forward in 2005 that futures products were more sensitive than other financial instruments to price changes and displayed different price elasticity from physical industries. Due to the feature in price elasticity, when the futures industry develops to a certain scale, it can stabilize the macroeconomy. Some economists even argued that to develop commodities and financial futures markets was likely to help to damp down inflation. It can ease excess liquidity, control inflation, and reduce the pressure coming from the concentration of capital in one or a few areas. The rise of information technology in the 1980s pushed forward changes in futures exchanges worldwide. Starting from the 1990s, there was a surge of exchange restructuring, listing, and mergers in the whole world. For example, in 1998, Deutsche Terminbörse (DTB) and Swiss Options and Financial Futures Exchange (SOFFEX) merged to form a European Exchange which was also publicly traded; By the end of 1999, the publicly listed Singapore Exchange was established with a merger between the Singapore International Monetary Exchange and the Stock Exchange of Singapore; In 2000, the Stock Exchange of Hong Kong (SEHK), Hong Kong Futures Exchange (HKFE), and the Hong Kong Securities Clearing Company (HKSCC) merged under a single holding company called the Hong Kong Exchanges and Clearing Limited (HKEx); The Sydney Futures Exchange (SFE) was listed on the Australian Stock Exchange (ASX) in 2002 and merged with the ASX in 2006; The Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) achieved the transformation from a membership system to a listed corporation, respectively, in 2002 and 2005, and the two merged in 2006 to create the world’s largest future exchange. After more than a decade of development, China’s futures market broke the RMB100 trillion mark of turnover in 2009, becoming the second biggest commodity futures market in the world, second only to America’s. The role of the futures markets in serving the real economy has gradually been displayed.

Lessons Learned from the “327 Bond Futures Scandal” China has long delayed the opening of the financial futures markets, because it was feared that the development of financial futures would encourage

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excessive speculation. The 1994 – 1995 “327 bond futures scandal” seriously disrupted financial order and left many financial authorities in a state of shock. In fact, a positive function of the Treasury bond futures market is hedging. It is helpful for institutional investors, especially financial institutions, to maintain the liquidity of short-term assets held by them through hedging. In addition, the Treasury bond futures market also plays a role of value discovery. It can promote the market-oriented reform of Treasury bonds and that of interest rates in related financial markets. During the “327 incident,” the value of inflationlinked subsidy ratio and interest subsidy was discovered. The inflation and fluctuations of interest rates between 1994 and 1995 indicated that there was a need for Treasury bonds to minimize risks in economic life. And the “327 incident” was a result of systematic defect and regulatory misconduct. I published an article in Beijing Economic Daily on March 12, 1995 to analyze this incident shortly after it had happened. M ovies need suspense to increase their appeal to audiences. For Treasury bond futures, the magic of suspense will only add irresistible temptation and market pressure to excessive speculation. Treasury bond futures aim to hedge or to speculate on the price movement of bonds. Originally, there was only one uncertainty for fixed-rate Treasury bonds and that was the fluctuations of the market interest rate. And since the government bonds would receive an inflation-linked subsidy, a sword of Damocles was hanging over their heads and the temptation to overspeculation was further increased. But the bond futures contract coded 327 also involved an interest subsidy. The futures contract was created based on the three-year-term government bonds released in 1992, whose nominal interest rate was scheduled to be 9.5% per year along with an inflation-linked subsidy. One year later, the Central Bank raised the interest rate of three-year deposits to 12.24% in July 1993, creating a two-year interest margin. Whether those bonds would be compensated for by the difference in interest rates at the maturity date became another unknown mystery. Various guesses were made in the market and what behind these rumors were the bets worth tens or hundreds of millions of renminbi. Until February 24, 1995, when new Treasury bonds were scheduled to be launched, the government authorities announced compensation to the bond holders. In this way, a Treasury bond future contains three variables. One more variable means more speculative pressure for the market. This crisis may have been avoided if the government could launch a clear policy at an earlier date during the more than one-year period between July 1993 and February 1995.

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This shows that the “327 bond futures scandal” did not result from a problem of the future itself but a failure in product design and market monitoring. Treasury bond futures are generally only susceptible to fluctuations of interest rate in design, but the “327 bond futures” contain three variables: market interest rates, inflation-linked subsidy ratio, and compensation to interest rates difference (or interest subsidy). Besides, regulatory authorities should have made an earlier announcement about whether there would be an interest subsidy to the 1992 government bonds after the rise of deposit interest rate. And even if the decision of interest subsidy had not yet been made, those authorities could have applied “trading halts” to give the market a buffer time. China’s financial regulators also underestimated the amplification function of futures and under a relatively low margin deposit of Treasury bond futures, excessive speculation was encouraged, which finally caused the “327 incident.” That is why I said in the above article: “As China developed from a planned economy, it was very hard for the country to completely get rid of the influences from the old economic management system. During the transition towards a socialist market economy, the financial department released a series of policies and measures, whose impact was far larger than those of a planned economy. Therefore, relevant financial authorities must take the power of the market into consideration and never underestimate market forces.” “Under a socialist market economy, how to escape from the habitual thinking of the planned economy in management, predict the huge impact of a macro policy on the market, and ensure less uncertainties and more cushions in the Treasury bond market are lessons learned from the ‘327 incident.’ These lessons should also be applied to stock markets, futures markets, foreign exchange markets, real estate markets, and many other markets.”1 The “327 bond futures scandal” in 1995 caused a great pain in the financial circle. Now it has been over 10 years from the “327 incident” and China has transformed itself from a planned economy to a socialist market economy. In April 2010, the stock index futures were first formally launched in China. It should be said that China has gained the ability to master a market economy.

China’s Financial Futures Market Is Underway In 2010, China’s securities market marked its 20th anniversary. There were more than 2,000 companies listed on the Shanghai and Shenzhen stock exchanges with a total market value of RMB26 trillion. This meant that China’s securities market was ranked second in the world, similar to China’s status as the world’s

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second largest economy. In those 20 years, China’s capital market had raised RMB2.5 trillion through equity financing and RMB2.9 trillion through the

issuing of corporate bonds which vigorously supported the sound and rapid

development of the real economy. In 2009, China totally released medium-term notes of RMB695.89 billion, short-term financing bills of RMB447.91 billion,

and corporate bonds of RMB71.29 billion. Together with enterprise bonds, 2 the

total volume of direct debt financing of non-financial companies for the first

time outnumbered RMB1.5 trillion. In the same year, financing through IPO reached RMB202.20 billion and money raised through seasoned equity offering amounted to RMB309.81 billion. The volume of direct equity and debt financing

totaled RMB2 trillion. In 2010, the number of active stock accounts reached 126 million in China, and continued to grow each year. The existing 106 securities companies recorded a total asset of RMB1.8 trillion and a net asset of RMB500

billion. There were 619 funds under the management of 61 fund companies,

which issued 240 million shares with a net asset value of RMB2.2 trillion. The number of securities practitioners amounted to 230,000.

In response to the appeals from all sides, the China Financial Futures

Exchange was established in August 2006 and stock index futures also

started trading in April 2010. This marked an important step forward made by Shanghai’s derivatives market. This was not only a significant advance of Shanghai’s capital market, but also a milestone for the construction of

Shanghai’s international finance center. Due to massive changes of stock index, fluctuations of interest rate, and appreciation pressure on the renminbi, there

was a need to hedge against risks in the market. So, it was very timely and necessary to launch stock index futures as well as other financial derivatives, such as Treasury bond futures, foreign exchange futures, stock index options,

and gold ETFs. Following that, efforts should also be put in perfecting the

benchmark interest rate function of Shanghai interbank offered rate and actively develop multiple derivatives whose prices are determined based on the base

rate. According to the authoritative data and the estimate of experts, at present, China’s national assets are basically composed of: deposit balance of RMB64

trillion, real estate market value of RMB67 trillion, stock market capitalization of RMB26 trillion, insurance funds of RMB4 trillion, wealth investment

products of RMB11 trillion, and margins in the futures markets of RMB110

billion. By comparison, savings, the real estate market, and stock markets are the main investment channels for Chinese citizens while the futures markets are comparatively small in capital size and still have a broad prospect.

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A Dialectical Understanding of Speculation and Investment To develop the financial futures markets, it is necessary to acquire a dialectical understanding of investment and speculation. In China, speculation is often connected with or treated as the crime of speculation and profiteering. In A Dictionary of Modern Economic Law complied by Liu Longheng, the crime of speculation and profiteering is defined as: “Whoever, for the purpose of obtaining illegal profits, violates the state regulations of finance, foreign exchange, gold and silver, and business management, by engaging in illegal business activities and disrupting and undermining the economic order, where the circumstances are especially serious, is considered to commit the crime of speculation and profiteering.” In fact, the Chinese word “touji” (投機, mostly means speculation) also contains positive connotations, and cannot be viewed as a derogatory term. The expressions such as “to seize every opportunity,” “to make a prompt decision,” and “to act as both an opportunity and a challenge,” that people frequently use in their daily lives, actually are very close in meaning with “touji.” In the financial market, “touji” is a synonym for “capturing investment opportunities.” All these connote a positive meaning. In people’s daily interactions, “touji” is often related to being agreeable, for example, to describe “having an agreeable chat.” It conveys a more positive meaning. Zheng Xueqin made a more accurate explanation on “touji” in his article “Speculation and Investment” published in China Securities Journal on February 21, 2008. Speculation and investment, two concepts from Western financial theories, were translated into Chinese by directly borrowing two existing Chinese words. In this sense, when using the Chinese word “touji” to describe trading activities, we should neither be overly swayed by its meanings used in Chinese ancient books, such as “hit a window of opportunity” and “speculate to profit,” nor link the word to the negative meaning of “being opportunistic” or “speculating and profiteering” in modern language usage. That is because the English word “speculating” and its Chinese translation “touji” do not have a continuing relationship in their origin. However, when “touji” is used in stock and futures trading, it corresponds to “speculation” in English. In English, speculation means trying to predict the future based on inconclusive evidence. In the area of finance, it refers to buying or selling

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a security or asset based on the prediction of the price changes in order to make a profit. Here, we can draw the following inferences. First of all, as it is a guess, there will be a risk. Second, the capital used in transactions does not matter itself, because it is just a tool for making profits, and its capacity of appreciation will not be taken into consideration unless such a capacity will affect the asset price. Third, since to make a profit is the only objective, speculation is inclined to use leverage and borrowing to get the maximum rate of return. In this sense, if we refer to “touji” as “trading activities of selling or purchasing a product that you neither need nor will store but solely for the purpose of making profits,” then “touji” is similar to the meaning of speculation in English. Speculative activities are not unique to China. They can be found in every country in the world. They are only different in intensity in each country at a certain period. In the nearly half a century, stocks and real estate have been major targets for speculation in all parts of the world. There are two types of investment opportunities or speculation in financial markets. The first is to make an investment by being discerning in the selection of financial products and able to spot what others cannot. For example, brave speculators dare seize an opportunity to make a bold investment in stocks of new industries that have potential and prospects when most investors dare not venture into the fields. The second is to make an investment by having a pioneering spirit in product and industry selection. Speculators have the courage to decisively buy or sell certain products after a thorough analysis of market trends. For example, they are able to catch chances to buy in a bull market while selling in a bear market. Speculation by taking up investment opportunities should be encouraged in not only financial markets but also any other economic works. To truly achieve speculation, namely capturing investment opportunities is not easy. Here, it is necessary to have a wealth of experience, an in-depth awareness of market changes, rational predictions and judgments on future trends, some investment skills, the courage to take the inevitable risks, and, lastly, ability to make a prompt decision after carrying out a comprehensive analysis of the above factors. This kind of speculation, in fact, resembles the art of command in a war to look for an opportunity to wipe up the enemy. In the financial market, speculation and investment are both profit-seeking activities via the purchasing of financial products or securities. The speculation in securities transactions is different by nature from the speculation meant in speculating and profiteering. Speculation in the securities markets refers

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to the legal activity of profiting on the price difference by reselling securities based on the predication of market movements. Especially after the financial futures markets were opened, financial futures were allowed to be traded on margin, which gave them a relatively high leverage ratio. It not only turned the possibility of avoiding or transferring price risks by hedgers into a reality, but also provided conditions and opportunities for speculators to gain a risk premium through leverage or risky investment. By placing a certain amount of margin, speculators can control the trading volume multiple times when dealing with exchange rates, interest rates, and stock index futures. The high leverage ratio thus encourages speculators to run a risk and enter into futures contracts in exchange for high returns amid price fluctuations. In a stock market, whether the purchase of a stock is an investment or speculation is very hard to tell. There are a bunch of studies on securities investment in Western countries and most of them are dedicated to discussing the boundary between investment and speculation. Some argued for using the holding period of a stock to distinguish between short-term speculation and long-term investment. Some believed the motives of profit-making activities should be used to make such a distinction: Investment is concerned about longterm benefits from business development while speculation focuses on gains from price fluctuations and stocks transfer. Others thought we should judge based on the amount of risks: The one with a large risk is speculation whereas that with a small risk is investment. In fact, there is no strict distinction between stock investment and speculation. Under certain circumstances, investment and speculation will transform into each other. For example, an investor may sell a stock which was meant for long-term investment shortly after he bought the stock due to drastic market changes. Similarly, some speculators who originally intended to engage in short-term trading, have no choice but hold their stocks for a longer time when the market was gloomy. This actually turns speculation into long-term investment. So it is really hard to draw a dividing line between the two activities. In real economic lives, each country often categorizes speculation into two kinds on the basis of the nature of speculative activities: justifiable speculation and illegal speculation. Justifiable speculation refers to the speculative activities that are carried out under the permit of laws and regulations. It features openness, legitimacy, and competition, and it is also called “legal speculation.” For example, leverage trading in financial futures markets as mentioned above is legal speculation. Illegal speculation is the speculative activities forbade by state laws and policies and characterized as being unlawful, monopolized, and fraudulent. Therefore, each nation in the world encourages justifiable

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speculation, suppresses illegal speculation, and condemns excessive speculation in the management of securities markets. In financial markets, investment and speculation are both trading activities concerning the selling and buying of financial products, but they are also different in certain ways. First, attitudes towards risks. Investors wish to avoid risk, so they generally purchase financial products which can generate a stable expected return and where their principals are relatively safe. Speculators dare to purchase high-risk securities in exchange for high returns during sharp price fluctuations. So, they can also be called risk takers. Second, holding periods of financial products. Investors are often longterm holders who receive periodic dividends or capital gains. Speculators prefer quick purchases and quick sales in order to gain a price difference in transactions. Third, modes of doing business. Investors usually engage in spot trading and physical delivery. By contrast, speculators mostly do credit trading, buy and sell short, or conduct no physical delivery. Fourth, analytical methods. Investors emphasize the analysis and evaluation of the intrinsic value of financial instruments. Speculators are only concerned about price fluctuations rather than the intrinsic value of financial instruments. It is not surprising that there is speculation in the financial market. The key is we should update our concepts and develop a dialectical view towards speculative activities in the financial market. 1. Speculation can activate markets. There are always price ups and downs in the securities markets. If all buy when prices go up and all sell when prices go down, there will be no transaction that can be made. The securities market will turn into a stagnant or dead market that has only demand but no trading. Similarly, if everyone purchases the safest securities and dares not touch new securities, there will be neither the issuance of new securities nor primary markets. If in the secondary market, no one dare run a risk to sell when prices rise or buy when prices fall, the secondary market will not continue to exist. So, it may be an exaggeration to say that speculation can create a market as believed by some people in the West, but justifiable speculation indeed activates markets. 2. Speculation maintains liquidity and continuity in stock markets. One function of equity financing is to turn short-term capital into long-term funding by the constant transfer of a stock among different short-term

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capital holders. However, an affluent investor may not be able to purchase a certain amount of securities whenever he wishes and a securities issuer will not necessarily manage to finance enough capital in the securities market anytime he needs. At this point, speculators fill in the gap of transactions by reselling securities. This, therefore, ensures a constant flow of a moderate amount of securities in the market and maintains the continuity of market transactions. Meanwhile, owing to speculators, normal investment and hedging transactions become possible. 3. Justifiable speculation ensures a reasonable and balanced market price. In an open, fair, and legitimate competition, wise speculators who buy low and sell high will survive in the end. It helps to maintain the market price at a stable level, make the price accurately reflect the supply and demand in the market, and ensures the price of the securities of the same kind in different markets or at different times to be within a reasonable range. 4. Legal speculation disperses various kinds of risks in securities markets and brings financial futures markets and hedging into existence. Financial markets involve the trading activities of securities based on constantly changing stock prices, exchange rates, and interest rates within a certain period of time. Both investors and fund raisers wish to maintain the stock price, interest rate, exchange rate, and stock index within a certain range at the maturity of securities in order to avoid a significant loss caused by violent fluctuations. For this reason, the trading of financial futures and options has come into existence, and it is actually another kind of speculative transactions. It can not only secure the value of an underlying asset by transferring risks to the market, but also form the price of futures or options through specifying the expected future prices (of exchange rate, interest rate, stock index, etc.) by two parties in a contract. This kind of speculative activity maintains the existence of futures and options exchanges and enables investors to realize hedging and risk aversion. The fact that speculation comes along with investment is not subject to man’s will. Speculation requires risk taking, so does investment. In fact, there is no investment without risks and risks will bring about speculation. Securities investment involves at least two types of risks. One is inflationary risks. It is difficult for securities investors to avoid the loss caused by a price rise, even though sometimes the loss is only a small fraction. The other is credit risks, namely, investment may incur a loss of principal or a financial reward. In the international securities market, there are also interest rate risk, exchange rate risk, and price risk. In addition, risks from political changes, disasters, and

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economic downturns will also affect investment. In this way, any investment, whether a securities investment or an industrial investment, will contain certain risks, so it is inevitable for investment to involve a bit of speculation. Even if such a risk is as small as 1/1,000 or 1/10,000, there will still be a 1/1,000 or 1/10,000 chance of speculation, and the investment is by no means 100% risk free or speculation free. Of course, it should be noted that we must also be aware of the negative impact of justifiable speculation. First, excessive speculation should be prevented. To completely rely on good luck or chances and take reckless moves are considered to be gambling. And gambling is neither an investment nor speculation. It has nothing in common with speculation which aims to capture investment opportunities as we talked about above. Second, it is important to be careful of the contagion of speculation. Even justifiable speculation is contagious. It will easily encourage the masses to push their luck, thereby starting a wave of excessive speculation through panic buying or panic selling, either of which will create a threat to the stability of the economy and society. More importantly, illegal speculation must be clearly forbidden by law. For example, naked short selling which will influence the market price and successive trading of a certain security by buying high and selling low for the purpose of speculation ought to be prohibited. Since speculation rises along with investment in the securities market, will the development of the securities market promote frauds and illegal speculation and thus make the socialist economic construction lose its way? The prevention of frauds and illegal speculation is a regulatory issue. Even in the securities markets and financial futures markets of developed countries, frauds and illegal speculation frequently take place. These countries constantly learn from the fraudulent and illegal speculative cases that have happened in order to strengthen market supervision, protect the public interest, and prevent the occurrence of similar cases in advance. The credit system of mature markets advances economic development by a couple of centuries. Although there are deceptions and frauds made through taking advantage of credit in societies with a market economy, the market economy is built based on a credit system. Without credit, the economy even cannot survive for one more minute. Accordingly, capitalist societies of developed countries are committed to promoting and guaranteeing the orderly operation and development of the credit system through all sorts of scientific methods, legislation, and moral standards. As socialist countries claim to put people’s interest in the first place, they ought to intensify their financial management through laws and regulations from the very beginning. But even the most comprehensive

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scientific management can only reduce, instead of completely eliminate, frauds and illegal speculation. Therefore, it is important that any government which is responsible to its people has to take every effective measure to ensure that the financial market is built based on a scientific system and legislation and that it operates in an orderly manner if the country wants to develop its securities market and financial futures market. In fact, frauds and speculation will take place in not only securities markets and financial futures markets, but also any business that is built on credit whether it is related to commerce, banking, clearing, insurance, or securities. If without strict management, fraudulent and speculative activities are very likely to arise. It is clear that credit provides a few capital managers with control over others’ capital but without themselves being controlled by the private capital. So, it is possible for those people to run a risk by using others’ capital. The few people, thus, are able to occupy social property and are pure risk takers in nature. This feature of credit applies to both capitalistic societies and socialist societies. It also works in the same way for all business managers no matter if their companies have issued stocks or not. In enterprises of a socialist country (even if they are unlisted companies), the managers may abuse their power for personal gains, appropriate public property, or participate in frauds and illegal speculation by using public property. All these problems stem from the nature of the credit system. Socialist countries should treat those malpractice cases seriously and try to get rid of them. However, there is no reward without a risk and regulators should not close all companies and abolish all transactions just for fear of official profiteering or official speculation. Similarly, credit and financial markets should not be abandoned in order to avoid frauds. It must be made clear that socialist reform is a kind of self-improvement under the premise of a socialist system and to develop securities markets in a socialist country is for the purpose of building socialism rather than capitalism.

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The Investment Banking Mentality and Capital Operation at Investment Banks

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Banking Redistribution and Ten Financing Assumptions by Liu Lixin Before we go into investment banks and their mentality, let us first review the history of what happened during the early Reform and Opening Up era. In 1979, China had just been transformed into a “large public finances but small banking industry” system and this system continued for 30 years after the founding of New China. However, China had no idea of how to get banks extensively involved in the economy, let alone investment banks. As soon as enterprises were granted greater operational autonomy and were allowed to keep more of their profits, the proportion of fiscal revenue in national income decreased from 40% to 31%. This drew attention to an important issue: There was a large demand for investment, but state finances did not have enough money. It was in 1980 that the Central government promoted economic unification. Lateral economic ties were built between different provinces, government departments, enterprises, and ownership systems. The Shandong Longkou government entrusted China Construction Bank (CCB) to undertake equity financing for the construction of power plants; Gansu Province set up its first investment company; the Shanghai government established a cement plant in Zhejiang Province by using cement as compensation to Zhejiang; the nation’s first leasing company, China Oriental Leasing Company, was founded with the injection of Japanese capital. New businesses successively sprang up and this reflected a demand for lateral capital financing. In a meeting of the Development Research Center of the State Council in 1981, Ma Hong chaired a discussion on how to resolve the financial predicament and raise capital for urgent infrastructure construction. During the meeting, Liu Lixin, Vice President of CCB, put forth a new solution. He said: “Do we have money? There are two different views. Some believe we do not have money, and are under a financial deficit, if banks increase money supply, commodity prices will go up. Others think that although the state finances are poor, institutional reforms have motivated all parties, hence local governments, enterprises, and citizens have money in their hands. If the measure is right, it is possible to collect some funds for necessary construction. I agree with the second view. We can finance urgent construction projects by applying different approaches to different investors and take banking redistribution as a supplement to fiscal redistribution.” This turned out to be a brilliant solution. Liu Lixin’s proposal was confirmed by Premier Zhao Ziyang. Zhao almost completely repeated Liu’s speech in the meeting of the Central Politburo of the Communist Party of China (CPC). Later, Workers’

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Daily reported in detail on Liu Lixin’s ten fundraising assumptions and his idea of making banks’ redistribution a supplement to fiscal redistribution. This proposal was a powerful impetus to lateral economic unification and capital financing between different regions. Banking redistribution may not be an effective supplement to fiscal redistribution, but it set into motion the liberation of mind in financial management and reform at the early stage of the Reform and Opening Up era. Since then, the financial sector has gotten rid of many longstanding, narrow perceptions, such as earmarking a fund for only a specific purpose or limiting credit funds to shortterm purposes. The four specialized banks (Industrial and Commercial Bank of China, Agricultural Bank of China, Bank of China, and CCB) competed to make long-term investment loans on the basis of deposits. It gradually became a common phenomenon that financial funds were used to sustain government operation while economic construction relied on bank loans. Thus, China developed from a “large public finances but small banking industry” system to the banking-dominated indirect finance system which lasted for more than 20 years. As a result, a large group of state-owned enterprises were built through bank financing. Among them, a considerable part was made up of large- and medium-sized enterprises, which became the backbone of China’s economy and played a significant role in the country’s economic development. Unfortunately, under the reign of indirect finance for more than 20 years, China developed another abnormal economic pattern — an excessive, large banking system but an extremely small capital market. It became an obstacle in contemporary economic and financial development. The reason why I mentioned Liu Lixin and his proposal of using banking redistribution as a supplement of fiscal redistribution is because, for one thing, as a senior member of CCB and a pioneer in opening up the investment field, Liu Lixin has made enormous contributions to financial reforms and investment theories. For another, his idea of making banking redistribution a supplement to fiscal redistribution is definitely an excellent example of applying the investment banking mentality ’to solving fiscal difficulties by replacing the 30-year “large public finances but small banking industry” system with economic construction relying on bank loans.

What Are Investment Banks and Their Business Scope? Investment banks exist independently as non-bank financial institutions, the opposite of commercial banks. There are many kinds of non-bank financial

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institutions, including not only insurance companies, investment trust companies, leasing companies, and finance companies, but also investment banks, securities firms, and financing and investment consultant companies. The latter group is, in practice, collectively referred to as the investment banking sector. Investment banking originated from the accepting houses of bills of exchange in foreign trade in mid-18th-century England. So, in the U.K. and most European countries, investment banks are also known as “merchant banks.” In the United States, the term “investment bank” is more frequently used. Although named as banks, investment banks, in fact, do not engage in general monetary services. Japan learned from America the separate management between banks and securities after the World War II and classified investment banks, according to their business nature, as “securities firms” which specialize in securities underwriting and trading. Examples include Nomura Securities Co., Ltd. and Yamaichi Securities Co., Ltd. Institutions involved in corporate mergers, restructuring, and asset management are under the category of “investment advisory companies,” such as Nomura Asset Management Co., Ltd. and Daiwa Asset Management Co., Ltd. The investment banking industry has its own unique service coverage. Generally speaking, commercial banks provide general monetary services such as accepting deposits, making business loans, offering remittances, and facilitating settlements. But investment banks do not offer such kinds of services. The main lines of business of investment banks include: 1. Corporate capital financing mainly through dealing with securities and related businesses including securities issuance, underwriting, and trading, which is the conventional service of investment banks; 2. Intellectual and financial services in regard to asset restructuring and realization, as well as corporate mergers and reorganization; 3. Fund management, direct investment, and asset management; 4. Company advisory. The latter three businesses were developed later on. Therefore, it can be said that investment banks engage in capital- and asset-related businesses in the capital market. Early investment banks mostly participated in securities transactions in the capital market. So, investment banks, in the narrowest sense, are limited to the institutions which raise capital by underwriting securities in the primary market and act as client’s’ agents or dealers when trading securities in the secondary market. Back then, vital matters, such as business mergers and capital expansion were more often than not achieved by depending on a capitalist’s operating strategies, schemes, and skills in capital operation. What brought about such a historic opportunity for the investment banking industry was the rise of the Euro-dollar market in the second half of the 1960s.

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At that time, European countries had recovered from the trauma of World War II and faced a strong demand for dollars in industrialization. On the one hand, the United States started to collect an interest equalization tax (IET) in 1964 and the tax was levied on domestic investors in the purchase of foreign securities. Since the United States strengthened its control over dollars, foreign fundraisers had to leave the country and collect dollars in the European market. In this way, a large amount of surplus dollars flowed to Europe. Shortly after that, plenty of oil dollars also joined this trend. This was a major reason for the rapid growth of the Euro-dollar market. The co-existence of huge capital demand and sufficient dollars supply provided investment bankers with a chance to use their wisdom and talents, which in turn promoted the rapid expansion of the Euro-dollar market. Due to the collapse of the Bretton Woods system in 1970, a great variety of low-cost financing securities and financial innovations appeared in the Eurodollar market between the 1970s and 1980s. Apart from traditional fixed-interest bonds and floating-rate bonds in the European market, new securities such as convertible bonds, multiple currency bonds, European commercial papers, option bonds, and securities with a subscription right to various financial instruments, came out. Later, swap transactions (such as currency swaps and interest rate swaps) were created by taking advantage of violent fluctuations of exchange rates. The talents of investment bankers were given full play. In 1960, the volume of pure intermediate trade in the Euro-dollar market was as small as USD4.5 billion. However, the bonds issued in the Euro-dollar market reached USD80 billion in 1984, similar to the issue amount of the U.S. dollar bonds. In particular, during this period, “offshore finance” was developed in Hong Kong, Bahrain, Singapore, the Bahamas, and the Cayman Islands and that constituted an international financial market, parallel to the financial market of each country. Consequently, the Euro-dollar market became a huge duty-free store and wholesale market which strongly integrated international finance in an indirect way. Another historic opportunity in the development of the investment banking industry was the fourth and fifth merger waves in the 1980s and 1990s and mergers and acquisitions, management buyouts, and leveraged buyouts between enterprise groups arose. Investment banks realized commodification, marketization, and industrialization of their intellectual services relating to corporate mergers, reorganization, and capital operation. Since then, investment banks went beyond the business scope of securities and removed the role of securities brokers from themselves by setting up specialized brokerage firms. Meanwhile, they transformed into professional planners and organizers of corporate mergers and restructuring and carved out a new area in company advisory and corporate mergers.

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Strictly speaking, investment banks have nothing to do with either general monetary business or the securities trading business. Now, investment banks in fact have developed into a knowledge industry of investment advisors or financial consultants specialized in business mergers, acquisitions, and reorganizations. Therefore, some scholars argued for the need to distinguish between the investment banking and the securities industries and only focus on the studies of the securities trading activities which would affect the capital market by excluding research on retail business.1 I believe the biggest difference of investment banks from commercial banks lies in the arrangement of resources in addition to lines of business. Commercial banks create credit and allocate resources. Investment banks create markets and optimize the allocation and reorganization of resources. Moreover, the two are different in their attitudes towards enterprises. Commercial banks undertake business credit based on what an enterprise originally is and take a negative attitude towards the enterprise without doing anything to change it. In contrast, investment banks adopt a positive, dynamic, and innovative approach towards enterprises and even reshape them by undertaking mergers, expansion and reorganization businesses, on which basis enterprise assets of different quality and risk will be priced. China’s securities business was, at first, undertaken by banks. The public bonds for economic construction in the 1950s, the government bonds released since the 1980s, and a large number of corporate bonds were all issued and underwritten by banks. As trust investment companies were founded in the 1980s, stocks and bonds businesses were completed through them. It was not until the late 1980s that securities firms were finally established. Their business scope roughly corresponded to that of Japanese ones and did not truly assume the business of investment banking. In 1990, China’s stock markets began pilot trials; however, investment banks did not develop rapidly afterwards. There were two concerns in China’s economic management: The first was a fear about the excessive expansion of credit and investment; and the second was the fear of excessive speculation in securities trading. In real economic life, trust investment companies repeatedly used shortterm loans in long-term investment and securities firms contributed to excessive speculation through speculating on stocks, which increased the government’s concern in developing the investment banking industry. It was precisely for this reason that I proposed to justify investment banks in the mid-1990s by stating that investment banks were not banks in nature but investment and financing consultant firms or an investment and financing advisory industry. Such a distinction was necessary in order to differentiate investment banking from the monetary business of banks and general securities trading. In fact, my concern was not necessary. After

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the founding of the Sino-foreign China International Capital Corporation Limited (CICC) in 1995, China owned its first investment bank. It signified an important step of China’s financial reform in developing the investment banking industry. And when the CICC led large Chinese business groups in overseas listings in 1997, to develop investment banks became a logical step and was not a problem any longer. In the following, I will talk about the necessity of building investment banks and the theoretical basis of this idea. In the area of finance, investment banking fulfills society’s needs for direct financing and is associated with the intermediary service of capital supply and demand in the capital market. The existence of investment banks reflects the socialization of production in economic life. 1. As a country’s economy grows, individual income and national savings increase. When people become richer and national savings tend to be increasingly dispersed, it is necessary to have a mechanism that translates savings into investment in the economic field, in addition to fiscal redistribution and banks’ indirect finance. As direct finance and capital markets arise besides indirect finance, securities firms and investment banks have to act as intermediaries between the supply and demand sides of capital. 2. The essence of capital markets is an exchange market where assets are traded for capital. Here, the assets refer to property, property rights, or securities of a company. Under a market economy, investment and financing activities are, in nature, the trading of capital. The price of capital transactions is subject to not only the quality of assets but also the amount of risk the assets have as well as capital supply and demand in the market. Overall, the general principle is to decide the price according to quality and make returns correspond to risks. Therefore, to maintain a fair, open, and just transaction of capital, it is necessary to have investment banks which provide special services (such as to price stocks or act as sponsors for a listing company) for such a kind of trade, especially in determining the trading price in the capital market. 3. Enterprises under a market economy will present a declining average rate of profits due to the changes of resources, technology, markets, and the variations in the lifecycle of the enterprises, products, and technologies. This is a common rule. So, there is a need for a market-oriented method to maximize and reorganize existing resource allocation. Asset reorganization, and mergers and acquisitions between advantageous companies and disadvantageous companies, industrial consolidation, and adjustments of industrial structure become necessary. Investment banks are rightly

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4.

5.

6.

7.

professional institutions which offer the services for corporate mergers and asset reorganization. It is the nature of industrial capital to pursue efficiency and expansion. During business and capital expansion, a mechanism which can continuously accumulate, centralize, and reorganize capital should be established through the market, and investment banks should play a role of financial advisors and carry out capital operation. In a market economy, capital owners and capital users are separated. Those who suffer from capital shortage want to raise enough long-term capital through the most convenient methods and at the lowest price; and those who have surplus capital also wish to lend out their money in the easiest and relatively safest way and with proper gains. The cooperation between the supply and demand sides requires investment banks as intermediaries to find an appropriate form of trade through various financial services and financial innovations. The capital market is like high technology in the market economy. When commercial banks play a leading and monopolist role in the competition of the indirect market with their standard and regulated financial products and services, there is a need for investment banks and investment bankers to provide intellectual services for the enterprises and business groups of different trades in the marketing of direct finance through financial innovations. Due to the information asymmetry between investors and fundraisers, it becomes necessary for investment banks to act as a bridge between the two parties. Investment banks have advantages in information and credibility accumulated through long-term involvement in the business and they are the ideal intermediaries for the two sides of investment. In the traditional business of financial intermediation, the interests of investment banks are essentially the same as financing enterprises: Only when an investment bank acts as the intermediary, can an enterprise be successfully listed; and only when the enterprise succeeds in listing, will the investment bank make money. The conflict of interest between investment banks and listing enterprises only reflects the selection of underwriting teams and stock pricing.

In this way, investment bankers and the investment banking industry have made a contribution to the development of the world’s finances and economy through playing a traditional role as intermediaries.

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The Mentality of Investment Banks Investment banks and their capital operation are products of modern economy and finance. During a very long period after the 1970s, it was investment bankers and the investment banking industry that created miracles in capital formation and made a great contribution in optimizing resource allocation during economic development. Now, of course, investment banking is no longer a new term in the economic field. But in the early 1980s, when China was just transforming from a planned economy to a socialist market economy, investment banking was indeed an unfamiliar thing. At that time, “investment banking” was understood from the perspective of industrial investment, and that was why CCB termed a subsidiary bank, which handled loans granted by the World Bank, as a “China Investment Bank.” In the international interactions of CCB, foreign sides always focused on the word “construction” in the name of CCB and related the bank to the building industry, while CCB boasted of itself as an “investment bank.” Moreover, Zhao Ziyang required the development of CCB into an investment bank like the World Bank. In 1986, when making contacts with foreign banks, CCB heard from them about “merchant banks.” Our interpreter, however, rendered the term as “commercial banks” due to a lack of financial knowledge. Until much later, we came to realize that the “merchant bank” mentioned by the U.K. and Canada was in fact the investment bank. Shortly after that, Hiroshi Takeuchi, a director of the Long-Term Credit Bank of Japan (LTCB), told me that the LTCB had a department called “merchant banking.” During that time, I also represented CCB to negotiate investment cooperation with Japan’s Nomura Securities. By this chance, I specially invited Hiroshi Takeuchi of the Nomura Research Institute (NRI) to give us a lecture on the situation of merchant banks in the international market. When I was working for China Investment Consulting Company (CICOC) in 1988, I had a chance to communicate with the World Bank about the reform orientation of CICOC. Richard Stein from the World Bank said that during China’s economic reform, there would be a dramatic increase in the demand for merchant banks and he suggested that we should make early preparations. The merchant banks mentioned by Stein were actually investment banks. In later discussions, the expert from the World Bank advised us to set up a joint venture investment bank by cooperating with a famous foreign investment bank and recommended 100 large enterprises to be listed overseas through shareholding reform. This idea was, in fact, close to the mode of CICC. But we were not

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confident as we lacked the necessary knowledge about investment banking. To that end, Xia Bin, Li Xujun, and I met Liu Hongru who was then the Vice President of the Central Bank to hold an in-depth discussion. Liu consented to this proposal and believed it was the best way to utilize foreign capital. We even talked with Lu Xueyong, President of the People’s Bank of China’s Beijing branch, about the equity participation in Beijing Municipal Securities Company. At that time, the capitalization of the Beijing Municipal Securities Company was around RMB10 million. On that basis, we planned to transform the company into “Beijing Securities” by injecting RMB20 million from the Beijing municipal government and the CICC and wished the new company would serve as a springboard for cooperation with foreign investment banks. However, things were not always smooth in China. Due to the clean-up and rectification movement towards Chinese companies, this idea was not put into practice. Unexpectedly, the predication of a dramatic increase in the service demand for merchant banks by the World Bank was delayed for more than 10 years owing to the rectification and clean-up movement and the reluctance on the part of the government to give up its role in resource allocation during industrial consolidation and business mergers. In 1990, I got a chance to visit America and Canada for the purpose of investigating the business of investment banking and corporate mergers and acquisitions. This was an extremely rare opportunity to study investment banking and probably the first time that China’s domestic banks could investigate Western investment banking operations. During this chance, I got access to the mentality of investment banking; before that, my shallow understanding in this regard was gained from the experiences during China’s Reform and Opening Up. Since then, I have become interested in the thinking of investment banks and collected some materials and articles on this topic. Originally, I thought that since investment banks originated in the West, there would be some concrete studies about capital operation. However, Western books on investment banks were often ambiguous and vaguely written. I asked some professionals in the investment banking industry about this question and their answer was very straightforward: “That may be because it is not appropriate to let out the secret in the practical operation of Wall Street.” Another more realistic explanation was that investment bankers in Wall Street were too busy to write a book while professors were too proud to make money, so those books were only skin-deep. I experienced the old society. Before China’s liberation, I once lived in Shanghai where financial awareness was the most keen in all of old China, and worked for the Bank of Communications (BOCOM). It set up a Trust Department and entrusted the department with the business of industrial investment. The

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department operated very flexibly under two names: One was China Pacific Insurance Company and the other was No.31 Securities Broker. After the founding of New China, I personally experienced the construction of CCB on the basis of the old BOCOM, practiced the most rigid financial management of the planned economy in the Ministry of Finance, and got involved in the transition of CCB from a specialized bank to a commercial bank. The government advocated that we expand our thoughts after the Reform and Opening Up era, and in the face of a series of flexible and invigorating measures, what impressed me most in the financial field was value discovery. As far as I am concerned, the mentality of investment banking is about monetization, realization, flexibility, and invigoration. In fact, when looking at traditional Chinese thinking, the wisdom behind overall planning in military deployment, game theory in playing Chinese chess, and strategic alliances in the Warring States era is completely the essential thinking of investment banks. Later, in my interaction with investment bankers, I deeply felt that the most creative strategy investment banks had was to leverage policy loopholes. The originality of the strategy lies in that it does not follow the common practice but does not violate laws or regulations. It invigorates the financial market through flexible means, discovers value under the permission of multiple laws and regulations, and creates value by taking advantage of policy loopholes. So, what is at the heart of investment banking is value discovery. In the 1990s, when investigating investment banking and business mergers in the United States and Canada, I asked an investment banker from Morgan Stanley: “Why is it the investment bank rather than the commercial bank which has worked miracles in corporate mergers as the latter has more financial contacts with commercial banks?” He responded to me very straightforwardly: “It is because commercial banks are familiar with the financial staff in companies whereas investment banks establish connections with decision-makers, such as directors and CEOs. And it is the decision-makers who have the final say over business mergers and acquisitions.” During my later investigation, I became further aware of the difference in attitude of the two types of banks. Commercial banks undertake granting a business credit based on the existing condition of the enterprise and take a negative attitude towards the enterprise without doing anything to change it. In contrast, investment banks take a positive, dynamic, and innovative approach towards enterprises, and even reshape them through business mergers, expansions, and reorganization. On the basis of that, they will discover value and price the enterprises’ assets according to quality and risks. Of course, the most critical part is value discovery, i.e., whether you are able to find investment opportunities or not.

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In 1995, China launched its first investment bank — China International Capital Corporation, or CICC, a joint venture by CCB and Morgan Stanley International Incorporated. The cooperation dates back to 1993. At that time, John J. Mack, President of Morgan Stanley Group, invited Edwin R. Lim, World Bank Country Director for China, to join Morgan Stanley and entrusted Lim to negotiate with the Chinese side about jointly establishing an investment bank. Lim visited the Central Bank which later appointed Zhu Rongji, Vice Premier and Governor of the Central Bank, to negotiate this matter with the CCB. Consequently, CICC was set up. The Vice President of CCB, Wang Qishan, was appointed as Chairman and Lam as President. I was invited as Senior Consultant. The name of CICC also reflects the thinking of investment banks. Serving as the World Bank’s first Chief of Mission to China for many years, Lim was a China hand. He knew that China avoided saying “capital,” so he determined that the Chinese name of CICC should be “中國國際金融 公司” (literally, China International Finance Corporation). In this way, the name not only manifested the real practice of investment banks, which was capital operation in the international market, but also conformed to China’s avoidance of the word “capital.” That was why I said the Chinese name of CICC both reflected the mentality of investment banks and contained Chinese characteristics. CICC was established in September 1995. As the company’s consultant, the first task for me was to get large state-owned banks out of the bad loans of overindebted state-owned enterprises. Fang Fenglei, Bi Mingjian, and I conducted research in Shanghai and picked out Shanghai Xinghuo Pulp and Paper Mill from the list of bankrupt companies to try out the debt-for-equity swap. Back then, banks were not allowed to hold shares, so we had to take a detour. We asked CCB to transfer its claim of debt of the paper mill to CICC and made CICC a shareholder of the paper mill through a debt-for-equity swap. Here, taking a detour is equally important as leveraging policy loopholes as a strategy of investment banking. To be honest, I did intend to solve the non-performing loans of banks and save over-indebted state-owned enterprises by advocating Xinghuo’s practices. This idea was approved by President of CCB Wang Qishan, State Economy and Trade Committee, Shanghai Municipal Government, and the Central Bank. The President of CICC even praised this plan by saying metaphorically: “We have dug a gold mine.” But surprisingly, the only objection was from senior government officials. In spite of that, until today, I still believe that Xinghuo’’s way of debt-for-equity swaps is indeed a creative strategy of investment banking. Later, in the attempt to reform and bail out state-owned enterprises, although the senior government officials encouraged business

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mergers and standardized bankruptcy procedures, a fundamental problem was that the government could not afford to replenish capital in a large number of distressed companies and therefore was unable to completely reverse the overindebtedness. Until 1998, since the three-year deadline to help out distressed state-owned companies as committed by the government was approaching, the government had no choice but to implement the debt-for-equity swap in the second half of 1999. Four newly-established financial asset management companies transformed loans into shares of stock in the companies which defaulted on loans from state-owned commercial banks, thus fundamentally relieving the enterprises of excessive debts and the banks of bad loans. This debt-for-equity swap basically borrowed some of Xinghuo’’s experience and core principles. Although we criticized it for lacking creative intellectual services and active financial innovations tailored for different projects like those provided by investment bankers, it was almost impossible to completely solve the over-indebtedness of enterprises and non-performing loans of banks within just three years if the government did not make the debt-for-equity swap into an administrative policy. In 2001, Premier Zhu Rongji declared success in the three-year bailout plan for state-owned enterprises in the Report on the Work of the Government. Despite bureaucratic habits of ingratiating with power and the rent-seeking behavior of government officials during this project, it was really a significant achievement. From a series of flexible and invigorating measures in the Reform and Opening Up era to the present exploitation of policy loopholes, there were many creations which were achieved by following the thinking of investment banks. Here, I believe, the core point of the investment banking strategies is the discovery of value and the making of innovations. What is at the center of innovation is to be able to size up the situation, grasp market opportunities, optimize resource allocation and reorganization, and create and capture markets. It is also imperative to adopt a positive, dynamic, and innovative attitude towards enterprises and even reform enterprises through business mergers, expansion, and restructuring. In addition, the courage to challenge inappropriate laws and regulations, the dedication to reforming political and legal systems, and the efforts to rationalize economic relations, create new financial instruments and means, and promote the development of productive forces are also essential. After the mid-1990s, I have not continued research on the mentality of investment banks for a long time. During the decade-long equity division in China’s stock market, what had been frequently seen was to buy non-tradable state-owned shares through negotiated transfer and then acquire huge capital

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through issuing additional shares at the market price. Here, it was not a smart invention but an unfair capital operation. Still, many people were eager to make quick money and the distorted system of the China Securities Regulatory Commission (SCRC) was impotent to monitor the unjust money operation. This is by no means a reflection of the thinking of investment banks. After entering the new century, especially in recent years, China’s reform got bogged down. Each government department stuck to the old routine for the purpose of safeguarding existing interests and thus the practices of exploiting the loopholes in existing laws and regulations by these departments frequently occurred. Let me give you the most typical examples. In the bond market, the Central Bank allowed enterprises to issue short-term financing bills and medium-term notes in addition to bonds and negotiable instruments. China’s bond market lagged behind and the two main reasons were: First, the Negotiable Instruments Law prohibited enterprises from issuing promissory notes and only allowed them to issue banker ’s acceptances; and second, the non-financial sector kept the management right of enterprise bonds under control while the National Development and Reform Commission (NDRC) insisted on approval authority over enterprise bonds issued to finance capital construction. The Central Bank bypassed those two obstacles and opened up short-term financing bills and medium-term notes. So, the bond market was injected with new vitality by gaining two kinds of new bonds and commercial banks extricated themselves from the worry of excessively concentrated risks from acceptance bills. Similarly, the CSRC invented corporate bonds apart from enterprise bonds in order to bypass the examination of the NDRC. Another example was financial leasing. In the 1980s, when I represented CCB to cooperate with a Japanese company in forming International Union Leasing, I noticed that the tax was very high in aircraft leasing. Unexpectedly, this problem continued for 20 years and the taxation department was still unwilling to lower the tax. In 2010, CBRC led several relevant banks to approve the setting up of “project companies” in bonded zones of China by ICBC Financial Leasing Co., Ltd. (ICBCFL), CCB Financial Leasing Corporation Limited (CCBFL), and Minsheng Financial Leasing Co., Ltd. (MSFL). Through these project companies, the original one-off payment of taxes and dues in aircraft import can be amortized into a series of payments to be made during the lease term, indirectly solving the high tax problem. The project company was a unique innovation by CBRC and the three commercial banks in an attempt to break the restriction of high tax in developing a leasing business by bypassing the taxation department. What the two cases did reveal was that the power conflicts between different departments gave rise to the above unusual bypassing practices. In

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Western countries, it is investment banks that help enterprises to leverage policy loopholes whereas in China, it is government departments who exploit the loopholes in the administration of other departments. Although it was an expedient out of a unwilling choice, the “innovative” practice of bypassing the NDRC and taxation department led by CSRC and CBRC was not only a financial innovation making use of the strategies of investment banks, but also a special way unique to China in solving the power conflicts between different departments and breaking the stalemate of reform. But in any case, productive relations must conform to the development of productive forces and the superstructure must comply with the economic base. This is a universal law of the development of human society. If the development of productive forces breaks through the restriction of existing relations of production and the superstructure is incompatible with the economic base, how to change the superstructure becomes the key. There are only three ways out: First, to give in and compromise. This is actually to stick to the present condition. Second, to confront it and break it down which may result in an unusable mess. Unless absolutely necessary, it is not a wise choice. Third, to find an alternative. It means to follow the thinking of investment banks — to think out an expedient, exploit policy loopholes, and bypass government authorities, in order to reshape the superstructure to suit the existing economic base. Most of the above stories happened 20 years ago. The reason why I recalled those histories and admitted the past limitations in understanding is to explain that there will be a gradual process in economic transition as well as in people’s updating and accumulation of knowledge. And back to the topic of the mentality of investment banks, the core is whether one can discover value and investment opportunities, and find out new ways to optimize resource allocation.

Capital Operation: Unique Financial Services Western countries often refer to investment bankers as “financial engineers.” It is because what investment banks provide are highly intellectual professional services that are necessary for capital operation in order to enhance a company’s efficiency and market competitiveness. Investment bankers know best how to optimize resource allocation to maximize benefits. Investment bankers are different from general bankers in that ordinary bankers sell financial instruments and financial services. Investment bankers, however, offer a package of flexible financial services customized to a particular

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enterprise and financial innovations under specific conditions. This is what people call “packaging.” Financial engineers differ from general engineers because the former do not commit to studying and discovering the value of a product or a technique but are skilled in researching and comparing the opportunity costs and marginal revenue of a certain capital operation method in order to discover its value and maximize the value through “packaging” various operation methods on the basis of their unique highly intellectual financial services (including the financial services and innovations that are available in modern society). In this regard, what investment bankers promote is not the capital operation in a general sense but companies which undergo business restructuring and special capital operation and can manifest the value of the capital managed by applying various intellectual services. Investment bankers know best how to optimize resource allocation to maximize benefits. Investment banks, from the very beginning, were designed for capital operation. They aim to increase the efficiency in enterprise and capital operation, namely carrying out external expansion of enterprises through financial innovations. If an enterprise uses its own capital or internal accumulation to invest, it is just an investment activity, namely capital utilization, rather than financial behavior. But when an enterprise transforms the assets with future income into securities (either stocks or bonds) to finance and be traded in the market, it is a financial activity. Meanwhile, as an enterprise raises capital in the capital market and undertakes business mergers or asset swaps to realize business and capital expansion, it becomes the capital operation in the capital market. So, capital operation is a kind of economic activity related to market financing and business expansion. The object of operation is not products or techniques but capital. But the capital operation of an enterprise must be based on the product management of the enterprise. Neither side can be underestimated and product management should always be the base. The capital operation of a company under a market economy includes five aspects: capital allocation, capital financing, capital utilization, capital concentration, and capital circulation. The target of capital operation is to rationalize and optimize capital allocation, simplify and reduce the cost of capital financing, make capital utilization more sufficient and efficient, increase the liquidity of capital deposits, and enlarge the scale of capital concentration. The capital operation in the stock market refers to how investment banks capitalize the assets with the future income of a company. Investment banks can either amplify the function of capital and gain the actual control over a

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company’s capital by holding shares, or increase the efficiency of an enterprise and its capital and realize capital expansion through business mergers, asset restructurings or swaps, or capital injection (including stock allotment and seasoned equity offering). Under the condition of full stock circulation, this kind of capital operation, though gambling, is the basis of the same price for the same share, and thus is seldom unfair. Sometimes, takeovers and reverse takeovers may cause huge ups and downs of stock prices and the cost is significant. It is important for capital operation to take advantage of capital markets and equity transactions. The capital market is a place where assets with future income are exchanged for capital. Asset (stocks and bonds) securitization is its basic way of operating. The law of capital movement in the capital market is the balance between risks and returns. The transactions of equity are essentially the trading of corporate control. During this trade, investment bankers and financial intermediaries have to price the assets of an enterprise, measure the risks or growth potential of the enterprise, and manifest the value of both the capital and the enterprise through a variety of intellectual services. This is the so-called “packaging.” Yet, this “packaging” must be based on real data and prospect analysis rather than exaggeration or deception. Here, the “packaging” refers to a kind of artistic creation and is by no means fabrication and fraudulence. Some intermediary institutions deliberately “package” poor quality stocks into high-yield “quality” stocks through accounting fraud to cheat investors in order to gain the position and interests of lead underwriters. This is deception and has nothing in common with what we call real “packaging.” There are also some securities firms which want to compete to be lead underwriters, but solely rely on a formulaic prospectus. They follow each requirement in the prospectus mechanically in every project. It is at most imitation and by no means “packaging” or innovation. The capital operation of investment bankers should be a real work of art rather than a forged piece of art. If investment bankers want to become well-deserved financial engineers, they have to make sure their creations can withstand the test of the market and time and they are truly responsible to investors. There are too many small enterprises in China. Therefore, it is necessary to carry out external expansion and industrial consolidation by taking advantageous enterprises as the backbone and industrial structural adjustments as the base. In 1997, the Report at the 15th National Congress of the CPC by Jiang Zemin put forward: “By using capital as the linkage and relying on the market forces, we shall establish highly competitive large enterprise groups with transregional, inter-trade, cross-ownership and trans-national operations.” 2 The economic development, industrialization, and quality improvement of economic

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agents in a country have to rely on large enterprises and enterprise groups. So, for large enterprise and business groups with international competitiveness, especially state-owned large enterprise groups that are large in scale, leaders in respective industries, and related to the lifelines of the national economy, the question of how to operate capital by depending on the market and enable themselves to grow stronger and larger has significant bearing to the reform and development of the state-owned economy. It should be said that for this reason, investment banks and capital operation have a broad space for development. The development of industries must take capital as the linkage and this is the law of socialized production in modern economic development. During business expansion of enterprises, how to connect and control production technologies, the supply of raw material, parts, and semi-finished products, and production and management personnel? Certainly, there may be various ways to achieve the results, but the most important and vital approach is to connect and control by using capital as the linkage. Capital is both a connector and a controller. It is able to bring technologies, products, the supply of raw material and parts, distribution channels, and staff and operation management under control. The expansion of large business groups especially international groups in the world is all realized through capital expansion. Their business operation also starts from capital operation. To use capital as the linkage, it is essential to take the basic functions of capital as levers and improve the efficiency of business and capital operation. As was said, the fundamental functions of capital are: 1. to establish an enterprise and ensure its continual operation; 2. to generate a high return (it is a more expensive scarce resource than loan interest); 3. to develop corresponding debt-paying ability; 4. to represent ownership — the control over a company is reflected by how much capital one has contributed. On the basis of those functions, the capital operation of enterprises realizes capital expansion through creating, splitting, or merging another enterprise under different circumstances. It may aim to enhance the return on capital and achieve the maximization of profits through controlling the enterprises and using low-cost borrowed capital (such as loans or bonds). It can also determine the control mode of the enterprises (direct or indirect holding), the degree of control (equity participation or taking majority stakes, and engaged in personnel management or compensation management), and whether voting by hands or feet. There is a learning curve for us to understand capital operation. Prior to 1978, Chinese people avoided saying capital, and of course, never talked about capital operation. The Third Plenary Session of the 11th CPC Central Committee in 1978 declared the transition from the planned economy to the socialist market economy

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and people gradually broke through the shackles of their way of thinking. They came up with the idea of achieving industrial consolidation through business mergers, but did not know how to solve the problem of restricted property rights flow. There was no real progress as the government only encouraged enterprise mergers but steered clear of property rights flow and asset restructuring. In September 1995, the CPC Central Committee adopted the Proposal on the Ninth Five-Year Plan on National Economy and Social Development and Long-Range Objectives to the Year 2010. It confirmed the policy of liquidizing and restructuring stock assets and proposed to “promote rational flow and optimized reorganization of existing assets through market competition,” and “realize strategic restructuring of state-owned enterprises through liquidizing and reorganizing stock assets.” The proposal paid unprecedented attention to stock assets. Since then, the economic sector brought forward the issue of capital operation. But even at that time, there were many people who only advocated asset management and asset operation but still considered “capital operation” taboo words. Until the 15th National Party Congress of the CPC in 1997 removed the clouds over capital in a socialist society and brought up the ideas of “using capital as the linkage,” “amplifying the function of capital,” and “enhancing the operational efficiency of enterprises and capital,” capital operation became a hot topic in the capital market. For me, I started to develop a positive attitude towards capital operation when I was asked by Zhao Bingxian to write a forward for his book On Capital Operation. I wrote a 7,000-word article which carefully reviewed different views towards capital in the 40 years of New China and the article probed into the operation of capital. The Chinese edition of the Financial Times published this article under the title “Capital Operation: A New Topic for Us” in May 1997. Subsequently, on the eve of the National Day of the same year, under the request of Wu Jinglian, I wrote “The Reform of State-Owned Enterprises and Capital Operation” for the Reform magazine. In 1997, the media started to focus on the topic of capital operation. An article written by Ai Fei in Economic Daily published on June 12, 1997, stated that the transition from strengthening state-owned enterprises to strengthening the stateowned economy was the first leap in cognition while the thoughts on capital operation were the second. Zhan Guoshu published an article on September 8 and suggested that the first leap in cognition happened when enterprises transformed from product producers to commodity producers and the second leap in cognition was their transition from commodity producers to capital operators. Regardless, during the 40 years of economic life in New China, from the avoidance of saying “capital” to the acknowledging of capital in socialist societies and capital operation with capital as the linkage, there was undoubtedly a leap in understanding. In

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that period, there were two kinds of fever in Beijing: capital operation fever in the business circle and investment banking fever in the financial circle. This reflected the fact that enterprises have huge demands for capital operation services, and investment bankers are eager to grasp this opportunity.

Initial Attempt by Chinese Enterprises at Capital Operation during Overseas Listing The first step of a company’s capital operation is to get listed. Once the company is listed, it is naturally qualified to take up direct finance, control social capital, and undertake capital operation. In the 1990s, China had just opened its economy and Chinese enterprises had no idea of the benefits of capital operation due to a lack of exposure to the capital market. The pioneers were companies which realized back-door listing in Hong Kong, such as CITIC Pacific and Shougang Group. These companies had accumulated sufficient capital in China’s Reform and Opening Up era and longed to enter into the global market from Hong Kong to enhance market visibility. They purchased a public company in Hong Kong and then directly injected capital in the shell company to achieve indirect listing in the Hong Kong Stock Exchange. By doing so, those private companies could avoid the disagreement between domestic accounting, auditing, legal practices, and international practices as well as the regulatory and financial requirements associated with an IPO. Early back-door listing implied the strategy of registering companies overseas by investment banks. Through back-door listing, a company can manage a large sum of money without selling assets, paying interest, or applying for a mortgage. This tangible benefit brought much joy to those pioneer enterprises in a closed economy. Reviewing the practices of China’s enterprises in capital operation, we can find that there was an evolution from spontaneity to consciousness.

Overseas back-door listing The first case of overseas back-door listing was the establishment of CITIC Hong Kong (Holdings) Limited by CITIC Group in 1985. In 1986, CITIC Hong Kong purchased Tylfull Company Ltd. The acquisition was completed through Tylfull issuing HKD270 million in shares to CITIC Hong Kong who would hold a 64.7 % stake in the former. It fixed the cost of mergers by avoiding the negative impact of stock market swings. This was considered the first attempt of Chinese companies in overseas capital operation. After purchasing Tylfull, CITIC Hong

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Kong successively acquired Dragonair, Companhia de Telecomunicações de Macau S.A.R.L. (CTM), and Dah Chong Hong Holdings Limited (DCH), and injected these stakes in Tylfull. In 1991, Tylfull changed its name to CITIC Pacific Ltd. From 1990 to 1992, Tylfull or CITIC Pacific had raised more than HKD8 billion through issuing new shares to pre-existing shareholders or to third parties. When CITIC Hong Kong purchased Tylfull in 1986, the latter had a net asset value of only HKD350 million. This figure grew to HKD6.12 billion in 1991 and was further expanded to HKD26.64 billion in 1995 with the assets under management reaching HKD39.30 billion. The listing of Shougang Group in Hong Kong was another example. In July 1992, the State Council granted Shougang Group the rights of foreign investment, equity financing, and foreign trade. At that time, Tung Wing Steel Holdings Limited held by Lee Ming Tee encountered difficulties in operation. It was said that among the 1 million tons of Hong Kong’s steel imports in 1990, one third was contributed by Tung Wing, one of the largest steel suppliers in Hong Kong. China Shougang International Trade & Engineering Corp. under Shougang Group spent USD22 million to acquire a controlling stake in Tung Wing by partnering with Cheung Kong (Holdings) Ltd. and CEF Holdings Ltd. Therefore, Shougang Group was able to indirectly get listed in the Hong Kong Stock Exchange after establishing a Shougang Holding Ltd. in Hong Kong to help the group manage its overseas investment and stock controlling. Then, Tung Wing raised capital by issuing new shares in the stock market and injected that money in Shougang’s subsidiaries (such as steel wire plants and strip steel mills), which expanded Tung Wing’s assets. In February and April 1993, Tung Wing, cooperating with Cheung Kong and CEF Holdings, acquired Eastern Century Holdings Limited and Santai Manufacturing Limited at the prices of HKD164 million and HKD314 million, respectively, by using its stocks as collateral. Following that, in June 1993, Tung Wing collected HKD1.88 billion through equity financing to gain the controlling interest of Santai and changed its name into Shougang Concord Technology Holdings Limited. Then, the investment alliance contributed HKD384 million to purchase a 50.32% stake in Kader Investment Company Limited which was later renamed into Shougang Concord Grand (Group) Limited. Starting from acquiring Tung Wing when the market value of Shougang Holding was HKD300 million, within less than two years, Shougang Holding increased its value to HKD6.36 billion. Then, through a series of stock offerings and mergers, its market capitalization reached as high as HKD12 billion. This capital operation mode of snowballing assets was known as the “Tung Wing development mode.” That is to say, by taking advantage of Shougagng Group’s influence, to first acquire a listed company, and then raise

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money through stock offering before leveraging the acquired company’s assets to pursue new acquisitions. The back-door listing of CITIC Pacific became a role model for many other enterprises which planned to undertake cross-border operation. Subsequently, there were some departments, cities, and enterprise groups which developed a variation of the back-door listing. That variation involved transforming an overseas subsidiary of a business group into a shell company instead of buying a shell company in order to realize the overseas listing of these parent companies (business groups). The first mover trying this new listing method was Hai Hong Holdings Company Limited under China Merchants Group (CMG). It was initially created as a paint maker to support the shipping business of CMG and was responsible for manufacturing marine paint in Hong Kong. Later, under the lead of Yuan Geng, the head of CMG, Hai Hong built technical cooperation with Hempel Marine Paints A/S (Denmark) and quickly occupied half of the Hong Kong marine paint market. In 1981, Hai Hong set up a factory in the Shenzhen Shekou Industrial Zone and continuously developed new products such as building emulsion paints, interior and exterior wall coatings, and road-marking paints, after absorbing the Danish technologies. Starting from 1989, Hai Hong diversified its business by branching out into building coatings, road markings, protective coatings for heavy industry, and container paints and even entered into the anticorrosive paints market by designing and producing heavy-duty anti-corrosion coatings used in wide areas including bridges, port machinery, power plants, railcars, boarding bridges, oil and petrochemical storage tanks and pipes, and marine drilling platforms. Hempel-Hai Hong enjoyed a high reputation in the worldwide electrical (hydro, thermal, wind, and nuclear power) anticorrosion market. In 1991, Hai Hong transferred its technologies of wall coatings to Australia which signified that China’s building coating technologies were among the world’s best. In July 1992, CMG injected the capital from Hai Hong’s factory in Shekou into Hai Hong Holdings (Hong Kong) and got the latter listed in the Hong Kong Stock Exchange as Hong Kong’s first red chip company. Raising HKD90 million through its IPO, it was oversubscribed by more than 370 times, creating a new record in Hong Kong’s stock market. In 1997, Hai Hong Holdings (Hong Kong) was renamed China Merchants Holdings (International) Company Limited (CMHI). The gross turnover of CMHI soared to RMB1.3 billion in 2004 from RMB100 million when the company first went public. The practice of CMHI going public in Hong Kong was widely talked about among the business circle. As a result, many enterprises followed suit,

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for example, China Overseas Land & Investment Ltd. under China State Construction Engineering Corporation (CSCEC) was listed in Hong Kong in August 1992; China Travel International Investment Hong Kong Limited under China Travel Service conducted its IPO in October 1992; Denway Motors Limited under Guangzhou Automobile Group Co., Ltd. went public in February in Hong Kong in 1993; Hong Kong Stone Electronic Technology Limited (later known as Stone Group Holdings Limited) under Stone Group Corporation (Beijing) became a publicly-traded company in 1993; and Legend (Hong Kong branch) under Beijing Legend Group (now renamed Lenovo) floated shares on the Hong Kong Stock Exchange in 1993. Together with the back-door listing of CITIC Pacific and Shougang Tung Wing, a red chip wave surged in China. Red chip companies later were expanded to more than 50 as many local enterprises or business groups were eager to emulate those forerunners. Here, I would like to explain why those companies are called red chips. In Hong Kong’s stock market, people usually call the most valuable stocks as “blue chips,” which is a practice derived from American poker where blue poker betting discs are the ones with the highest value. And at that time, the international world also referred to China as “Red China.” Correspondingly, Hong Kong investors named stocks of mainland China companies incorporated outside mainland China and listed in Hong Kong as “red chips.” During that period, apart from issuing renminbi-denominated A shares, China’s stock market also issued B shares that are traded in foreign currencies and some large- and medium-sized Chinese enterprises, such as Sinopec Shanghai Petrochemical Company Limited (SPC), Tsingtao Brewery, and Maanshan Iron & Steel Company Limited, were allowed to go public in Hong Kong with their stocks called H shares. The reason why Hong Kong is a preferred listing place for many Chinese companies was mainly because Hong Kong is subject to the international standards in operation philosophy, governing structure, and accounting system, and offers a rigorous regulatory environment, besides the reason of leveraging overseas capital through equity financing. By contrast, the Hong Kong financial circle favors red chips more than B and H shares. That is because red chips are incorporated in Hong Kong and their management teams are also based there. So when compared to other Chinese companies, they have better access to market information, are more sensitive to market changes, and can deliver more timely services. Similar to B and H shares, red chips are also particular to China and benefit from China’s Reform and Opening up era and subsequent high-speed economic growth. The only difference is that red chips are less prone to administrative intervention and restrictions. For example, in material purchases, product distribution, and

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price controls, B and H shares are subject to the government’s macroeconomic regulation or direct control whereas red chip companies are more flexible in management and receive fewer restrictions. Additionally, red chips enjoy complete freedom in financing and can seize favorable opportunities to raise funds in the best methods while B-share and H-share companies are more likely to lose the optimum financing chance due to lots of administrative restrictions. Lastly, red chips have high transparency and are the same as Hong Kong companies in terms of information disclosure, business development, and operational philosophy. However, at the early stage, red chips, similar to overseas listed H shares, only centered on enterprises themselves and operated capital in a disperse and spontaneous way without taking advantage of governments’ functions. Until May 1996 when Shanghai Industrial Holdings Limited got listed, red chips were transformed into “window companies,” and were involved in the capital operation where governments had injected money, and thus became popular among investors.

Controversy over acquisitions by China Strategic Holdings Limited In 1992, China Strategic Holdings Limited headed by Oei Hong Leong purchased 55% and 51% stakes in two rubber plants located in Taiyuan and Hangzhou, respectively, through investments of USD20.25 million, and the company then registered China Tire Holdings Limited in Bermuda. China Tire Holdings Limited was listed in New York and raised USD103.7 million by issuing American depositary receipts (ADRs). Shortly after that, it merged three tire plants in Chongqing, Dalian, and Yinchuan by holding 51% to 52% shares in each. In the brewery industry, Oei Hong Leong brought Beijing Beer Factory, Hangzhou Beer Factory and another two beer factories and “repackaged” them as “China Beer Holdings Ltd,” which was also registered in Bermuda. It was later put onto the Toronto Stock Exchange in Canada. And in less than 2 years, the new company was sold to the Asahi Beer Corporation of Japan and it went on to become the “Beijing Asahi Beer Corporation.” From April 1992 to August 1993, China Strategic Holdings managed to acquire more than 200 companies within just four months and people referred to this series of events as the “China Strategic Storm.” Apart from some half-way terminated contracts due to government intervention, China Strategic Holdings in fact merged 196 companies. After purchasing those Chinese enterprises, China Strategic Holdings recorded an interim turnover of HKD1.79 billion (HKD1.03

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billion when listed) and a pretax profit of HKD203 million (HKD116 million when listed) in 1994. The success of China Strategic Holdings in capital operation stirred turmoil in China. Some criticized its practice as “creating something from nothing” and speculating on Chinese state-owned enterprises by purchasing at a low price before selling at a high price. Some questioned its contribution to China’s economic reform and argued its capital operation caused the drain of state assets. For a time, China Strategic Holdings became the center of the debate over China’s state-owned enterprise reform. Looking back, I think the success of China Strategic Holdings is firstly owing to the fact that it had the right timing. Deng Xiaoping’s southern tour speech and the prevalence of the “China miracle” in the international capital market in 1992 created favorable opportunities to invest in China. Second, China Strategic Holdings chose the right industries and enterprises. The industries it invested in had positive market prospects, large demands, and significant profits and the acquired enterprises were middle-sized stateowned companies with fixed assets being less than RMB100 million but having a considerable scale and profit potential, whose approval rights were in the hands of municipal governments. Third, there were loopholes in China’s laws and regulations concerning Sino-foreign joint ventures. For example, China allowed foreign investment to be made by instalments and a foreign company can easily obtain corporate control by prepaying 15%–20% of the total investment. China Strategic Holdings took advantage of this policy by listing the acquired companies in overseas markets before leveraging the raised capital to make the instalment payments and purchase other companies. In addition, China Strategic Holdings also benefited from China’s favorable policies to joint ventures in taxation and exchange rates. Fourth, China Strategic Holdings was very successful in capital operation by listing acquired Chinese enterprises abroad. At that time, China had just started to transform from being a planned economy to a socialist market economy. Before that, people longed for a product economy, and until the Reform and Opening Up era, they accepted the planned commodity economy and finally recognized the socialist market economy in the 14th National Congress of the CPC in 1990. Under the planned economy for over 30 years, China’s stateowned enterprises always manufactured and distributed their products according to the state’s plan. During the first decade of China’s Reform and Opening Up era, enterprises were only regarded as “relatively independent product makers” and never truly assumed the role as the main market players.

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They neither had the legal personality nor exercised the power of legal persons and lacked basic knowledge and experience of equity transactions, let alone the trading of corporate rights. Meanwhile, in fundraising, Chinese enterprises were only accustomed to attracting foreign investment and establishing joint ventures and not until much later, did they learn to borrow money from banks and issue stocks in securities markets. It is no wonder that in the face of Oei Hong Leong’s fundraising of several billions of dollars in the stock market, people would think he violated state interests and caused the loss of state assets. Surprisingly, the listing of Hai Hong, China Travel International, Stone Electronic Technology, and Legend in Hong Kong was not questioned by Chinese people. There must be some irrational emotion in the controversy of China Strategic Holdings. Last, the capital operation of China Strategic Holdings through establishing joint ventures and overseas listings not only strengthened the acquired companies in terms of capital and equipment, but also brought a huge shock to the longclosed Chinese state-owned enterprises with respect to management philosophy, governance model, leadership arrangement, and personnel placement. Overall, China Strategic Holdings completely renewed the management system concerning not only production and distribution but also personnel, capital, and materials. It will act as a role model and incentive in the reform of state-owned enterprises. Besides, some people were oversensitive to the flow of state assets and mistook it each time as the drain of state assets, but they were not aware that to leave state assets unused was also a kind of waste.

Window companies and capital operation of government funds In the early 1990s, many cites in China were in great need of construction funds. Some foreign investment banks noticed the favorable investment policies of the Chinese government and looked for investment opportunities in China. Meanwhile, some overseas back-door listed companies also sought business opportunities in China by relying on offshore funds. People called these companies pseudo-foreign companies. Some of those cities attempted to undertake new construction projects by raising money from transferring the right of management of existing infrastructure assets, namely, selling old roads in order to build new ones. At that time, Shanghai transferred the management right of a tunnel and two bridges to CITIC Pacific through the transfer-operate-transfer (TOT) method in exchange for capital for new infrastructure construction. This action inspired the officials of Shanghai’s industrial sector to build a “CITIC Pacific” of their own. This resulted in the listing of Shanghai Industrial Holding Limited (SIHL) in the Hong Kong stock market.

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When SIHL went public in 1996, the prices of “China concepts stocks” languished in the Hong Kong stock market. At the time, Peregrine Investments Holdings and Morgan Stanley were the financial consultants and principal underwriters for SIHL. After analysis, they concluded that in the past, red chip stocks mainly comprised enterprises of industrial production, which were highly susceptible to government regulation and control. In contrast, SIHL engaged in the manufacturing of consumer products with its constituent companies being Nanyang Tobacco, Wing Fat Printing, Shanghai Jahwa and Sunve Pharmaceuticals. Their products were less impacted by the government’s macroeconomic policies. Therefore, when listed, SIHL could emphasize its special value in location (Shanghai) and products (consumer goods) by saying that China is a large country with more than one billion people and which has a huge market for consumer goods, and Shanghai is an international metropolis that is open to the world. This strategy indeed contributed to the successful listing of SIHL and the revitalization of China concepts stocks. As a result, SIHL’s IPO was oversubscribed by 160 times and it attracted HKD30 billion. Later, in a meeting of SIHL, the leaders of the Shanghai Municipal Government promised, “SIHL will be built into a window company of the Shanghai government in Hong Kong. More capital will be constantly raised through its stock offering, and high-quality enterprises and assets will be injected into SIHL.” In fact, the real intention of the government was to use high-quality enterprises and assets to attract more capital through this window company. In the subsequent stock placements of SIHL, the Shanghai government fulfilled its promise by acquiring interests in Bright Dairy, Shanghai Orient Shopping Center, Shanghai Yan’an Road Elevated Road, Shanghai Huizhong Automotive, and North-South Elevated Expressway in order to maintain the high profits and high growth of SIHL. The successful practices of SIHL in raising funds through stock offerings and continuous acquisitions of high-quality enterprises and assets in Shanghai displayed high profitability, and were thus greatly sought after by Hong Kong investors. In 1997, when Beijing Enterprises Holdings Limited (BEHL) launched its IPO in Hong Kong, its financial consultants and principal underwriters were also Peregrine Investments Holdings and Morgan Stanley. At first, BEHL borrowed the mode of SIHL and promoted its stocks by highlighting the position of Beijing and the production of consumer goods. It was said that through buying shares of BEHL investors could gain an interest in almost every business they needed in Beijing, from Capital Airport Expressway, Beijing Jianguo Hotel, Beijing International Switching System Corporation Limited (a telecommunications equipment provider), Beijing Badaling Tourism

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Co., Ltd., Wangfujing Department Store, to McDonald’s, Sanyuan Food, and Yanjing Brewery. BEHL held shares in all of these companies. This showed that investment banks indeed provided many good ideas in promoting the selling points of BEHL. Since SIHL as a window company was welcomed by investors in the stock market, investment banks immediately adjusted their strategies and introduced the concept of a “window company” in the roadshow of BEHL. Therefore, the value of being such a company had been revealed: High-quality enterprises or assets would be constantly injected. This change in strategy reflected the flexibility of investment banks in capital operation. Consequently, BEHL’s IPO locked up HKD210 billion by being oversubscribed 1,200 times and BEHL suddenly became a popular stock in the Hong Kong market. The Beijing Municipal Government also kept its promise by continuously injecting highquality assets and maintained the growth of profits of the window company. The successful listing of SIHL and BEHL triggered the boom of red chip stocks in many cities of China and these companies also learned from the two window companies about post-IPO capital operation, namely, stock placement and high-quality asset injection. From then on, red chip stocks were no longer limited to the spontaneous listing of and fundraising by an independent company but included the planned capital operation activities by local governments through the setting up of a window company to raise capital and inject high-quality assets. This was a large breakthrough during this period. It should be said that the red chip stock was a major breakthrough for China’s state-owned companies in capital operation. After all, the key of the state-owned economy was in its controlling power and competitiveness. The success of red chip stocks like SIHL and BEHL was owing to the full play of the controlling power and competitiveness of the state-owned economy. The planning and decision-making role of local governments in the capital operation of red chip stocks was realized through them acting as large shareholders instead of exerting administrative power. State-owned capital is contributed to by the state and therefore should be planned, operated, and utilized by governments. As long as governments participate in the operation and planning of a company as shareholders, it is totally lawful and complies with the “rules of the game.” In fact, any holding group under a market economy operates its capital in the same way. For red chips and all listed companies, what matters in capital operation is not whether governments participate or not but how governments play their role. Companies should consider: Whether governments act as shareholders or administrators; whether governments inject assets based on arbitrary decisions or careful choices; whether governments simply aim to reduce their burdens or focus on business

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returns and profit growth (this is an important indicator to measure the growth potential of a company); and whether the capital is operated in accordance with market rules, mechanisms, and orders or by relying on mandatory administrative intervention of governments. Experience has shown that if red chips want to make some contributions in capital operation, they should focus on financial operation and regard providing high-quality enterprises to the market as a constant goal rather than counting on speculations in the secondary market.

The listing of China Telecom in Hong Kong opened a new era in the overseas listing of large Chinese enterprises When local governments were busy with the capital operation of red chip companies, China’s Central Government decided to reform the monopolistic telecommunications industry by separating government functions from enterprise management. China’s telecommunications industry is an enormous industry, including 33 telecommunications bureaus at the provincial level and 2,385 telecommunication systems at the municipal (prefectural) or county levels. At that time, postal and telecommunications services were under unified management of the Ministry of Posts and Telecommunications of China. While starting the separate management of the two types of services and undertaking a reform in industrial consolidation, the ministry was also preparing the overseas listing of a telecommunications company. According to the plan of investment banks, a company named China Telecom (Hong Kong) Limited would be first incorporated in Hong Kong before a fully-owned subsidiary, China Telecom Hong Kong (BVI) Limited, was registered in the British Virgin Islands. This arrangement was the result of learning from the listing experience of red chips. The subsidiary owned 100% interest in Guangdong Mobile Communications Co. Ltd. and 99.63% interest in Zhejiang Mobile Communications Co. Ltd. During that time, under the unified management of postal and telecommunications services, provincial companies were responsible for the operation strategies and network building of the mobile phone business while municipal and county level posts and telecommunications bureaus were in charge of actual operations, maintenance, and billing. There were some slight differences in the specific division of labor in those two provinces. The largest obstacle in business restructuring before listing was the system conversion in accordance with the international standard. The past administrative and closed management mechanism must be transformed into an open, transparent, and standard management system in line with international practices. China

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Telecom (Hong Kong) faced a series of difficulties in its reorganization in the aspects of telecommunications network interconnection, accounting standards, financial and accounting systems, and corporate structure, and also encountered many challenges in reform practices. On October 23, 1997, China Telecom (Hong Kong) (subsequently renamed China Mobile [Hong Kong]) was listed in both Hong Kong and New York and successfully raised USD4.22 billion by taking advantage of its RMB19 billion capital base. Shortly before that, China Southern Airlines raised USD700 million through its IPO in Hong Kong, which was already a huge volume IPO, but the capital collected by China Telecom (Hong Kong) was six times larger than that gathered by China Southern Airlines. During the IPO of China Telecom (Hong Kong), CICC and Goldman Sachs acted as sponsors and underwriters. The successful listing of China Telecom in Hong Kong was attributed to two major successes in capital operation. First was the success in issue pricing. When China Telecom (Hong Kong) was listed in 1997, the offering price was first set at HKD7.75–10 per share on September 26. During roadshows, investors showed confidence in the company’s stocks. On October 12, after careful research, investment banks and China Telecom decided to raise the issue price to HKD10–12 per share. Unfortunately, the impact from the Southeast Asian financial crisis on Hong Kong was increasingly dramatic, the Hang Seng Index dropped from its peak of 16,000 points to 14,000 points in mid-October and how to price the stock became an acute issue. On October 16, China Telecom finally set the offer price at HKD11.8 per share. When China Telecom (Hong Kong) made its IPO on October 23, the Hang Seng Index fell to 10,426 points. On that day, Hong Kong share prices fell across the board and China Telecom (Hong Kong) also dropped below the offer price, but its price soon stably returned to above HKD12 and remained rock solid even during the East Asian financial crisis. This indicated that investment banks had done a good job in evaluating the company’s profitearning capacity and potential risks. The second success is the overall listing. In preparation for the listing of China Telecom (Hong Kong), some suggested that Guangdong and Zhejiang mobile telecommunications should be listed separately. But CICC believed that to list China Telecom as a whole was better than separate listings for the sake of highlighting the family brand. Admittedly, the telecommunications market itself was very attractive, but the overall listing of China Telecom (Hong Kong) displayed the charming brand value of an industry in China and thus the Hong Kong market hailed this stock as a “red chip giant.” This event initiated the overall listing of industry-based holding companies in China and marked a new

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era in the overall listing of China’s large enterprise groups in overseas markets. Following that, China Unicom, China National Petroleum, China Petroleum and Chemical Corporation (Sinopec Corp.), China National Offshore Oil, the Bank of China (BOC), CCB, and BOCOM successively floated abroad, and ICBC was dual-listed in both the Shanghai and Hong Kong markets. Now, it has become an important channel to utilize international capital and also created a new mechanism for Chinese enterprises to be geared to international standards in terms of management and governance structure.

Offshore spin-off listing of Chinese companies In 1999, Hong Kong opened its growth enterprise market (GEM), attracting many of the Mainland’s small- and medium-sized enterprises to go public in Hong Kong. It offered a new channel for capital operation. In 2000, Tong Ren Tang, one of the oldest traditional Chinese medicine companies in the Mainland, set up a holding company (Tong Ren Tang Technologies Co. Ltd.) which was successfully listed in the Hong Kong GEM and became the first offshore spin-off listing of a Mainland enterprise. The uniqueness of Tong Ren Tong’s mode lies in that it not only improves the competitive edge of Tong Ren Tong in the international pharmaceutical market but also offers a stable way for the listed company to spread risks while entering into the high-tech industry. Additionally, Tong Ren Tang Technologies raised a huge amount of capital through spinning off the stock premium of the listed parent company whose stock price would also appreciate at the same time. Meanwhile, according to the provisions of GEM, the newly-established company is able to establish an incentive mechanism in the distribution system in order to enable its senior management staff and the core technical experts to obtain shares in the company in the form of performance shares or stock warrants. In the original equity of Tong Ren Tang Technologies Co. Ltd., this incentive scheme accounted for approximately 1.91%. This brought about a huge shock to the egalitarian remuneration system of the Mainland’s state-owned holding companies. In the above, we have outlined the back-door listing of Chinese enterprises, the overseas listing of local window companies, and the overall listing of large Mainland enterprises in Hong Kong, and it can be summed up as the process of capital operation by Chinese enterprises in the overseas stock market. The stock market of Hong Kong is a full-circulation market, and the above-mentioned Chinese enterprises magnified the function of capital through share holding, got the actual control of corporate capital, and raised capital through planning IPO and secondary offerings. This type of capital operation, though gambling,

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is based on the principle of the same price for the same share and expands capital by improving the efficiency of companies and capital through normal means, and therefore the capital operation is fair, just, and open. It is strictly different from what we will discuss later — unfair capital operation under equity division.

Early China’s Stock Market Left No Room For the Capital Operation of Investment Banks Beginners in stock markets always wonder why a stock worth RMB1 can be sold at a price of RMB10-20; why a net asset worth RMB1 can be sold tenfold or twentyfold; how a stock price is determined. In the above, we have briefly mentioned that in stock markets of mature market economies, the stock value is collectively decided by the future earnings of assets and the value discovery function of the market. An important role of investment banks is to reflect, in an appropriate way, the price expectation of the market formed based on the value discovery function via their special financial services. However, in China, during the 15 years from the stock market pilot project in 1990 and the equity division reform in 2005, what people frequently saw was the market manipulation and speculation by brokerage firms and large capital groups instead of the intellectual services provided by investment banks and investment bankers. In the first 15 years of China’s stock market, there was a strange phenomenon: The primary market was booming while the secondary market was struggling. The root cause was that new shares were priced too low. Why were new shares underpriced and why can these shares not be priced reasonably as in mature capitalist markets? The key did not lie in the method of pricing but in the fact that China lacked a mature investment environment like that in the Western countries. The capital market is a place where assets are exchanged for capital and in this market, listed companies are sellers while investors are buyers. The two trading parties are separate and the asset value of listed companies is priced based on the quality and risks of assets. In a mature capital market, it is investment banks who are responsible for the pricing (in China, it is securities companies). The duty of investment bankers is to discover the value of a particular asset and reflect the value through their intellectual services. In general, investment bankers work as sponsors and underwriters in IPOs. The question is how to set a reasonable offer price. Issuers hope that the

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price of their stocks can be as high as possible in order to raise more money. Underwriters think the same way in that the higher the offer price is, the more fees they can receive. But if the price is fixed too high, there will be a chance that the stocks cannot be sold. If brokerage firms (or investment banks) enter into a firm-commitment contract with issuers, they will assume the risk of an enormous sum of money being tied up when the price goes down. If they sign a best-efforts or stand-by underwriting contract, they should bear the risk of failed selling, which will impair the reputation of the underwriting investment banks. So, it can be seen that the pricing of new shares concerns the two sides of the market (namely, buyers and sellers) and cannot be determined solely based on the wishes of sellers and brokerage firms. In this way, it is necessary to take full consideration of the opinions of buyers. Among buyers, an important participant is institutional investors, including investment funds, pension funds, business groups, insurance companies, securities firms, banks, etc. In the mature stock markets of Western countries, there is a significant part of securities underwriting of investment banks — road shows. When visiting some large investment banks in Western countries, we frequently heard: “Our investment banks do not have money in hand, but we know where to get it and we can help you to find ‘cheap’ money.” These few words are very critical because this means investment banks have a long list of institutional investors, or to be exact, a network of institutional investors. The road shows are held by investment banks to give issuers a chance to introduce new stocks to potential buyers. During this process, institutional investors can have a full understanding of the listed companies and the management skills of their managers while issuers can also take this chance to seek out advice in respect to share prices and subscriptionrelated issues. Institutional investors serve four functions for listed companies. 1. When institutional investors participate in road shows and express their intent to subscribe, listed companies can identify opinions and reactions from potential buyers. 2. Holding shares by institutional investors implies support for newly-listed companies and their stock prices. 3. Institutional investors can play an exemplary role for public investors in purchasing shares. 4. Institutional investors usually undertake long-term investment and thus will stabilize the stock market. As the price determination involves such a complicated process, the price difference between the primary market and the secondary market will not be significant in Western countries. However, the capital gains in China can be several times as many as the purchasing price. This is a challenge for the intellectual services provided by investment banks in stock pricing.

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China’s stock market was an incomplete capital market during the early stages. First of all, the qualifications of investors were strictly controlled. There was a fundamental flaw in the system design of China’s stock market. Financial authorities only planned to raise funds in securities markets but failed to make full preparation for dealing with investors’ capital collected from various channels. In 1993, when the stock market pilot project was in full swing, capital raised from various sources swarmed into the market. The supervisory body thought that the stock market was highly speculative and too risky, so they strengthened the regulation and supervision towards the capital flowing into the stock market. As a result, illegal inter-bank lending was cleaned up in 1993; pension funds and insurance funds were no longer allowed to enter the stock market in 1994; bond repurchase funds were kept away from the stock market in 1995; and state-owned enterprises and listed companies were prohibited from investing in stocks and bank funds were forbidden from flowing into the stock market against regulations during the bull market between 1996–1997. Additionally, securities companies were only allowed to participate in the stock market by using their own capital and could not engage in margin trading or short selling. And investment funds were not opened until much later. However, the problem was that when closing the doors of illegal trading, the supervisory authorities did not open new channels for legal fundraising in the stock market. The market was almost completely made up by individual investors but it lacked institutional investors, so it was built based on an unstable capital base comprised of 40 million individual investors. Under such a condition, even though securities firms were able to fix a reasonable price for new shares, there was no standard institutional investor to review and endorse listed companies and their stock prices in road shows. If new shares cannot be sold out at the set price, it is impossible to demand that brokerage firms sign a firm-commitment contract every time. After several rounds of pricing experiments after 1993, especially after the stock market slump and the fear for market expansion between 1994 and 1995, the securities brokers decided to sell new shares at a price-earnings ratio (P/E ratio) of 13–15 and allow millions of individual investors to directly subscribe to the shares through filling securities deposit forms or online purchasing. It was in fact equivalent to using a low offering price in the primary market to lure investors to profits by selling at a higher price in the secondary market. This is a non-normative expedient aiming to expand the stock market based on the condition of a lack of institutional investors in China’s stock market. An extremely low offering price of new shares brought about two major drawbacks:

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First, there was asymmetry in risks and returns between the primary and secondary markets. The P/E ratio of stocks in the secondary market was generally around 30 to 40 times earnings while in the primary market, the ratio was only 13 to 15. Generally speaking, once the subscribed new shares are traded in the secondary market, investors will receive capital gains of several times the purchasing price. Some people made statistics especially on this matter in 1998 and the result showed that the capital used for subscribing new shares could record an annual rate of return of 70% in 1996 and 50% in 1997. In 1998, there were a large number of new large cap shares of state-owned enterprises in the stock market, whose annual rate of return was still above 30%. In short, the primary market generated sure-fire returns and contained no risks, while the secondary market saw frequent price rises and falls and accumulated high risks. Second, capital gathered from the public was overly concentrated in the primary market. New shares usually have high earnings and the subscription rate was around 200 times but the average demand-to-offer ratio was only 0.5%. Additionally, the full amount of the subscription price must be paid in new shares subscription. According to the situation in 1998, there would be two new shares issued every week, which could raise about RMB1 billion, but over RMB200 billion would be tied up. At that time, the market value of the secondary market was around RMB600 billion and the average daily transaction volume in the market was only RMB10 billion. The capital concentration in the primary market was caused by the fact that investors would sell old shares in the secondary market before new shares were offered in order to free up their capital. After subscription, their capital would be locked in the primary market for four days and four days later, unsuccessful subscribers would get their money back into the secondary market. Some investors even stayed away from the secondary market and devoted all their funds into the primary market. They became specialized new share buyers. It was because too much capital was accumulated in the primary market that the secondary market suffered a deficiency of capital. The booming primary market caused the inactivity in the secondary market. The shortage of institutional investors in the stock market system encouraged the low offering price of new shares, and, more importantly, fostered excessive speculation. As a result, securities firms did not make efforts to standardize stock pricing but were dedicated to decorative or even deceptive packaging and therefore they did not make money through providing intellectual services as their counterparts in Western countries but sought profits through speculation and manipulation in the secondary market. In addition, since there were no

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institutional investors for public investors to follow, the latter made blind investments, which increased the risk of investment. So, at that time, some people said that the vicious purchasing of new shares in China’s stock market was a kind of excessive speculation stemming from the systematic defect. This was no exaggeration. As new securities were issued at a low price and corporate mergers and asset reorganization were conducted under the government’s planning through the transfer of state-owned assets and equity replacement, so it was said that China needed only brokerage firms rather than investment banks. Under such a condition, before 2005, regulatory authorities stipulated that the underwriting fee charged by securities firms should not be above 1.5%–3.0% of the raised capital and for the fundraising amount over RMB400 million, the fee should be less than RMB10 million. This was the lowest underwriting fee in the world. It seemed to imply that in the regulations China did not need the high intellectual services of investment banks. In 1999, the financial environment of China’s stock market changed. First, legitimate financing channels for brokers were clarified and banks were able to invest in the stock market through lawful means. Second, holding shares for six months by state-owned enterprises and listed companies were no longer considered speculation. Third, insurance funds were allowed to enter into the stock market through investment fund companies. These were the three major breakthroughs in laws with the purpose of creating financial channels for the stock market. Meanwhile, brokerage firms were able to undertake business consolidation and increase share capital, securities investment funds were expanded (in 1999, there were 19 securities investment funds from 10 fund companies with a total sum of RMB47 billion), and state-owned enterprises and listed companies could act as institutional investors to hold new shares. The direct result of those policies was a sharp increase in the subscription amount of new shares. On September 23, 1999, Shanghai Pudong Development Bank (SPD Bank) launched its IPO and locked up RMB226 billion. During that week, the money frozen in the new share subscription amounted to more than RMB400 billion, breaking the weekly record of RMB250 billion. Certainly, compared to the frozen capital of new share offering in the great bull market between 2006 and 2007, this number was insignificant. In 2006, capital locked up in IPOs was: RMB780 billion for ICBC, RMB839 billion for China Life, RMB1.16 trillion for Industrial Bank (IB), RMB1.1 trillion for Ping An Insurance, RMB1.43 trillion for China CITIC Bank, RMB1.46 trillion for BOCOM, RMB2.66 trillion for China Shenhua, and RMB3.3 trillion for China National Petroleum Corporation (CNPC).

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At the same time, more and more listed companies developed towards large cap blue chips and were open to private stock companies and technology stocks, and the stock issue method turned to be a market-oriented one. Since 1999, IPOs were no longer issued at a price of 13–15 times earnings and they adopted an improved stock issue method for larger cap shares with a total capitalization over RMB400 million. Starting from Beijing Shougang Company Limited, listed companies introduced share ownership by institutional investors and legal persons and held road shows to introduce their companies and shares under the lead of securities firms. For one thing, through direct communication between investors and listed companies, the entrepreneurs were able to display their managerial and administrative expertise while the investors could know whether these managers were trustworthy or not. For another, this communication provided a chance for buyers and sellers to negotiate the offering price. Additionally, by combining legal person allotment and online issue, institutional investors and legal persons could be attracted. As they engaged in long-term investment, their participation would stabilize the stock market. This made a good start in changing the stock issue method, but due to the delayed equity division reform and especially the enforced implementation of circulating state-owned shares at the market price in 2001, a bear market continued for five years and all new stock offerings was suspended, let alone the development of investment banks.

Unfair Capital Operation in the A-Share Market under Equity Division The international stock market is a full-circulation market where same shares are traded at the same price. However, in China’s stock market, starting from its pilot project in 1990 to 2005, there was a price difference between tradable shares and non-tradable shares in the same state-owned enterprise. The fundamental cause was a fear of the loss of state-owned assets in circulation. But the real problem was not the restricted circulation of state-owned shares. Without the trading of those shares, the capital operation of equity transfer, asset reorganization, asset swap, and corporate mergers would not happen, and the worst impact would only be the deterioration of resources allocation and the loss of faith by holders of state shares in state capital operation and business efficiency improvement. It would only create losses to large shareholders and would not damage the interests of medium and small investors, so it was not unfair. The unfairness during this period was caused by the fact that though

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state shares were forbidden from being circulated, they were allowed to be transferred via negotiation outside exchanges. It brought about all sorts of the pursuit of profits through speculative means and stimulated fundraising activities and unfair capital operation in the stock market. The unfairness had four major features: First, two parallel markets of different prices for the same share were created. One was a public tradable share market where stocks were traded at the market price. The other was a private market for non-tradable shares. In this market, non-tradable state shares can only be transferred through negotiation at a price a little higher or lower than the net asset value and their prices were much lower than the price of their counterparts in the public market. Second, the two markets with a price difference for the same share implemented the same financing system as the full-circulation market, thus creating a system defect. People were encouraged to pursue low-price transfer of state-owned shares and assumed the position of major shareholders in order to manipulate stock offerings. This was the so-called “money hunting trap.” Additionally, in the year 2000, the requirements for secondary offerings were lowered and the volume of new shares issue was generally three times the size of stock allotment, which promoted excessive secondary offerings. Large shareholders of state shares can choose to give up their preemptive right to purchase new shares in allotment, which further encouraged the issuance of new shares. Third, the unfair capital operation in China’s stock operation was reflected in the backdoor listing through negotiated transfer of non-tradable shares at a low price. And it was also reflected in the deceptive packaging (mostly, in the aspect of asset replacement) of listed companies which were going to undertake the allotment and issue of share capital in order to increase the proportion of new share offerings. This packaging was achieved through either local tax relief and rebate by local governments, or the appropriation of subsidiary funds, or the sharing of a portion of earnings after the purchase of partial assets of the listed companies by its large shareholders at a high price, or the granting of assets or the right to earnings by those large shareholders. All these actions serve the same purposes: to create high profits, raise stock prices, and control more social funds. Additionally, large shareholders used the listed companies as their own “cash machines” and occupied the companies’ capital at will. Fourth, there was excessive speculation through insider trading and the market-making by large capital groups. For one thing, negotiated transfer

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and asset reorganization of state-owned shares were planned and operated by governmental departments and involved a lot of people, so it was difficult to ensure confidentiality and avoid insider transactions. And the reason why many securities companies participated in asset reorganization was not for reorganization fees but for speculation in the secondary market. Similarly, many listed companies would deliberately disperse reorganization news for the purpose of bidding up their stock prices and accumulating more social capital. These operations all aimed to take away the money of small investors. For another, asset reorganizations through negotiated transfer created opportunities in the system for large capital groups to manipulate stock prices in the secondary market. So, the prices of asset restructuring-related concept stocks and even underperforming stocks frequently fluctuated and their P/E ratios were as high as several hundred times earnings. Those features indicated that since there were two parallel markets, anyone who could acquire low-cost non-tradable shares through negotiated transfer would become controlling shareholders. They would be able to control the whole company, undertake asset reorganization, obtain the right to dispose the funds raised through secondary offerings, and operate the social capital of high market value with a low-cost controlling stake. Meanwhile, as insider trading was inevitable, it enabled large capital groups to manipulate the stock prices through market making. Profiting through seasoned equity offerings and unfair capital operation by taking advantage of the two parallel markets stimulated the unreasonable rise of tradable share prices and stock indexes and the accumulation of bubbles. They were abnormal dynamic bubbles which would exert larger destructive power on the market. In theory, it was a punishment for violating the laws of the market economy and the cost that should be paid by certain rigid understanding. This reflected the incompatibility between some reforms in relations of production and superstructure and the development demand of productive forces. In addition, I would like to discuss the loopholes in the regulations of the non-tradable share transfer market. The regulatory institution opened the negotiated transfer of state-owned shares and legal person shares in the restricted circulation market for several reasons. First, the regulatory authorities tried to be flexible in dealing with non-tradable state-owned shares by facilitating the transfer of these shares. Second, the policy was announced as a response to the government’s intention of relieving state-owned enterprises of heavy debts and supporting industrial restructuring in the capital market. Third, the authorities wished through negotiated transfer of state-owned shares to accelerate the elimination of

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insufficient companies and give full play to the resource allocation function of the stock market. Consequently, the Securities Law passed by the National People’s Congress of China confirmed the legitimacy of negotiated transfer of state-owned shares. It, however, created a loophole in the law for investors to manipulate the seasoned equity offerings and unfair capital operation in the tradable market through negotiated acquisition. Later, the regulatory institution noticed the problems existing in the negotiated transfer and acquisition of state-owned shares and issued several orders to regulate the transfer by focusing on substantial restructuring, tender offers, and requirements on the selection of transferees in order to help listed companies to find proper and reliable transferees who could assume control person liabilities and the fiduciary duty of controlling shareholders and thus ensuring the long-term stable operation of the companies. A series of documents including Administrative Measures for the Takeover of Listed Companies promulgated by the authorities specified new trading rules and financing methods concerning negotiated transfers, management buyouts (MBOs), share swaps, and targeted offering. Their aims were to standardize takeover activities and promote the marketization of mergers and acquisitions. But if the unfair capital operation in the negotiated transfer market of non-tradable shares, which was against the laws of the market, was not outlawed, no matter how many regulations targeting the technical or detailed problems of mergers and reorganizations were implemented, it was merely regulated unfair capital operation. To continue doing the same would not only not cure the problem of unfair capital operation but also create the risks of manipulating the market of tradable shares by using the negotiated transfer of non-tradable shares. The solution is very clear. If China wants to eliminate equity division and eradicate the unfair capital operation in the stock market, the fundamental way out is full circulation. Here, as to the question of whether same shares can be traded at the same price, the key lies in circulation. But if state shares want to be circulated again, there is a cost to pay. We know that the value of circulation was unveiled by the value discovery function of the market. In a market of full circulation, the stocks of a listed company can appreciate above the net asset value, because the market finds in the circulation the value of expected future earnings generated by net assets. Under the equity division in China’s stock market, the price difference between tradable and non-tradable shares was caused by restricted circulation. If non-tradable shares cannot be circulated in the market, their market value will not be discovered and revealed and that was why private negotiated transfers were created. This transfer price was fixed around the net asset value

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and always below the market price. In contrast, tradable shares were priced above the net asset value and appreciated day by day. For one thing, the market found out the value of expected earnings of net assets in circulation; for another, as non-tradable shares of a large number were prohibited from being sold in the market, tradable shares gained a scarcity value. So, it was not surprising that the price of tradable shares went up. Admittedly, the price rise of some stocks was the result of unfair capital operation by insiders and speculation groups in manipulating the market through negotiated transfer. Therefore, whenever there was news about the circulation issues of state-owned shares, social investors would underweight their tradable shares, which would cause the depreciation of tradable shares. In 2001, the decision on the transfer of state shareholding at the market price brought about a market slump for five years. This became a typical case of the reduction of government shares. The prohibition of state shares circulation not only made their value undiscovered, but also encouraged the appreciation of tradable shares. It was a great irony to the advocates who were strictly against the circulation of state shares in the fear of the drainage of state assets. That was why during the equity division reform, many theorists believed that in order to protect the interests of medium and small investors, if stateowned shares which accounted for two thirds of the stock market were going to be circulated again, compensation to social investors must be made. The solution was very simple: One was to ask state stockholders to buy in all tradable shares from social investors at the market price before pricing and listing these shares again in the market; and the other way was to compensate social investors by making up the difference between net asset value and market price of tradable shares. This was the cost that must be paid in order to avoid starting all over again. However, as to the opinion that stock prices were unfairly priced, I cannot agree. People holding this view thought that to sell the state share worth RMB1 at a premium in stock offerings was a kind of unfairness. The truth was that the offering price of a company’s stocks was determined based on the present earnings and expected returns of the company. During the company’s IPO, social investors voluntarily paid a premium to hold stakes in that company and shared the benefits of net asset appreciation with pre-existing shareholders. This did not damage the interests of small and medium investors. The premium was a kind of founders’ profits, investment returns that entrepreneurs deserved for assuming the risk of failure. This was like interest and profits, and it should be protected by law.

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Unfair Capital Operation by Large Capital Groups and Market Manipulation through Excessive Speculation Following state-owned capital, social capital also acquired majority stakes in a listed company by taking advantage of the low-cost transfer of non-circulating shares in order to control a large sum of funds raised at a high price through seasoned equity offerings. Typical cases included acquisition of Chang Zheng Machine Tool Group by Chengdu Top Sci-Tech Company, takeover of Hunan Wuyiwen Industry Co., Ltd. by Powerise Information Technology Co., Ltd., and a series of negotiated mergers and asset reorganizations by Xinjiang Delong Group towards Xinjiang Tunhe Co., Ltd., Torch Automobile Group Co., Ltd., and Hejin Holding Co., Ltd. Those takeovers were also unfair, but if not involving market making or manipulation, they did not break laws. What state-owned companies can do, private companies also can. We cannot hold bias and criticize social capital since it has adjusted the structure of ownership and invigorated listed companies. What should not be allowed was speculation, namely, large capita groups make profits by using the information about negotiated transfer and the subsequent business restructuring to manipulate the secondary market. Reports like “major funding providers control the market” and “market makers unload stocks” by the securities media were reflections of unfair capital operation. At the end of 2000, some stock commentators estimated that the market control rate of at least 30% market makers was above 50% and around 50% market makers have a market control rate of over 30%, which denoted serious speculation in the market. A system defect in the stock offering can be covered up by the insensitivity and inability of the operators of state-owned companies. And the profit-seeking activities of private capital would amplify the defect a thousand times. The most widespread speculative practice by large capital groups was to manipulate the market by integrating market making with the negotiated transfer of non-tradable shares and unfair capital operation. The most typical example was the operation of China Venture Capital (Group) Co., Ltd. (formerly known as Shenzhen Kondarl [Group] Trading Co., Ltd.) by Lü Liang. According to the report by Caijing Magazine in February 2001, Zhu Huanliang, a market maker in Shenzhen, who controlled 80% of the circulating shares of Kondarl Trading Co., Ltd., consulted another experienced market manipulator, Lü Liang, about withdrawing the capital from these stocks in 1998. Lü Liang agreed to purchase 50% circulating stocks from Zhu on the condition that Zhu had to help Lü to acquire parts of the state-owned shares in Kondarl in order to realize the control and restructuring of

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the company. Later, Lü Liang soaked up capital from different sources to acquire 34.61% state-owned shares of Kondarl with RMB175 million in April and May 1999. Together with 55 million shares purchased from Zhu Huanliang with over RMB600 million, Lü Liang transformed Kondarl from a poultry breeder and supplier into an agricultural and high-tech company in the name of reforming state-owned enterprises and renamed the company into China Venture Capital (Group) Co., Ltd. Due to the operation by Lü Liang, the stock price of Kondarl rose from RMB36 to RMB40–45, which lasted for four months. Although Lü Liang’s manipulation of the market failed at the end, it was clear that all his speculative activities stemmed from the system defect of negotiated transfer of non-tradable shares and without the unfair transfer, his control and restructuring over the company would be impossible. The case of Kondarl indicated that speculators not only manipulated the stock price by making use of the information on non-circulating shares transfer and business reorganization but also manipulated the market by connecting market making to negotiated transfer and unfair capital operation. This was a kind of “creation.” Speculators not only created bubbles but also “soaps.” The negotiated transfer of non-circulating shares provided conditions for these speculators to create both bubbles and “soaps,” which pushed unfair capital operation in market making to its peak.

Unique Financial Services of Investment Banks Offered High Added Value to the Market How do investment banks provide high value-added with their unique financial services for enterprises in capital operation? As we know, when listed companies undertake IPOs, seasoned equity offerings, or financing for mergers and acquisitions, due to the information asymmetry between equity investors and the firms, investment banks can act as sponsors and underwriters in stock offerings for they have advantages in information and credibility formed through longterm engagement in the capital market. They are ideal intermediaries for the two parties. In the following, I will focus on several major capital operation activities of investment banks.

Intellectual financial services provided in equity financing As noted before, the value of a company lies in its assets’ capability to create profits in the future. For this reason, not any company or corporate asset can

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be exchanged for capital through stock issue. Investment banks, as sponsors and underwriters in stock issue, should first identify whether a company can win investors’ favor or not and whether a company’s assets can generate future income by using their long-term experience in the capital market. Then, investment banks will reform the company’s assets through several steps. First, by performing assets restructuring, namely detaching the subsidiaries which have no or low profitability. For example, to separate the auxiliary businesses and social functions (such as, catering, entertainment, commerce and trade, hospitals, vocational schools, and property management) from all-round enterprises, in order to maintain the main business and the affiliated companies which have the best ability to create future income; Second, to carry out a shareholding reform, that is, to transform the company into a joint-stock company. But not anyone or any company can be shareholders and well-known investors and enterprises are preferential choices (for example, Li Ka-shing and his Cheung Kong Holdings). Third, reputable accounting firms are necessary to give an accounting judgment on the value of assets under reorganization. Fourth, renowned law firms will provide a legal proof for the ownership of the company’s equity. Fifth, investment banks and investment bankers will conduct due diligence, estimate the profit-making capacity of the listed company’s assets and related risks, and perform stock pricing, promotion, and sponsoring services. These are financial services provided by investment banks when acting as sponsors and underwriters in equity financing through an IPO in the primary market. They are in fact special high intellectual financial services offered by investment banks for listed companies in the selection, development, and pricing of the assets with future profit-making capacity. For enterprises, stocks are abstract things which signify the value of the enterprises’ business and capital. So, investment banks have to identify what can represent the nature of a company by using their acute insights in order to price the company’s assets based on their quality and risks. It is usually said that the stock pricing by investment banks is a perfect blend of science and art. To call it science, because investment bankers will present scientific basis for preliminary stock pricing after conducting quantitative research and scientific analysis via numerical models established based on financial data of a company’s past performance and taking into consideration the development trend of macro economy, the supply and demand of capital and interest rates in the market, stock prices, and profitmaking capacity of similar enterprises, changes in exchange rates, and expectation of investors’ demand. Meanwhile, investment bankers will also conduct a comprehensive risk assessment, including risks from inflation (rising prices and currency devaluation will undermine the purchasing power of the investment and expected earnings), credit (whether a company is able to redeem its bonds upon

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maturity based on its financial strength and debt repayment capacity), operation (the chance of business failure), competition (damage incurred as a result of fierce product, technology, or market competition), market (losses from sharp ups and downs in the stock market), financing (fluctuations in exchange rates, interest rates, and financial markets), etc. The reason why stock pricing is considered an art is due to the fact that in pricing, there are some factors that cannot be quantified but reflect the nature of the company, similar to inspirations and feelings, which should also be expressed concretely. Whether such a stock pricing is appropriate or not usually determines and has an important bearing on the market image and status of an issuer and the market standing and future development of an investment bank itself. I will illustrate this point with a few examples of the above-mentioned red chips. In 1996, when SIHL went public in Hong Kong, the prices of “China concepts stocks” were depressed owing to Mainland China’s macro regulation and control. To differentiate SIHL from other China concepts stocks, investment banks highlighted SIHL’s unique value in its location (Shanghai) and the production of consumer goods. The innovation in the stock promotion was reflected in the connotation of the two highlights, that is, the assets quality of SIHL was far higher than those of general China concepts stocks while the risk of SIHL was far lower than that of general China concepts stocks. As a result, on May 30, 1996, SIHL raised HKD1.4 billion at a price of HKD7.28 per share and its listing was a success with its stock price rising by 25% in the first day. Subsequently, SIHL fulfilled its promise as a window company of Shanghai by undertaking seasoned equity financing and asset injection in November 1996 and April 1997. Within just 11 months, the price of SIHL stocks soared to HKD45 from HKD7.28, an increase of six times. The company which had a net asset value of just HKD700 million at the start grew to a listed company whose market capitalization amounted to over HKD37 billion within less than one year. This enabled the Hong Kong market to discover the new investment value of SIHL as a window company. Take BEHL as another example. When BEHL was listed in 1997, investment banks promoted its stocks by switching to emphasizing its status as a window company rather than focusing on its consumer goods products by taking advantage of SIHL’s success as a window company. It implied that BEHL, the same as SIHL, was also a window company, and although its assets quality and risks were different from those of SIHL, BEHL’s stocks were also profitable. Not surprisingly, this promotional idea was attractive to investors and BEHL was 1,200 times oversubscribed by locking up HKD210 billion. It suddenly became a popular stock in the Hong Kong’s stock market.

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Another example is the listing of China Telecom (Hong Kong). If the company chose a separate listing of Guangdong and Zhejiang mobile telecommunications, not only will the financing cost be higher but the stock price will be lower. The overall listing of China Telecom (Hong Kong) as an industry-oriented holding company by CICC displayed the advantage of centralized financing and revealed greater investment value than window companies like SIHL and BEHL. In the face of a severe impact from the Southeast Asian financial crisis on the Hong Kong stock market, the stocks of China Telecom (Hong Kong) were still priced as high as HKD11.8 per share. As a result, among the dropping prices of all major stocks in the Hong Kong stock exchange, the stocks of China Telecom (Hong Kong) alone showed stable growth. Investment banks’ innovation in the stock pricing of China Telecom (Hong Kong) not only firmly established the position of China Telecom (Hong Kong) as a red chip giant, but also exposed the investment value in the overall listing of China’s industry-oriented companies to investors in Hong Kong. More importantly, by acting as the sponsor and underwriter in this IPO, CICC established its brand value and upgraded its status and position among international investment banks. From here, we can see clearly the contribution made by investment banks through their high value added financial services in stock pricing. In the above, we talked about the financial services offered by investment banks who acted as sponsors and underwriters in the IPO. Similarly, after a company is listed, it also needs investment banks to serve as sponsors and underwriters in seasoned equity offerings. Compared with those provided in IPOs, services from investment banks are comparatively simpler. The capital operation in this stage features the selection of assets or new projects for capital injection after investigations. For example, when SIHL went public, the government officials committed to constantly raising capital through equity offerings and injecting high-quality assets into the window company SIHL. Subsequently, the Shanghai municipal government fulfilled its promise and helped SIHL raise HKD7.8 billion by injecting in SIHL partial equity of Shanghai Orient Shopping Center, Bright Dairy, Shanghai Yan’an Road Elevated Road, Shanghai Huizhong Automotive, and North-South Elevated Expressway. Here, whether the capital injection can maintain the high profits and growth of SIHL depends on the financial services of investment banks as sponsors and underwriters in capital operation and the success is inseparable from the proper judgments and the decisions of investment banks on the profit-making capacity of assets. It can be said that each time the process of stock issue, pricing, or underwriting involves a series of intellectual services of investment banks. It needs to be mentioned that the stock issue and underwriting services

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of investment banks in the primary market is closely related to the securities trading in the secondary market. Securities markets are able to convert scattered short-term capital into a huge sum of centralized long-term capital through stock holding and trading by investors. A premise for this is a fully liquid secondary market where securities can be freely traded and long-term securities can be readily cashed in. To turn short-term funds into long-term ones must be based on the condition that the long-term funds can be easily exchanged for cash. This is another law of capital movement in the securities market. The successful pricing of securities in the primary market must be backed up by sufficient liquidity of the securities in the secondary market. It is crucial for investment banks to undertake proprietary trading and act as securities brokers and market makers in order to sustain the trading price of securities. It is owing to the high liquidity of the secondary market that investors are confident about the stock issue and sale in the primary market.

High value-added services during business mergers and asset reorganizations If the stock pricing by investment banks based on the assets’ quality and risks of a company in the primary market is an art, then business mergers and acquisitions and assets restructuring conducted by investment banks in the capital market are a perfect mixture of artistic processes. The high value-added services provided by investment banks in business mergers and acquisitions and assets reorganization are mainly manifested in the huge benefits obtained through enterprise mergers. These benefits are as follows. 1. Synergy effect in corporate mergers and restructuring As mentioned previously, corporate mergers have a synergy effect of 1+1>2. The aim of the intellectual services provided by investment banks is to discover the synergy effect after mergers and acquisitions of targeted enterprises through analysis and research. For instance, investment banks have to decide whether a company after business takeovers can achieve optimum economic scale in production and management and benefit from economies of scale; whether the acquiring company can gain financial benefits by increasing its debt-paying ability and reducing the cost of debts; and whether the mergers of two similar enterprises can stop the strength offsetting in business competition in order to benefit from rising market competitiveness and a larger market share.

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2. Creative benefits in MBO By converting managers into owners of a company, MBO raises the value of management and human capital, turns economical and reasonable assets stripping and restructuring into a reality, optimizes resources allocation through relating agency cost reduction to profit maximization of shareholders, further improves the growth of enterprises and capital. The most difficult step in MBO is financing. But since American investment banks initiated leveraged buyouts in the 1970s, especially when they used subprime mortgage loans as a financing means for leveraged buyouts in the 1980s, MBOs became much easier. Therefore, the real value of intellectual services offered by investment bankers in corporate acquisitions and reorganizations, leveraged buyouts, and financial innovations lies in high value added. The essence of corporate mergers and business restructuring is the transfer of corporate control. Experience in China and Western stock markets has shown that only with control transfer, can there be real optimized resources allocation, assets and industrial restructuring, and the synergy effect. In fact, any capital market cannot be called a mature capital market if there is no transfer and trading of corporate control. In company acquisitions and restructuring, investment bankers should commit themselves to the smooth transfer of corporate control apart from providing a series of services like planning, negotiation, and financing. Many of the mergers and acquisitions of listed companies in China’s stock markets are the allocation of state equity led by governments and the personnel changes in the management are similar to the transfer or promotion of government officials. However, mergers between companies with different ownership systems will usually cause equity disputes. This in reality reflects the fight for corporate control. In the late 1990s, disputes arising over corporate control of many listed companies in China’s stock markets constantly aroused the awareness of ownership rights among both medium and small shareholders and stirred up their strong desire to change the dictatorship by major shareholders of stateowned shares and legal person shares. In addition, those disputes reminded investors that the reason why many listed companies performed poorly and could not get rid of the impact from the old system was closely related to the unreasonably large proportion of state-owned and legal person shares in the equity structure. Thus, only when we promote the transfer and trading of controlling stakes, can the capital market of China be more efficient and vigorous.

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To adjust the layout of state-owned economy and ownership structure, the first key is to properly arrange the withdrawal of state capital and the participation of private capital. Here, it is important to prevent the loss of stateowned assets and also encourage the involvement of non-state capital to enter in the state-owned sector and contribute to economic development as the stateowned shares to be transferred were very large in number. However, at present, the Chinese government has put too much energy on the former without giving sufficient attention to the latter issue. The disputes over the controlling stakes in listed companies during this period revealed a contest for corporate control between private shareholders and state-owned shareholders. This clearly showed that the enthusiasm of private capital in investing in state-owned enterprises was under a test. Certainly, the dispute over corporate rights is a very complex issue in relation to proprietary interests and although there are two sides to every question, we still can conclude some facts from these complicated disputes. First, state capital is usually compelled to exit those listed companies, either because state-owned equity is used as a pledge which will be acquired by a private company later, or for the reason that some loss-making state-owned companies have no choice but to seek help from private capital. Second, representatives of shareholders in private companies sometimes go against rules and regulations in business operation and financial transactions due to their lack of managerial experience in corporate governance, thus creating occasions for scandal and doubts in corporate rights disputes. T h i rd , l o c a l s t a t e - o w n e d s h a re h o l d e r s , t h o u g h t a k i n g a b a c k s e a t , still maintain their connections with local powers. In spite of all sorts of weaknesses, those shareholders, representing the old system, are able to gain the initiative by using their social connections. Fourth, one trick used by state-owned shareholders in the disputes was the excuse of preventing the loss of state assets. Under such an excuse, even public security organs can be utilized to prohibit the transfer of corporate control to non-state shareholders. Worse still, some state-owned companies will seek help from private capital when they are in a tight corner, but will force the private capital to withdraw once they are out of trouble. In all fairness, when considering this from the perspective of private capital, we will doubt why private capital enters into state-owned companies if it cannot gain corporate control and achieve profit maximization and how it will be protected by laws and public opinions if it fails to gain corporate control. Additionally, to prevent the drainage of state-owned assets is a pretentious excuse. The fact is that the state-owned controlling stake in many listed

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companies was lost due to the poor management of state-owned shareholders. It is unfair to force out the private capital which has helped the state-owned enterprises turn losses into profits. If they allege that state-owned assets should be prevented from draining, how can we tolerate the loss of the interests of private capital? Therefore, I believe that the priority of current adjustments in state economy layout and ownership structure is to protect the enthusiasm of private capital in participating in state-dominated sectors and ensure the development of private capital free from the discrimination and disruption from the old system. There was a sign in the equity disputes over the past few years that although a new party representing promising emerging forces had come into being, it was often in an inferior position. This reveals that it is necessary to not only adopt market-oriented principles, but also formulate new regulations, and strengthen management and supervision in the transfer of corporate control during business mergers and reorganizations. The equity disputes also show that the new forces usually cannot achieve the final success by solely relying on their own power. It implies that the transfer or circulation of corporate control is a large project, which cannot be handled and controlled by entrepreneurs themselves, and therefore requires the capital operation of investment banks and investment bankers, which creates many opportunities for the investment banking industry.

Intellectual services in financing arrangements The high value-added services offered by investment banks include not only the formulation of acquisition plans for acquirers, but also the implementation of these plans and various relevant financing activities. As we have mentioned in Chapter 12 about corporate mergers and acquisitions, investment banks pushed the leverage buyout in the 1980s to a new high by leveraging bridge loans and subprime mortgage loans. It shows the significance of appropriate financing arrangements to business mergers and acquisitions. He Jinsheng published an article in Beijing Economic Information in 1994 to introduce the financing activities during the acquisition of Hong Kong Telecom by CITIC (Hong Kong). This case fully manifested the wisdom of investment banks. In 1990, CITIC (Hong Kong) purchased 20% stakes of Hong Kong Telecom from its controlling shareholder Cable & Wireless Worldwide PLC with an

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intention to acquire Hong Kong Telecom. During this takeover, Barclays Bank PLC was acting as the lead financial adviser. The acquisition required a total of over HKD10 billion, among which HKD2 billion was contributed to by CITIC (Hong Kong) and the rest was from equity and debt financing. According to the financing plan of Barclays, funds were raised through: 1. making a ten-year syndicated loan of HKD5.4 billion with 14% stakes in Hong Kong Telecom as collateral (its interests would be paid by the dividends from its holdings of Hong Kong Telecom); 2. issuing five-year zero coupon bonds of USD224 million (HKD1.75 billion); and 3. releasing five-year covered warrants of its stakes in Hong Kong Telecom worth HKD1 billion. This plan was smart because by issuing covered warrants, CITIC (Hong Kong) could borrow less money from the syndicated loan market, thus lowering the ratio of debt to total acquisition cost (HKD10 billion) from 80% to 70%. And among its debt of HKD7 million, zero coupon bonds of HKD1.75 (USD224 million) were sold to investors at a price below par and CITIC (Hong Kong) did not need to pay regular interest. So, the company could focus on the interest payment of the syndicated loan. Moreover, Hong Kong Telecom belonged to high-growth stocks in the area of public utility and would pay out stable dividends. Although the loan interest was two times higher than the stock dividend, the value of 20% stakes of Hong Kong Telecom exceeded HKD10 billion which was two times larger than the syndicated loan. This deal was a real bargain as CITIC (Hong Kong) could acquire 20% stakes of Hong Kong Telecom with HKD2 billion of the own capital. This was a typical case of leveraged buyout. Those financing arrangements by investment banks were only a tip of the iceberg. In addition to that, investment banks will also provide intellectual services for acquired companies during their anti-mergers actions.

Why Did Five Major Investment Banks on Wall Street Collapse during this Financial Crisis? In the financial crisis of 2008, five major Wall Street banks collapsed. On April 16, 2010, the U.S. Securities and Exchange Commission (SEC) charged Goldman Sachs for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages named “synthetic CDO.” It caused a stir in the investment banking industry. On April 26, 2010, Century Weekly published an article written by Huang Ming.3 The article, named “The Root of the Interest Conflict between Investment Banks and Their Clients,” specially focused on the changes in investment banks

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in the past 30 years and pointed out the causes of the conflict of interest. According to Professor Huang Ming, the conflict of interest between investment banks and their clients had deteriorated in the last 30 years. Prior to the 1980s, the major business of investment banks had remained more or less the same: acting as the bridge between investors and fundraisers. In the capital market, the information asymmetry between the two sides would cause market paralysis in the worst case scenario. So, investment banks became ideal intermediaries by virtue of their advantage in information and credibility formed in their long-term engagement in the market. Through performing this traditional role as intermediaries, investment banks have made indelible contributions to the development of the world economy. It is worth noting that the most renowned brands in the investment banking industry were run by a family or partners who tended to hold on to shares for a long time and would forsake short-term interest in order to maintain long-term brand value and reputation. In the traditional business of financial intermediation, the interests of investment banks are essentially the same as those of financing enterprises: Only when those enterprises are successfully listed, the investment banks can make profits. The conflict of interest is not serious between investment banks and listed enterprises, which is only reflected in the selection of underwriting teams and stock pricing. Therefore, the bad reputation of Goldman Sachs in the derivatives market would not affect its judgments in traditional investment banking businesses such as underwriting. But starting from the 1980s, the interest conflict started worsening owing to two factors. At first, top investment banks transformed from partnerships into listed companies and long-term shareholders were gradually replaced by short-term shareholders and professional managers who focused on short-term bonuses. This led to a weakened force for safeguarding the internal long-term reputation in the investment banks and increased the possibility of hurting the interests of clients for the sake of short-term profits. Meanwhile, innovations of financial derivatives and the expansion of proprietary trading offered plenty of temptations for investment banks. Businesses concerned with derivative products from the very beginning contained a severe conflict of interest and investment banks and their clients were at opposite ends of the financial contracts. From the perspective of clients, it was better to invest in the simplest derivative products in that they would achieve their aim of hedging or speculating at the expense of a small commission fee. But investment banks usually preferred to introduce high-risk and complex products. Excess innovations and sales of complicated derivative

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products by investment banks increased the risks in the market, which was also an important cause of this financial crisis. In the derivative markets of different regions around the world, investment banks faced similar short-term temptations and pecuniary attractions. But owing to the restrictive and deterrent forces from market supervision and legal charges in European and American markets, there were seldom cases of physical enterprises and individuals falling victim to complex derivative products in recent years. On the contrary, the regulations of over-the-counter derivatives in many countries and regions of Asia were more relaxed than in the U.S. and the direct result of loose supervision was the damage to clients’ interests. The originality of Huang Ming in this article was reflected in the following words: The charge against the financial derivative of Goldman Sachs was not surprising. Based on my research and analysis on the Asian derivatives market in recent years, the activities of international investment banks in the complex derivatives market of the U.S. were nothing compared with their behaviors in the Asian derivatives market. At the end of 2004, China Aviation Oil (Singapore) Corporation Ltd. lost RMB4 billion in its trade with Goldman on complex derivative products. Hired as an expert advisor after this incident by China Aviation Oil, I concluded that the problems exposed in the transaction between the two parties were more serious than those exposed in the cooperation between Goldman and American local companies after detailed analysis on the contract and communication between China Aviation Oil and Goldman. In the complex derivatives market of Asia, investment banks which make profits at the expense of their clients’ interests are more than just Goldman Sachs. But with preeminent brand influence and derivatives innovation capability, Goldman will exert greater destructive power. How should the regulatory body in Asian countries and regions respond in the face of the severe conflict of interest in the international derivative market? Although a supervision reform is under consideration, the effectiveness of the reform is still questionable. Therefore, Chinese enterprises and investors have to understand such a conflict of interests with investment banks and bolster resistance to temptations from complex derivative products. At the same time, investment banks should also be required to modify their behaviors in selling derivative products. Certainly, the most effective way is to improve the Chinese government’s awareness towards the significance of those problems. To ameliorate the regulatory environment will be a win-win solution in the end and also the trend of the post-financial crisis era.

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Chapter

Time-Space Compression Leads to the Urban Era: Capital Accumulation and the Urban Economy

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Wenzhou Longgang Town, the First Town of Farmers Longgang Town in Wenzhou City is a well-known name in China. Longgang Town is a modern town that was developed by farmers themselves through smart leveraging of the rapid growth of the market economy in Wenzhou after the start of the Reform and Opening Up era. As an economic heavyweight in southern Zhejiang Province, the town has worked and is still working miracles in China. The rise of Longgang Town is a wonder in the course of China’s reform path towards being a market-oriented economy.

The first leap forward: Local farmers self-funded “China’s first town of farmers” Located in southeast Zhejiang Province, Longgang Town faces the East China Sea and is situated at the south riverbank near the estuary of the Aojiang river. Before the policy of Reform and Opening Up was implemented in this area, what its geographical advantage could bring to Longgang Town was the sea water inflow caused by tropical storm surges between August and October. Consequently, not a single grain of crops could be reaped. So, there was a popular ballad among the local people: “A farmer ’s small plot of land, often flooded by sea water unplanned; / Rice crops grow with no spikes most times, the farmer will only cultivate two dimes.” The Reform and Opening Up policy in 1979 boosted the economy in Wenzhou City where the market was comparatively active. At that moment, the household handicrafts industry was thriving in Wenzhou and it later spread to many towns in the Cangnan area of Wenzhou, such as Jinxiang Town, Qianku Town, and Yishan Town. For instance, as the college entrance examination system had been resumed in 1977, there was a large demand for school badges. Jinxiang people grasped this opportunity and gradually built family workshops for the manufacturing of aluminium scutcheons, hard plastic sheets, and other goods. Just within the Cangnan area, there were already 6,500 households with an annual income over RMB10,000, among which more than 90% lived near the Longgang port. The development of the economy requires space expansion and city formation. In June 1981, Zhejiang Province divided the old Pingyang County into Pingyang County and Cangnan County. In April of the following year, Cangnan County saw a business opportunity in the favorable geographic location of Fangyanxia

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Village (located in southeast Zhejiang and northeast Fujian) and decided to establish a port town as the collection and distribution hub of Zhejiang and Fujian provinces. As a result, Longgang Town was built on the site of Fangyanxia Village and, according to the initial plan, the local population size would be 12,000 in the short term and 19,000 in the long term. At the beginning, there were only five small finishing villages in Longgang Town with a population of over 6,000 and the funds for town construction added up to just RMB8,000. As the first Secretary of the Longgang Town Committee of the Communist Party of China (CPC), Chen Dingmo gasped at the sight of the vast wasteland and a small group of little cottages. It was only a new town with a preliminary structure but short of residents. Then, the Central Committee of the CPC and the State Council issued the No.1 Central Document of 1984 which “allows farmers to settle in towns on the condition of self-providing their own food grain.” This policy made a breakthrough in the strictly segregated household registration system between rural and urban areas. The market economy in Wenzhou was known for being very active after the Cultural Revolution. At that time, Guangming Daily carried a report about “Building a city for Shandong Weifang people by the people,” which offered an inspiration to Chen Dingmo. With the vision to develop the wasteland into a modern port town, Chen Dingmo proposed the idea of paid land use, income from which would be applied to town construction. He set up a welcome office for migrant farmers and posted a notice which said, “Farmers are welcomed to settle down in Longgang Town on the only condition that they can arrange their own grain. In case migrants plan to build their own homesteads, different amounts of construction fees will be charged according to the house location. Different rates of municipal infrastructure fees will also be collected based on different locations, ranging from RMB2,000 to RMB5,000 per house.” It was said that anyone who was willing to take out RMB30,000 could construct a new house and acquire urban citizenship in Longgang Town. Within just 10 days, there were more than 2,700 specialized households flooding into Longgang Town with the people gaining permanent resident status. At the same time, the town succeeded in collecting RMB10 million, which would basically solve the capital demand for initial infrastructure construction. It was recorded that shortly after Chen Dingmo put up the poster, Longgang Town became a construction site with an unprecedented scale. Over 3,000 buildings were being erected by 37 construction teams from all over the country. And there were more than 10,000 people onsite every day including over 4,000 carpenters and plasterers, 2,000 odd-job men, and thousands of house owners.

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By the end of 1986, the total area of the newly-built houses in Longgang reached 1.02 million square meters. A new town built up by farmers had finally been established. Some people concluded later that Chen Dingmo had introduced three major reforms in Longgang Town: 1. household registration reform, that is to allow farmers to be registered as urban residents only if they can arrange their own grain; 2. paid land use reform which solved the capital demand for building public facilities through selling land and charging costs for infrastructure development; 3. private economy reform, namely, to encourage small businesses in the town. For example, when Longgang Town was just formed, the local government had no money at hand, so it fostered the establishment of privatelyrun nurseries, kindergartens, and cleaning companies. Besides, having just transferred from being farmers to being urban dwellers, Longgang residents had a thirst for knowledge, and as a result, a great variety of learning classes were set up by private capital. The most popular one was free make-up courses by beauty salons for female customers with a view to developing customers and promoting cosmetics. Within a short time, the story of Longgang Town had spread far and wide. In 1986, I was the General Manager of China Investment Consulting Company (CICOC), and some postgraduates from Renmin University of China and Dongbei University of Finance and Economics worked there as interns. I arranged for them to conduct a special investigation in Longgang Town and their report was very impressive. Among all the stories about Longgang Town, two were most widely told. One was about the land sale by Chen Dingmo, which violated the country’s law and offended top local officials. Yuan Fanglie, Municipal Party Secretary of Wenzhou, specially convened a meeting for Chen Dingmo to report his work. Under the old system, a Township Party Secretary was responsible for both towns and subordinate villages. Chen Dingmo reported that in the town, the primary task was to sell land for the purpose of building more houses while in the villages, the priority was to reclaim land for agricultural production. After detailed questioning of the accurate acreage of sold lands and reclaimed lands, Yuan Fanglie made a conclusion that the size of newly reclaimed lands was larger than that of sold lands. Accordingly, Chen’s bold policies were recognized by government officials. This may be the earliest case where an increase in land use for urban construction was linked to the decrease in that for rural construction. Another widely known story was that in 1985 when Premier Zhao Ziyang paid an inspection visit to Wenzhou, Yuan Fanglie intended to take this opportunity to win some investment for the Jinhua-Wenzhou Railway project which aimed to

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solve the transportation difficulty between Hangzhou and Wenzhou. However, the Premier was not interested in this project and directly asked to hear the report about Longgang Town. So, Yuan Fanglie accompanied Zhao Ziyang to travel to Longgang via a ferry and they listened to the work report by Chen Dingmo. Chen explained the whole story about selling homesteads and collecting the municipal infrastructure fee in detail. Zhao Ziyang listened carefully and commented with acknowledgment, “You are like a real estate developer.” Hearing those words, both Yuan and Chen were finally relieved. Within less than three years since the establishment of Longgang Town, tens of thousands of farmers moved into the town which they had built themselves. In 1990, the local population had grown to 48,000, far above the number stated in the long-term plan. Longgang Town was praised as an example of farmers financing urban construction and the “First Town of Farmers in China.” It was the first leap forward.

The second leap forward: From a farmers’ town to an industrial town The well-known brand of the “First Town of Farmers in China” drove up the economic growth in Longgang. In 1994, Longgang Town recorded a GDP of RMB920 million and fiscal revenue of RMB83.01 million to become the most powerful town in terms of overall economic strength in Wenzhou. In 1995, its population surged to over 160,000. In 1996, 11 state ministries and commissions implemented a comprehensive reform of small cities and towns in Longgang, and although not upgraded into a city, Longgang set up the first townlevel coffer of Zhejiang Province and enjoyed partial rights of a county-level government in economic management. Thereafter, the printing demonstration industrial park, small-scale packaging and printing industrial park, plastic woven industrial park, and eastern city comprehensive industrial park were constructed in Longgang Town, and they attracted around 208 enterprises to set up their factories. The town was also labelled by some national trade associations as “China’s printing town” and “China’s gift town.”

The next step: Where will the town head? In the mid-1990s, the population size, economic volume, town scale, and social comprehensive indicators of Longgang Town reached the standard of a county-level city. During the comprehensive reform of small cities and towns by the state government, local people strongly called for upgrading the town into a city. Unfortunately, this urgent request could not break away from the constraints of the vested interests of the local government under the tax-sharing

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system, and Cangnan County was unwilling to let go the goose that had laid the golden eggs. The comprehensive reform in Longgang ended up in failure. This led to the migration of local residents and the sharp decline of local house prices. Longgang Town found itself in a predicament. The town fell four places from No.1 to No.5 with respect to the comprehensive strength in Wenzhou City. It should be said that this revealed a conflict between the existing administrative system and urban economic development. Wan Chongdian, the richest man of Longgang, said with regret, “Farmers can create a town in Longgang, but we can never decide the government system of Longgang.” In 2007, the area of Longgang expanded to 83 km2 with a total population (including both registered and mobile population) of approximately 400,000, equivalent to a medium-sized city. Its economic aggregate exceeded the sum of the wealth of Dongtou County, Taishun County, and Wencheng County in Wenzhou. As Longgang remained a town, there was no public security bureau, industrial and commercial bureau, land resources bureau, and tax bureau. It was very difficult for a town-level government to govern such a large area. Another contradictory fact was that the Wenzhou government positioned Longggang Town as the heart of Aojiang River Basin in its plans. And according to the tenyear plan of Longgang Town, its population was expected to grow to 700,000 in 2020. How ridiculous it is to have a “town” with that many people! Imagine if Deng Xiaoping had not converted Shenzhen Town under the administration of Baoan County into a city and that today Shenzhen was a “town” with 12 million people. Longgang Town needs to follow a similar path to become such a city.

Industrialization and Urbanization Added Crucial Significance to Urban Economy When speaking of capital formation mechanism, we cannot overlook cities. They are a product of pre-capitalism, but as capitalism propelled mass production, cities underwent significant changes and development. In fact, it was industrialization that created cities and advanced urbanization. In the era of Karl Marx, capitalism had just started, and neither industries nor cities were developed to today’s levels. Therefore, Marx understood cities based on their contributions to the rise and growth of industrial capitalism and did not regard cities as his research focus.

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The urban economy has grown independent from the industrial economy under modern production Under mass production, the advances and changes in cities have displayed four features: 1. Industrialization created cities and boosted urbanization. Since then, industrialization produced supplies while urbanization generated demands, and industrialization was closely related to urbanization. Industrial capital set up industrial enterprises which attracted a large quantity of farmers to be away from the countryside and agricultural work and become industrial labor. This led to the growing number of workers and the middle class. Meanwhile, the expansion of those enterprises deprived rural areas and agriculture of a vast expanse of land and new cities were formed as a result. The urban infrastructure construction accelerated population flow, which benefited the concentration of production factors such as labor and capital, thus creating economies of agglomeration. The further growth of urbanization in turn put forward a higher demand for industrialization. 2. Urbanization underlined the effect of spatial elements (location, movement, and mode of existence) on economic development. Urbanization practice suggested that the economy (saving) not only consisted of the saving of labor time but also the economization and optimization of working space in order to realize a reasonable arrangement of economic elements. Urbanization required a perfect combination of value balance, objects (commodity) balance, and space balance. In optimizing the space structure, urban economy focused on the research of the neighboring benefits, layout benefits, and network benefits among economic elements and the aggregation economies of urban regions. Benefits from spatial patterns can exert more profound and extensive significance than the economic benefits of each sector in a city. 3. Apart from stressing the function of linking production with operation, cities put more emphasis on the role of household consumption demand in urban development, especially when economic growth has raised labor income. With the expansion of the upper-middle-income group and the middle class, an olive-shaped society has been formed. Uppermiddle income families had demands for more varied and high-quality living and consumption conditions in the aspects of accommodation, catering, transportation, shopping, healthcare options, cultural and

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artistic activities, education and training services, dwelling environment, and tourism. They, for the first time, asked for satisfactory consumption of the means of development (knowledge, education, and training necessary for improving the quality of labor) and the means of enjoyment (such as pastimes), as their subsistence consumption had been fulfilled. Urban residents required not only a wide range of consumer industries and consumption facilities but also relevant policies and programs promulgated by municipal administrative authorities to guarantee such a rich life. Practice also proved that when the population concentration reached a certain level, it would give rise to the need for the tertiary industry. This would provide a wide space for the development of the modern service industry such as postal operations, telecommunications, banking, and hospitals. 4. The development of cities formed the capital of urban infrastructure which existed side by side with production capital. Cities should have clear policies and urban planning and offer public goods, investment, welfare, and facilities within the scope of the public economy. Municipalities have to optimize the allocation of public economic resources and enhance the efficiency of public economy through city planning in the aspects of land development and utilization, and the construction of infrastructure, cultural facilities, public amenities, public health infrastructure, residential building, and communities. The city planning should meet residents’ needs in living, consumption, and culture, and turn cities into not only a place where production and life are linked to each other, but also a cultural high ground, a cradle of science and technology, and a breeding ground and gathering place for talents. It should also endow cities with distinctive characteristics, unique charms, and distinguishing competitiveness, and therefore drive forward the development of the urban economy. It is just because urban economics is a study of how to govern a city and completely different from business economics that some people sometimes refer to it as “mayor economics.” Overall, cities have developed into a form of an economy distinct from the industrial economy. In the development of cities, governments were integrated into the economy and had become an inner factor for economic growth. The urban infrastructure capital including land that was in the hands of governments not only played a special role in the capital formation mechanism, but also grew to be the urban economy independent from the industrial economy.

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Henri Lefebvre and David Harvey’s theory on time-space compression In the modern mode of production, as cities are the optimum spatial organization for mechanization, technology innovations, and economies of scale, industrial societies rely more and more on cities. Henri Lefebvre, an urban study theorist and neo-Marxist philosopher, once called this reliance “urbanism.” He believed that urbanism was starting to control industrial production and organizations and in the past industries were the creators of cities but now they are being created by cities. Lefebvre even proposed the concept of “urban revolution” and argued that the urban revolution, the same as the industrial revolution which signified a historical shift from an agricultural to manufacturing world, had crucial social significance and influence. Accordingly, human history could be divided into three overlapping and connected ages: agricultural age, industrial age, and urban age. He predicted that if capitalism spread to the whole world, it would change productivity and create a series of new sectors of production, exploitation, and domination, such as leisure activities, everyday life, knowledge, art, and urbanization. The globalized production which resulted from consumerism would definitely lead to the general suppression of differences and individuality, which would further transform into the social basis of people’s everyday lives, hence people were alienated by urban spaces. Those extreme opinions of Lefebvre were criticized and opposed by many people. Later, Lefebvre also gave up the idea of urban revolution and replaced the notion of cities with the notion of space. He just admitted the dialectical role of cities in productive relations and reproduction and stopped giving urbanism any unique theoretical attributes, but adopted a more inclusive concept of modernity to act as a substitute for past discussions of urbanization. It now appears that with the advances of mass production and urban economy, industrial societies increasingly rely on cities. This reliance is manifested in not only the fact that “cities became the optimum spatial organization for mechanization, technology change, and economies of scale, but also the positive influence of urban development on the economy. Cities will pose more demands for industrial societies, and therefore the concepts of “urban revolution” and “urban age” should not be easily denied. Another renowned social theorist was David Harvey, a neo-Marxist. He developed his theories on cities based on the division of labor between production space and living space. In his work The Urbanization of Capital, he specially focused on the suburbanization of America after 1945 and explained how capitalism created a physical landscape of roads, houses, factories, schools, shops, and so forth in its own image for the purpose of space expansion and

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capital accumulation. Then, from the perspective of capital accumulation, he pointed out the contradictions among production capital, urban infrastructure capital, and capital for scientific education and health care. But as financial institutions and government intervention had played their parts, the capital circulation of the above three aspects was formed. Harvey’s theory about urban infrastructure capital was an inspiration to us about capital’s unique role in the capital formation mechanism. In the past, people paid more attention to the production capital of capitalists but neglected the function of governmental and urban infrastructure capital in the modern mode of production. Originally, in the traditional capital formation theory, only capital and the labor force were counted in, so there were just competitions of the business groups of capitalists and the labor force in the market. At this time, governments were merely regarded as administrators who should not participate in the competitions. Therefore, in the classical economic growth model, governments were only deemed as an external factor. In fact, governments of capitalism dare not step beyond the line. If it is true that in the past, industrial capital of Western capitalist countries made investments spontaneously and separately under competitions and an anarchy of production while governments stuck to the traditional theory by attempting and accomplishing nothing, and cities were expanded as a result of spontaneous capital accumulation, accompanied by the advent of residential communities, public facilities, medical services, education, governmental services for a large amount of the labor force, then it can be said that in the modern mode of production, once governments are in charge of urban planning, they will gain an advantageous position in leading urban development and economic growth and intentionally use urban infrastructure capital (including the capital for scientific education and health care) to guide the industrial capital flow. Here, urban infrastructure capital has developed into the urban economy, independent from the industrial economy. And now, governments have been converted into an internal factor of economic growth. A d d i t i o n a l l y, D a v i d H a r v e y a l s o r a i s e d a c o n c e p t o f “ t i m e - s p a c e compression.” It is true that transportation assumes considerable economic significance in the process of industrialization and urbanization. Initially, vessels and carriages contributed to the formation of ports and market towns, and then the rise of steamers, railways, highways, airports, and expressways brought about huge economic benefits to transportation-developed cities. Harvey enumerated the changes of time-space compression generated by the advance of modern transportation technologies: In 1500–1840, the average speed of carriages and sailboats was 10 mph; in 1850–1930, the average speeds

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of steam locomotives and steam ships were 65 mph and 36 mph, respectively; in the 1950s, the speed of propeller-driven aircraft was 300–400 mph; and in the 1960s, the speed of jetliners was 500–700 mph. This led to the tremendous restructuring of spatial relations and representation. Harvey believed that the general trend of those time-space compression changes was towards the acceleration of turnover time in production and the condensing of spatial distance. The invention of highways, canals, railroads, steamships, telegraphs, radios, cars, containers transportation, air cargo, televisions, and electronic communications has altered the space-time relationship, and thus a changing cityscape. As early as the 19th century, the U.S. had built the transcontinental railway network, which boosted the economy of cities along the railways. The U.S has a vast territory and is also the world’s largest economic and technological superpower, so it is suitable for constructing railroads, especially highspeed ones. However, in the 1950s, Americans alleged that railways were outdated, so they were busy dismantling tracks while building new roads. This led the country to the development of expressways and civil aviation and postponed the arrival of high-speed railroads for half a century. Certainly, there were reasons behind ’this practice. During World WarⅡ, the crisscrossing expressways of Germany astonished Americans. Later research revealed that the developed road traffic system had been an important factor for Germany’s recovery after World WarⅠ as a defeated country and then its later development again as a superpower in Europe. The U.S. after World WarⅡ had a large number of demobilized soldiers and their employment became a crucial issue for the government. After taking the suggestion of many economic experts, the U.S. government decisively adopted the development strategy of Germany and mobilized millions of ex-soldiers to build expressways in order to ease the unemployment pressure. Meanwhile, the U.S. automobile manufacturing industry had developed a huge production capacity, which also required the expansion of road traffic to boost the demand for cars. It was owing to the largescale construction of expressways that within less than 10 years, the country had completed its interstate highway system. Cars were speeding on interstate freeways and traffic was running smoothly. Heavy trucks could deliver goods door-to-door in a fast and punctual way, far better than trains of rail transport. American residents got used to driving for either business or personal pleasure and did not rely on trains any longer. Consequently, both the government and the public believed that railways were outdated, leading to the conversion of lots of railways into highways. After the opening of the highway network, the States became a “kingdom of automobiles.” Although it paved the way for the

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national economic growth though vitalizing many cities along the highways and accelerating the development of automobiles and a series of related industries, it also brought about huge negative impacts on energy conservation and environment protection. In the 1960s when Americans advocated the theory of “railways being outdated,” Japan had completed its Tokyo–Osaka Shinkansen. Later, France opened the Paris–Lyon high-speed railway. The success of high-speed railways in the two countries completely overturned the theory. But due to the narrow territories of the two countries, the power of the high-speed railway did not come fully into play. Subsequently, Italia, Germany, Britain, the Soviet Union, Spain, and many other countries set off a boom of railway construction. So, now it has pushed the U.S. to reconsider its transport development strategy. In recent years, China also emphasized the construction of metropolitan areas and urban agglomerations based on high-speed railways and urban mass transit systems, especially the “four vertical and four horizontal railways” along Beijing–Guangzhou Railway and Beijing–Shanghai Railway. This not only expanded Bohai Economic Rim, Yangtze River Delta, Pearl River Delta, but also contributed to the formation of a group of urban agglomerations, including the Central Plains Economic Zone, city clusters in the middle reaches of the Yangtze River, open economic zone of Xiamen-Zhangzhou-Quanzhou Triangle, urban agglomeration of Shangdong Peninsula, urban agglomeration of the Central and Southern Liaoning, West Taiwan Strait City Belt, Sichuan-Chongqing urban agglomeration, and Guanzhong urban agglomeration. It revealed the special significance of time-space compression in creating cities. In 2010, Shanghai World Expo decided that its theme was to be “Better City, Better Life.” It reminds us that for cites which strive to get rid of high energy consumption, pollution, and emission rates and extensive growth, it is more important to avoid repeating the same mistakes in the future. It is necessary to overcome all difficulties and provide more comprehensive and thoughtful services in the areas of social life, economics and finance, healthcare, culture, education, environmental protection, tourism, consumption, and the modern service industry in order to guarantee people an affluent, comfortable, harmonious, and high-quality life. To change China’s rash industrialization policy and to stimulate urbanization, the top priority is to push forward in a large scale the revolution of new technologies such as green energy, green transport, and green building by taking the opportunities arising from the construction boom of urban agglomerations and metropolitan areas and new rounds of timespace compression. I think that it is not wise to doubt the theories of “urban revolution” and “urban age” and people have all the reasons to believe the

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advent of both the “urban revolution” and “urban age” and expect possible subsequent changes in the economic development mode.

China’s local governments employed land and urban infrastructure capital to lead urban economic growth China is a special case in which urban economic growth is driven by local governments. During China’s Reform and Opening Up era, capital was in a desperate shortage. Unlike Western governments, China’s local governments were not subject to the traditional ideology of the Western market economy which said “governments can only play a role of managing instead of participating in the economy.” In China, local governments not only govern cities but are also responsible for local economic development. Under the state-owned economy, governments assume two roles as managers and investors. Besides, during China’s reform towards a market economy, as private capital was not strong enough, local governments had to attract outside investment, first from Hong Kong and Taiwan, and then from Western countries. In this way, competition for capital took place first among four special economic zones (Shenzhen, Zhuhai, Shantou, and Xiamen), then among 14 coastal cities of the open economy, next between Yangtze River Delta and Pearl River Delta, after that among different provinces. Finally, as the famous economist Steven Ng-Sheong Cheung put it, after the value-added tax reform in China, since the local government could share a portion of the taxes, even county-level governments were motivated to join the competition. To be more exact, it should be called “urban competition.” The key problem was not competition itself, but what was used as capital by local governments to compete with each other. Local governments had no money on hand, and the only thing they had control over was land in cities where the public ownership played a dominant role. Therefore, when the Shenzhen Special Economic Zone was opened, the Shenzhen government first decided to undertake compensated transfer of land use rights as Hong Kong had done. This practice later spread to many other cities. Land controlled by governments would undergo “three connections and one levelling” (which means a construction site is connected to water and electric power supplies and roads, and that the ground is leveled before a project is begun) or even “seven connections and one levelling” (which expands to also include utilities connections to drainage, heating, telecommunications network, and natural gas or coal gas), in order to facilitate the construction of secondary developers. Later, local governments even leveraged old factory buildings and living quarters

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of local state-owned enterprises to attract foreign investment. Preparation works of “three connections and one levelling” and “seven connections and one levelling” constitute the aforementioned urban infrastructure capital of governments. In today’s China, local governments still control the land use rights. Having land and urban infrastructure capital at their command, they can lead the formation of capital. We know that Western countries spontaneously occupy the market through competition by relying on industrial capital. By contrast, Chinese governments count on land and urban infrastructure capital which is used to provide supporting facilities on the land to lead the investment of external capital. Steven Ng-Sheong Cheung thought that the Chinese government offered investors “a negative land price” in his book The Economic System of China. He wrote that local governments take “land to be the capital contributed by the landlord, [and] the possibility of using a negative land price means the landlord is offering infinite opportunities for adjustment, under which the equi-marginal condition required for efficiency can always be attained as long as the uniform sharing is within a reasonable range…. The xian (county-level governments) may not only give improved land to the investor free of charge, they may even build the facilities gratis, or allow the investor a rebate over a number of years out of the value-added tax the xian is entitled to.” Thus, Steven concluded that local governments used what he called “a negative land price” to attract overseas capital in order to build up industries, promote urban economic growth, enlarge local revenue collection, and speed up the rise of China. It took the economist Steven Ng-Sheong Cheung 28 years to arrive at a “general theory,” from his initial study of China’s development in 1979, and his theory of “Xian competition” in 2003, to his manuscript of The Economic System of China in 2007. This general theory boils down to “contracts restraining competition” which centers on “a negative land price.” However, local governments are very familiar with this practice and what they have frequently said when inviting investment — “seeking presence rather than ownership” — reflects the role of “a negative price.” It should be particularly pointed out that the reason why China’s local governments are very skillful at this practice is a result of the nature of the urban infrastructure capital of the urban economy, just as it is the nature of industrial capital to pursue scale expansion and profit maximization in the industrial economy. Local governments in China are engrossed in the urban economy. That is because China has implemented a market-oriented reform on the basis of a government-dominated state-owned economy. Local governments are

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responsible for the prosperity and economic growth of cities, but they only have control over lands and urban infrastructure capital. So, they develop the nature of urban infrastructure capital to the fullest for the purpose of building up industries, increasing employment, satisfying employers’ and residents’ demands in living and consumption, or adjusting the economy. However, things were different in Western countries. Industrial capital of Western capitalist countries made investments spontaneously and separately under competition and amid the anarchy of production, while governments stuck to the traditional theory of zero government intervention. Under the condition of a traditional market economy, industrial capital developed exceedingly owing to its nature of pursuing scale expansion of profit maximization and thus it caused the latest financial crisis and brought about a disaster to the whole world. Finally, governments had to intervene to save the economy. Some people said sarcastically that the U.S. was being transformed from capitalism towards socialism and China and the U.S. were implementing practically the same system. Although it was a joke, it reflected a truth that as long as a government works for the social welfare of people, be it a capitalist government or not, it will show a certain tinge of socialism.

The special role and function of governments in urban development As already stated, governments have been intensively involved in the economy and become an internal factor of economic growth in the modern mode of production. Urban infrastructure capital including land controlled by governments plays a unique role in the capital formation mechanism and has developed into an urban economy parallel to the industrial economy. First, governments can use their land use rights as original capital. Second, governments can carry out infrastructural developments including water supply, gas pipes, power grids, and roads, through urban planning and accumulate urban infrastructure capital through build-operate-transfer (BOT), transfer-operate-transfer (TOT), governmental fundraising, joint venture, and business cooperation. Third, governments make use of the urban infrastructure capital to attract domestic and foreign capital in order to build up industries, promote urban economic growth, and enlarge local revenue collection. Fourth, governments take advantage of the urban infrastructure capital to increase employment, satisfy employers’ and residents’ demands in living and consumption, provide residential communities, public facilities, medical service, and education service for the massive labor force, and even regulate the

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national economy when necessary. Chongqing is a good case in point. In 2008, the Chongqing government won two 40-million-unit laptop projects from HP and Acer, respectively, by advocating “a processing trade integrating machine manufacturing and spare parts production.” It encouraged the entire chain of the notebook industry to settle down in Chongqing. Additionally, Chongqing implemented a reform of household registration and built plenty of public rental housing for the benefits of the general public. These efforts constituted a favorable environment for investment as well. A large number of farmers-turned workers were attracted to the city and they could get both urban registered permanent residency and spacious public rental housing. Not only the “seven connections and one levelling,” but also the basis of the industrial chain, steady supply of labor force, stability of employers made up the advantageous investment conditions of Chongqing. Consequently, many world-renowned brand owners, contract manufacturers, and parts manufacturers gathered in Chongqing and so Chongqing became an emerging city for the IT industry. Governments play a vital role in economic growth. In China, not only did the local governments use the urban economy to guide capital investment in economic development, but also the Central government arranged industrial layout and regulated the economy through economic planning. More importantly, the Central government minimized the losses from the financial crisis by increasing government investment to boost domestic demand in 1997 and 2008. Therefore, when carefully analyzing the motivations behind the “China’s Miracle,” governments have become an internal driving force for economic growth. In control of urban infrastructure capital (including land) and urban economy developed on the basis of the former, governments in fact became quasi-economic organizations, similar to commercial institutions but independent from the industrial economy. If there is anything called the “China’ mode,” I think it will be an emphasis on governments’ functions in economic development. Governments use the capital of the urban economy to lead the investment of industrial capital, regulate the national economy, and even drive domestic consumption by enlarging government investment in order to pursue the maximization of people’s interests rather than commercial profits. This is a very important feature of China’s mode. Certainly, when leading the urban economic development by making use of urban infrastructure capital, governments may exert a negative impact. For example, some cities either blindly built development zones, technology centers, and expressways or designed the urban layout centering on government buildings with grand city squares and skyscrapers, which only turned out to be

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desolated cities and scarcely used buildings and expressways. This resulted in an enormous waste of resources and money. Some cities in Guangdong Province proposed the “dual transformation” (of cities and industries). However, the global financial crisis of 2008 made the outcome of the “dual transformation” lower than the expectation. In many destination regions of the industrial transfer in Central and Western China, industrial parks were built but only a few enterprises moved in, not to mention the fact that Vietnam, India and many other developing countries were also favorable choices for transferred factories. The industrial basis for the processing trade in those countries was no less than in Mainland China. Besides, governments may also make mistakes in the decision-making of urban planning. It was a vital weakness of government-led resource allocation and can only be prevented and improved by scientific and democratic decision-making process and effective supervisory measures.

The Mismatch between Industrialization and Urbanization in China’s 60-Year Economic Construction Industrialization and urbanization are closely related to each other. The former creates supply while the latter creates demand. Industrialization pushes forward urbanization and the two should develop in parallel. During the 60 years since the founding of New China, urbanization has substantially advanced. The number of cities has grown from 132 before the birth of New China to 655 in 2008, and the urbanization rate rose form 7.5% in 1949 to 45.68% in 2008. According to the 2010 Blue Book of Cities in China, China’s urban population reached 620 million and the urbanization rate arrived at 46.6% up to 2009, and the newly-increased urban population per year exceeded 20 million between 1996 and 2005 and was around 15 million between 2006 and 2009. But China took a detour in its path of urbanization after 1949, resulting in a serious mismatch between industrialization and urbanization and the long-term dual economy of China. This is the root cause of China’s insufficient domestic demand. The lagged urbanization was first of all caused by the counter-urbanization in China’s urban development. The expansion of large cities was restricted in the hopes of developing small towns as substitutes. In the early 30 years of New China, the government planned to turn consumer cities into production cities. Chairman Mao Zedong said, “The people’s political power can be strengthened only when urban production is

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restored and developed and consumer cities are transformed into production cities.” Starting from 1952, the Chinese’ government was busy with economic construction, while the focus of urban construction was put on small and medium-sized towns as well as company towns with a small number of medium-sized cities. Large cities were not expected to be built unless it was for special reasons. The government aimed to control consumption and facilitate the primitive accumulation of industrialization. The Great Leap Forward of 1958 generated short-lived rash urbanization which resulted in reckless expansion of city scale and a surge of city numbers and urban population. Yancheng in northern Jiangsu Province intended to build a metropolis of 1 million, Zhuzhou of Hunan Province targeted a population increase from 200,000 to 600,000–800,000, and Xiangfan of Hubei Province planned to develop itself into a city of 1.2 million people. As a result, the population rate of China soared to 19.5%, the highest number before 1978. To reverse the situation, in November 1960, the National Planning Meeting decided on “a suspension of urban planning for three years,” mobilized 25 million workers to return to rural areas, and repatriated the unemployed migrant rural workers to their hometowns. Between 1961 and 1963, the number of cities totaled 168, a decrease of 40. In 1964, the urbanization rate plummeted to 14%, signifying the beginning of China’s counter-urbanization movement. Moreover, the decadelong Cultural Revolution sent more than 17 million educated youth to remote villages and strictly limited the conversion of agricultural to non-agricultural population. After all, the development of cities was inhibited for the sake of industrialization. In November 1978, the Third Central Committee Meeting of the 11th National Conference of the CPC announced the policy of Reform and Opening Up, but China’s urbanization was still not smooth as favorable policies were given to small towns for nearly 20 years. In general, China’s urbanization after the Reform and Opening Up policy was implemented could be concluded in three stages. The first stage was the 10-year development of small towns. In 1978, the State Council requested to “do a good job of urban consolidation,” and “control the scale of large cities while building more small towns.” A city with a population of over 500,000 was considered a large city. In 1983, Fei Xiaotong published his influential article “Small Towns, A Big Issue.” Shortly after, a decentralized development mode with small towns at the center became the mainstream among theorists and decision-makers, and, as a result, a large number of small towns were established all over the country. In 1985, there were only 1,851 towns in China, but the number of towns nearly quintupled to reach 14,182 in 1992.

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The second stage started when the Urban Planning Law came into effect in 1990. It stipulated that “the scale of large cities should be strictly controlled and a reasonable number of medium- and small-sized cities should be developed.” This policy relaxed the restrictions on urban development and the free flow of production factors. However, Decisions on Several Big Issues on Agricultural and Rural Work announced in the Third Central Committee Meeting of the 15th National Conference of the CPC in October 1998, once again put forward the strategy of developing small towns. In July 2000, the State Council switched to supporting urbanization and stated in Several Opinions on Promoting the Healthy Development of Small Towns that since the time and conditions for speeding up urbanization were ready, the government should seize this opportunity to implement urbanization. There was a serious defect in the strategy of developing small towns and cities in those 20 years. China followed the traditional strategy of restricting the growth of large cities and developing small towns instead, which led to the unbalanced urban development between 1978 and 1998. The number of small and medium-sized cities, as well as small towns, quickly increased while large cities remained at a small number and developed slowly. According to the data from the National Bureau of Statistics, during the 20 years, medium- and smallsized cities with a population less than 500,000 increased from 153 to 583, a growth of 3.8 times; small towns surged from 2,000 to 18,000, an increase of nearly 9 times; and large cities of over 500,000 people only saw a rise of 2 times from 40 to 85. In 1999, Wang Xiaolu and Xia Xiaolin conducted an econometrical analysis based on the data of 666 cities in China, and they concluded that the average scale of China’s cities was too small and large cities were generally underdeveloped. In 2006, Chun-Chung Au and J. Vernon Henderson, two American urban economists, also drew the same conclusion that China’s cities were generally undersized based on econometrical analysis and China’s data. Henderson also estimated that if the city size in China could be expanded by two times, the actual unit labor output would increase by 20%–35%. Statistics also indicated that the population percentage of large cities (which have over 1 million people) was 43% in the U.S. and 48% in Japan in 2005, an increase of two percentage points compared to the figure in 1990. The percentage in Australia was even as high as 60%. By contrast, China’s urban population, which was 376.193 million, only comprised 28.31% of the country’s total by the end of 2008. Serious consequences of excessive small towns would be that the population size could not satisfy the requirement of economies of scale, the service industry could hardly develop, and the ecological environment would be badly damaged due to a waste of land resources and the low efficiency of energy utilization.

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Things were changed in the third stage. At the end of the 1990s, the government abandoned the policy of restricted development of large cities and officially announced a new policy of “coordinated development of medium and small cities and small towns.” This was a breakthrough in China’s urban development strategy. Starting from the 10th Five-Year Plan, urbanization was for the first time given strategic importance in the national development and ideas of coordinated development among different regions and mutual improvement between urban and rural areas were proposed. In 2005, the policy of “industrial development repaying agricultural production and cities supporting villages” was promulgated. In 2007, the Work Report of the 17th National Congress of the CPC stressed, “focusing on increasing the overall carrying capacity of cities, we [the government] will form city clusters with megacities as the core so that they can boost development in other areas and become new poles of economic growth.” In 2008, the new Urban and Rural Planning Law removed the provision of “limiting the scale of large cities.” More importantly, city clusters were more an economic and cultural concept than an idea of administrative division. Therefore, concepts of urban belts and economic circles became popular. Later, the Bohai Economic Rim, Yangtze River Delta, and Pearl River Delta became the most prosperous city clusters in China’s economic development. The open economic zone of Xiamen-Zhangzhou-Quanzhou Triangle, urban agglomeration of Shandong Peninsula, Central–Southern Liaoning urban agglomeration, Central Plains Economic Zone, city clusters in the middle reaches of the Yangtze River, West Taiwan Strait City Belt, Sichuan-Chongqing urban agglomeration, and Guanzhong urban agglomeration also came on the scene. During the 10 years between 1998 and 2008, the development of large cities was sped up and the overall urbanization rate was further improved. The urbanization rate increased by 12 percentage points, an average annual growth of 1.24 points, while the annual growth rate was only 0.77 percentage points in the 20 years between 1978 and 1998. It is worth noting that after the latest global financial crisis, China’s government again put urbanization on the top of its agenda in 2009 and to prioritize the development of medium and small cities and small towns seemed to be an important part of future policy-making. Another reason for the mismatch between urbanization and industrialization in China was the restricted flow of the rural population to urban areas due to the urban-rural household registration divide. We say that industrialization has stimulated urbanization, not only because the industrial capital of industrialization built enterprises, expanded city size, and increased the number of cities, but also for the reason that industries which developed in

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industrialization attracted a large quantity of farmers to move away from the countryside and agricultural work and so instead become industrial laborers. This led to the growing number of workers. Here, the migration of the rural population played a significant role in economic growth. The significance was manifested in at least two aspects: For one thing, rural migrant workers increased the supply of industrial labor and expanded the number of workers, which constituted industrial productivity and thus contributed to the economic growth through industrial production. For another, as more and more of the rural population moved and worked in cities, they increased urban purchasing power and created consumption demand for industrialization, which also led to economic growth. Consequently, the urban-rural population ratio was changed, so was the ratio between urban and rural economies. During the 30 years between 1949 and 1978, China’s gross industrial output value grew by 39.18 times, but its urbanization rate only rose to 17.9% from 10.6% with an annual growth rate of 0.25 percentage points. The overall pace of urbanization was very slow. China implemented a planned economic system during those 30 years. To solve the problem of insufficient food supply, a divisive household registration system between rural and urban populations was carried out for the purpose of limiting the migration of the agricultural population to cities. This further strengthened the urban-rural dual economic structure in China. In those 30 years, the country faced an acute shortage of consumer goods, farmers were impoverished, and workers received low wages. So, neither of them could afford high consumption. The economy during the 30 years was more a production economy than a consumption one. After the Reform and Opening Up era started, the Chinese government introduced a policy of “leaving the fields without leaving the countryside” in order to develop the rural industry. This policy, however, deepened the dual economic structure. Besides, due to the divide in the household registration system, hundreds of millions of farmers rushed into cities and contributed their labor to industrialization, but they were forbidden from settling in cities and enjoying basic urban welfare and services. Of course, the biggest change in the urban economy after the start of the Reform and Opening Up era was the transition towards a socialist market economy. In particular, the production of consumer goods was developed in the early years of the reform, a group of people was allowed to get rich first, 17 million educated youth returned to cities, workers became better-off, and the dependency ratio was lowered. Consequently, there was a boom of consumption represented by the massive purchase of household appliances in the 1980s. But, although industrialization moved forward, the lagged urbanization sustained the huge rural population

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size. In these years, cities grew larger and larger and 160 million farmers worked in cities, but they were not counted as parts of the urban population due to the divisive household registration system. On the surface, the proportion of China’s urban population rose from 17.82% to 45.68% between 1978 and 2008, and the urban population reached 607 million by the end of 2008 (some said the number should be 602 million in 2009). However, if excluding the number of farmers without a permanent urban residence permit, the actual urbanization rate was less than 34%. So, some people called this phenomenon pseudo-urbanization or periurbanization. This was particular to China and a result of lagged urbanization. More importantly, farmers contributed their labor to industrialization, but the industrial sector did not grow the working class proportionally and cities did not accept them as urban citizens and grow the middle class. In 1994, when talking about the impact of rural population migration on economic growth during Japan’s industrial take-off, Hiroshi Yoshikawa specially mentioned that between 1995 and 1975, Japan’s urban household increased by 80%, which greatly stimulated household appliance production and consumption. Boosting domestic demand became a driving force for economic growth. China’s policies on rural migrant workers lacked a similar stimulus. In countries with a developed market economy, the middle class usually accounted for 80% whereas in China, the proportion of middle-income families was only around 23%. This indicated a deficiency of consumption power. In the Southeast Asia Financial Crisis of 1997, China showed the signs of overproduction. Premier Zhu Rongji repeatedly asked to activate domestic demand, but hardly any result was seen from the small middle class. When those people who got rich first purchased cars and houses, it was difficult to form another boom of consumption. After entering the new century, the trend of globalization fueled the robust economic growth of China, and the expansion of external demand and massive exports covered up the conflict between overproduction and underconsumption. The problem of overproduction was not revealed until the global financial crisis in 2008 when external demand shrank to a large extent. The pressure of economic structural adjustments became prominent. The policies of “sending home appliances to the countryside” and “stimulating automobile consumption” initiated in 2009 received a worse result than expected. The main reasons were the low spending power of rural migrant workers and the lack of a middle class in cities. These factors were the major obstacles for the growth of domestic demand. In addition, when urbanization was sped up, the urban-rural household registration divide prevented 160 million farmers-turned workers from being registered as urban residents and caused a series of negative impacts, such as desolation in most traditional agricultural areas, a massive loss of high-quality

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farmland, ageing of agricultural work force, the participation of farmers in non-agricultural production, an increase of left-behind children of migrant workers, a wider gap between urban and rural income, and more and more mass disturbances. Anyway, the mismatch between industrialization and urbanization has become an obstacle in current economic growth. In the future, the Chinese government has to solve this deep-seated problem for the sake of economic development.

Time-Space Compression Led Us to the Urban Age The lagged urbanization in China is now speeding up. The construction of highspeed railways has brought about many opportunities and stimulated the rise of a group of cities. Therefore, it is important to grasp this chance to accelerate China’s economic growth, promote an increase in domestic demand, and facilitate economic structural transformation by converting hundreds of millions of rural migrant workers into new urban residents. Originally, the Chinese government considered building 20 city clusters by 2030. But, to cope with the global financial crisis in 2008, China announced a 4-trillion stimulus package to expand investment and consumption and the Ministry of Railways committed to finish the construction of 40,000-kilometer railroads which was originally scheduled to be completed in the next 11 years. Local governments also joined the trend and invested in the construction of high-speed roads and inter-city railways, with the total length exceeding 10,000 km. Between 2008 and 2009, the Beijing–Tianjin Intercity Railway, Wuhan–Guangzhou High-Speed Railway, and Zhengzhou–Xi’an High-Speed Railway were successively put into operation. In 2011, the Beijing–Shanghai High-Speed Railway opened to the public. The whole world witnessed the rapid development of China’s high-speed railways, which had taken other countries several decades to accomplish. This encouraged the rise of numerous new city clusters and brought about huge changes to the timespace compression of cities. A high-speed train could carry 600–800 passengers, equivalent to the capacity of 10 buses or 3 passenger planes. It overcame the shortcomings of highway network (short-distance transportation) and air service (small carrying capacity). If we say that the advance and application of computers and information technology realized remote transactions and rapid settlement and turned what was expensive and scarce into something inexpensive and common, then high-speed railways realized the connection among the rising city clusters, formed 0.5-hour, 1-hour, 2-hour, 3-hour, and 4-hour economic circles, facilitated the fast flow of massive labor force, technologies, materials,

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and capital through time-space compression, brought about convenience and efficiency by taking advantage of the complementarity of cities, and generated the coupling effect. The high-speed rail network also offered a brand-new timespace environment for urban economic growth and created opportunities for domestic demand increase and economic structural transformation. Why did we say that the urbanization represented by the rise of metropolitan areas and city clusters resulting from the construction of high-speed railways and urban mass transit would create great opportunities for China’s future economic development? The reasons are as follows.

The high-speed railway greatly reduced the time-space distance between cities The Beijing–Tianjin Intercity Railway has a length of 115.2 km and a reduced travel time 29 minutes instead of 69 minutes. If compared to the 2-hour travel time in 1994, the time needed now is three quarters less. The Wuhan– Guangzhou High-Speed Railway shortened the journey time of 1,068.8 km to less than 3 hours. The Zhengzhou–Xi’an High-Speed Railway is 505 km long and it significantly cut the minimal travel time between Zhengzhou and Xi’an to 1.48 hours from more than 6 hours. At the same time, owing to the construction of this railroad, the journeys from Xi’an to Beijing and to Shanghai take, respectively, 7 hours and 10 hours less than before (11 hours and 15 hours). The Beijing–Shanghai High-Speed Railway allows a passenger to finish the 1,305-kilometer journey within 4 hours. Although after the personnel changes in the Ministry of Railways, trains were generally slowed to a maximum speed of 300 km/h, reducing operating costs and risks while improving efficiency, the fastest trains would take 4 hours and 48 minutes to travel from Beijing to Shanghai. Additionally, a slower class of trains running at 250 km/h was also operated for those lines, making more stops and charging lower fares and would take 7 hours and 56 minutes to complete the Beijing–Shanghai journey. Nowadays, whether a city is connected to the high-speed railway system or not becomes an important factor to influence external investment decisions.

The rise of new city clusters along the high-speed railways would upgrade component cities and towns Emerging city clusters along the high-speed railways will help to turn key cities into metropolises, secondary or ordinary cities into large cities, and central towns into medium-sized or small cities. For example, along the Beijing–

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Shanghai line, the Shanghai government positioned Hongqiao Station (in the west of the city) as a comprehensive transportation hub, and its surrounding areas would be built into a business zone with a coverage of 86 km2, including Minhang, Changning, Qingpu, and Jiading districts. It was said that Shanghai used to build its hopes on the individual development of the east (Pudong District), but now it finally switches the attention to the west. The Shanghai– Nanjing Intercity High-Speed Railway was designed to include 31 stations, but now only 21 were put into operation with 10 stations saved for fostering future economic growth centers. High-speed rail stations will bring about massive flows of population, materials, capital, and information. Surrounding cities should learn to take advantage of the impetus effect of high-speed railways and formulate a proper urban development mode after analyzing the relations among resources, economy, industry, and population factors and their own resource advantages based on reality, in order to form a coordinated and interactive relationship among those cities and bring the development of those cities to a higher level.

High-speed railways facilitated maximized resource allocation and accelerated the adjustment and improvement of industrial layout Statistics showed that in 2010, China’s social logistics cost amounted to RMB7.1 trillion, accounting for 18.1% of the GDP, twice as much as the cost of developed countries. Additionally, according to the estimate by the United Nations Development Programme, the circulation cost of China’s manufactured products approximately took up 20%–40% of the total cost while in developed countries, this proportion was 9%–10%. And among the national logistics costs, industrial products constituted 88.8%. The formation of a high-speed railway network created plenty of opportunities for us to maximize resource allocation, adjust industrial layout, raise logistic efficiency, and lower logistics and transportation costs. Aside from the long-range planning of “four vertical and four horizontal railways,” the Wuhan–Guangzhou High-Speed Railway connected the north to the south and Beijing–Shanghai High-Speed Railway linked the Bohai Economic Rim and Yangtze River Delta Economic Zone. It can be predicated that Guangdong, Hong Kong, and Macau will accelerate the industrial transfer towards inland areas, Changsha–Zhuzhou–Xiangtan City Cluster would be increasingly integrated in the Pearl River Delta Economic Zone, Wuhan City Circle gradually would exert its influence to coastal and riverside cities, and the economic ties and cultural cooperation between the Pearl River Delta and Guanzhong urban agglomeration would be redefined. The rapid transit system

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would promote the coordination of city clusters and enable internal industries and enterprises to achieve better resource reassignment and allocation and layout arrangement. As a result, corridor industrial economic belts along the railroads and new coupling effects between cities were formed, remarkably improving the structure, efficiency, and results of resource allocation.

Urbanization will create considerable business opportunities The practice of urbanization proved that when a population accumulates to a certain amount, there will be a demand for the tertiary industry, such as postal and telecommunication services, banking services, and hospital services. In around 1965, Japan’s urbanization rate reached 65%–70%. During that time, industries which generated a higher profit growth rate than the industrial average were composed of service, retail, real estate, and food and beverage industries. Statistics showed that among the existing 57,000 business agglomerations in Tokyo, 34,300 (60.2%) were built near the metro or light rail stations and more than 90% of the department stores were located within 100 meters of the stations. Prior to 2010, according to the information from China’s National Bureau of Statistics, the service consumption expenditure only accounted for 40.1% of the household consumption expenditure, while the proportion in developed countries could be as high as 60%–70%. It can be predicated that urbanization resulting from the construction of a rapid transit system in China will accelerate the development of the broad-sense service industry and the growth of real estate, logistics, tourism, culture, music, publishing, catering, and fitness industries. The agglomeration effect of city clusters will especially benefit the intermediary services industry, such as financial services, and accounting and legal services. Besides, there will be a rising demand for low-rent and affordable housing in the cities along the highspeed railways. At the same time, interchange cities will face an increasing need for passenger and freight transport services via intercity railways (trains and metros), public buses, and taxis, as well as commercial and catering services. It should be pointed out that the culture industry is an important component of the modern services industry and also a promising industry. During the 30 years since the start of the Reform and Opening up era, China’s middle class has developed to a certain degree and will continue to grow in the future. How to meet the increasing cultural and spiritual needs of the group is a challenge faced by China’s cultural industry. The advance of urbanization probably means a chance for the industries with excess production capacity. In 2009, the total retail sales of consumer goods was

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expected to increase by over 15%, the highest growth rate in the most recent 20 years which indicates the huge consumption potential of China after the financial crisis.

The construction of urban agglomerations and metropolitan areas promoted the development of strategic emerging industries Strategic emerging industries are also a valuable indicator to observe economic growth and are composed of new energy, new materials, bioscience, biological medicine, information networks, marine development, geological prospecting, and other industries. Now, the U.S. no longer regards “re-industrialization” as its priority strategy in reshaping its competitive edge and shifts to the policies and measures of vigorously developing emerging industries, encouraging technological innovations, and supporting medium- and smallsized enterprises. European countries have already made massive investments in exploring low carbon economy, biotechnology, and the “internet of things,” generating profound influence on the structural adjustment and economic development of China. I think that high-speed rail construction which brings about enormous economic benefits and the rise of urban agglomerations is also a strategic emerging industry and will exert a driving effect on other emerging industries within the same region. Therefore, it will create a far-reaching impact on the transformation of China’s economic development mode and the advance of the social economy, if the government can seize the opportunity offered by the emergence of urban agglomerations and metropolitan areas resulting from the construction of high-speed railways and urban rail transit to accelerate the development of emerging industries in the areas of new energy, new materials, low carbon economy, biotechnology, and the internet of things and promote the large-scale revolution of new technologies such as green energy, green transport, and green architectures.

The high-speed rail economy will bring a new round of urbanization boom in China and facilitate the migration of the rural surplus labor force to cities Ming Lu, Professor of Economics in Fudan University (China), once mentioned in an article that the difference in population size of different cities in China was far smaller than the world standard when he made a comparison based on the data of 2000. The current issue is how to transform the 160-million rural migrant workers into permanent urban residents, accommodate another 300

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million members of the rural surplus labor forces in the cities, and foster a certain portion of these people into the middle class. This is the key to domestic demand growth and economic structural transformation. However, China’s central and western areas lagged behind in urbanization, compared to the rapidly-developed eastern region. It is reasonable to build a batch of medium and small cities and small towns in areas with relatively high carrying capacity of resources and environment and accelerate the accommodating of industrial transfer in Central and Western China. But, it does not mean that China should not switch back to the old path of “priority development of medium- and small-sized cities and small towns” and carry out “townization.” To force the newly-development city clusters to wait for the growth of small towns is irrational. Now, let us talk more about the high-speed rail. The development of high-speed railways and rail rapid transit in China propelled the time-space compression of urban agglomerations and metropolitan areas to a new level and changed the world’s impression towards the high-speed rail age. This is not only an unprecedented accomplishment of the urban economy, but will promote the unpredictable leap forward of China’s economy across its vast territory, and facilitate the industrial structural adjustment, maximized resource allocation, and the shift of economic development pattern. It will lead us to the urban era. It is incomparable with the patterns of Japan and some European countries with a narrow territory. This great achievement cannot be undermined by the corruption of the railway minister Liu Zhijun. I think that the problems of China’s railway system can boil down to two aspects apart from the corruption. One is that too many projects were carried out at the same time. Efforts should be first concentrated on several vital projects like the construction of the Beijing–Guangzhou and Beijing–Shanghai railways and more projects would be undertaken later based on local conditions and previous experiences. Second is the high indebtedness which is also related to the above mentioned excessive projects. Of course, it is still questionable whether every train should run at a speed of 350 km/h, every line should construct ballast-less high-speed tracks, every high-speed railway should be brand new or can be a combination of new railways and existing ones like in Europe, train fares should be lowered or can be differentiated into several prices, and the corruption of Liu Zhijun has impacted the safety of highspeed railway construction. There may be serious decision-making mistakes and other blunders, but these are a result of the mixing up between government administration and enterprise management and belated structural reform in the Ministry of Railways.

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As for the question of heavy investment in railway construction and other similar super-large infrastructure construction projects, and subsequent high operational costs, I believe that we should focus on the social marginal benefit of infrastructure investment rather than consider the economic benefits and investment returns of the construction project itself. It was reported that as the high-speed train service between Beijing and Shanghai was about to open, regional governments along the line invested heavily in building supporting massive infrastructure, comprehensive supplementary facilities, and environment renovation works. Lands cleared up by the supporting construction projects will be auctioned by rail investment companies and regional land resources bureaus and the auction proceeds will be shared by the two parties according to a certain ratio after repaying the debts of rail construction. Behind the heavy investment is the expectation of a new round of land appreciation driven by the high-speed rail economy. Some experts suggested that taking Nanjing City as an example, the distance between Nanjing South Railway Station and the downtown was around 10 km and judging from the present situation, the local government was able to recover its total rail investment as long as it sold several tracts of lands and cultivated enormous benefits by developing the rest of the land. Besides, investment in public and infrastructure projects which cannot recover the money in a short term but have special benefits to the overall economy should receive more support from governmental appropriations rather than heavily relying on government bonds and bank loans. It should be remembered that when Bill Clinton was elected the President of the United States in 1993, he fulfilled his promise made during the election campaign by announcing the development of the National Information Infrastructure (NII). This project for expanding the “information superhighway” was expected to consume USD200 billion in 20 years and be mainly financed by private enterprise. But it was said that the government’s long-term investment was approximately USD30 billion, equivalent to the money put in the Strategic Defense Initiative, or “Star Wars” Program. This indicated that for such a large project like building the “information superhighway,” even this capitalist country of America had to resort to government investment. Unexpectedly, the Wenzhou train collision on July 23, 2011 raised hot debates on the safety of high-speed rail transportation. In fact, like any other transportation vehicles, high-speed trains also have a breaking-in period. And even regular operation may result in accidents. The Intercity-Express (ICE) of Germany started service on June 2, 1991, with a maximum speed of 250 km/ h and recorded zero accidents until the Eschede train disaster in 1998. A highspeed train carrying 287 people derailed and caused the deaths of 101 people

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and with another 194 people injured. After a five-year technical review and trials, the German public finally restored their confidence in the high-speed rail. Nowadays, ICE remains the first choice of travel for Germans. Similarly, on April 25, 2005, a seven-car commuter train came off the tracks on the JR West Fukuchiyama Line in Amagasaki, Hyogo, and 107 people were killed and over 500 others were injured. On the surface, it was caused by speeding by the train driver in an attempt to make up for lost time. But the investigation and trails focused on the management of the train company, and it was thought that the narrow leeway in the train’s schedule was the main cause for the speeding. In the end, West Japan Railway Co. President was believed to be the person who was ultimately responsible and so he was charged with negligence. By relating these accidents, I want to prove that even the safest train may be susceptible to unpredictable accidents. What matters is not the accident itself but to find out the cause, learn a lesson, and remove hidden dangers. After the 7.23 incident, Eric Jackson published an article named “Wenzhou Train Collision in the Eyes of a Foreigner” in the Chinese version of The Wall Street Journal on August 3. After expressing his deep sympathy to the families of the dead and injured in the accident, he soberly put forward, “In today’s microblogging world where messages spread rapidly, it is especially important to remain calm and keep a clear mind.” In particular, the article mentioned, “Although some departments had not performed to their best in this accident, we cannot deny China’s highspeed railway and its advantages just because of one disaster.”

Urbanization Bonus and Farmers-Turned Workers Speaking of urban development, it is impossible to avoid the urbanization bonus. Governments attract outside investment as they believe capital will create an urbanization bonus. But in China, the 160 million migrant workers are the real creators of the urbanization bonus, because they can provide cheap labor for cities’ industrialization. So, to achieve the urbanization with Chinese characteristics, the government should not only expand the size of cities and towns, but also transform the migrant workers into urban residents. What is the urbanization bonus? It refers to the benefits gained by continuously reducing the gap between urban and rural areas in urbanization after deducting the original rural earnings. In fact, the urbanization bonus arises with economic development, and is attributable to several factors, such as agglomeration economies, economies of scale, demographic dividends, and differential ground rents.

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First, as modern industrial production tends to be centralized, industrial capital is likely to accumulate and expand in the surrounding areas. New factories will be established and a large number of farmers will be attracted to work there, away from the countryside and agricultural work. These workers will become industrial laborers. As a result, the number of workers and the middle class will grow and new urban regions will be formed. The construction of urban infrastructure accelerates population flow and is beneficial to the concentration of labor, capital, and other production factors, thus generating agglomeration economies. Benefits can be gained through the centralized operation of capital turnover, commodity circulation, labor force training, technological innovation, product upgrade, and market competition by taking advantage of the clustering of production activities. Here, urban infrastructure construction works as a trigger which not only initiates economic development but also creates an urbanization bonus. Eastern coastal areas seized the opportunities offered by the Reform and Opening up policy to build large cities, such as Shenzhen and Shanghai (Pudong New Area), exerting agglomeration and radiation effects. In particular, Shanghai focused on the infrastructure construction of bridges and tunnels across the Huangpu River when developing the Pudong New Area. Take Xiamen City as another example. Xiamen is located on the southeastern coast of China and faces Jinmen Island across a stretch of sea water. It used to be a war front in the Chinese Civil War and a city with poor transportation infrastructure and in need of economic construction. After the Reform and Opening Up period began, the Standing Committee of the National People’s Congress approved the establishment of special economic zones in Shenzhen, Zhuhai, and Shantou in Guangdong Province and Xiamen in Fujian Province. Between 1981 and 1983, Xiamen Gaoqi International Airport was built thanks to USD21 million in loans from Kuwait under the permission of the State Council which generated an urbanization bonus greater than the economic growth. Therefore, we should focus on the social marginal benefit of infrastructure investment rather than the economic benefits and investment returns of the construction project itself. Similarly, the development campaign of the western regions also meant a historic opportunity for the construction of cities and towns. The 10th Five-Year Plan invested RMB100 billion to build the 18,000 km rail network, RMB120 billion to construct 15,000 km roads (within 20 years), and almost RMB300 billion to undertake West–East Gas Pipeline projects (Phase I and II). Among the above infrastructure construction projects, eight expressways passed through 452 townships or towns and 41,000 villages, driving the development of a considerable group of small towns. Second, within urban industrial clusters formed based on the highly-

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specialized division of labor and collaboration, each medium- and small-sized enterprise can achieve economies of scale through establishing an external cooperation relationship, thus realizing the integration between flexible production and mass production. Besides, the construction of the high-speed rail network and metropolitan areas will accelerate the rise of a series of city clusters and strengthen regional industrial integration and economies of scale. Third, a convenient transportation network is beneficial to the population flow and will attract young adults and the educated labor force to cities which will have earlier access to the demographic dividend. In addition, the technological development of high-speed rail transit will bring about dramatic changes to cities in the aspect of time-space compression and will further promote the movement of the population and the realization of the demographic dividend. Fourth, the growth of the urban economy and constant industrial upgrading contribute to the evolution of industrial structure. This gives rise to differential ground rents resulting from the economies of agglomeration. As a result, economic benefits from large cities are generally larger than from ordinary cities and those from downtown areas are always better than ones from the suburbs. In 1984, the World Bank mentioned in an investigative report of China, “Experience from other countries suggests, for example, that the economic cost of land can rise by as much as 25% per kilometer as one moves from agricultural land on the edge of an urban area to core land in the inner city. If the economic cost of agricultural land on the edge of a Chinese city is assumed to be RMB0.8 per square meter, the economic cost of land in the city center would be about RMB10 per square meter for Wuxi, for example, which has a radius of about 10 km, but would be as much as RMB120 for Shanghai, which has a radius of 20 km.” The report concluded, “For the Shanghai Bicycle Factory, for example, the economic costs of production in its present location are at least RMB10–20 per bicycle greater than if it retained the same excellent management but was located in a nearby medium-sized city,” as the enterprise can avoid certain additional costs of locating in a large city.1 Practices of both China and Western countries indicated that it was necessary to reflect the differential income in urban land price, land rent, and land tax. When formulating land or property tax policies, local governments have to make full use of the special economic lever of the urban economy — differential ground rent, and make enterprises fully aware of opportunity cost, sunk cost, marginal benefit, and differential ground rent when making spatial decisions. It will drive certain industries out of cities, moving towards where the cost is lowest based on the principle of comparative cost. As those industries

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are located away from large cities and closer to resource deposits, they give place to new industries or industries with high value added, thus pushing the development of industrial structure to a high level in large cities and central urban areas. In the above analysis, it seems that the urbanization bonus is only related to economies of agglomeration, economies of scale, demographic dividend, and differential ground rent in industrial development and does not involve farmers-turned workers who are divorced from agricultural work. But it should be specially stressed that the real contributors of the urbanization bonus are those farmers. In China, it refers to the 160-million rural migrant workers who lived in cities but who are unable to get permanent residency permits. Although industrial capital of industrialization has built industrial enterprises, without migrant workers providing the labor force for industrial production, capital cannot work. Thus, everything related to industrial development, such as economies of agglomeration, economies of scale, demographic dividend, and differential ground rent will come to nothing. After China implemented the Reform and Opening Up policy, cities introduced capital and encouraged enterprises to recruit migrant workers as a source of cheap labor force. Upon entering the new century, many transnational industrial groups relocated their manufacturing factories to China. On the one hand, industrial groups reduced the cost of products by paying low wages but increasing competitiveness. Chinese cities gained an urbanization bonus as a joint result of economies of agglomeration, economies of scale, demographic dividend, and differential ground rent. Farmers who were divorced from agricultural work were the driving force for all those. Without those farmers-turned workers, even the most powerful industrial capital will turn out to be a pile of steel. On the other hand, while industrial enterprises were set up during China’s industrialization and urbanization, the middle class was not formed or increased proportionately due to the household registration system. Over 100 million farmers-turned workers contributed to industrial output and revenue to cities but they were not granted urban permanent residence permits and they were excluded from regular employers and the rest of the urban population. At the same time, since they still occupied a farmland in their villages, this process inhibited the largescale development of agriculture. Additionally, rural migrant workers lived in urban slums and tightened their belts in order to save money to build new houses in their hometowns, which they may have no chance to move into. Moreover, due to the urban-rural household registration divide, those migrant workers had to return to the villages to find spouses and their children would be charged sponsorship fees and could only be enrolled as transient students

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if they went to schools in cities. And urban education did mean those migrant children would have equal access to further education or universities as native students. Migrant workers were prevented from enjoying basic urban welfare and services, not considered as the main consumers of consumption, and unable to participate in the upgrading of urban consumption structure. City governments (enterprise groups as well) did not need to provide urban welfare and social services such as housing, health care, children’s education to migrant workers and could save this part of expenditure as an urbanization bonus. This is a special kind of urbanization bonus created by China’s rural migrant workers to the urban economy. Cities give migrant workers “neither the right of settling in cities nor basic urban welfare and services.”2 Therefore, the result of governments reaping all the benefits from the urbanization bonus will be a rich country with poor people. One who has visited Europe and the U.S. will know that there are a large number of illegal Chinese immigrants (mostly, from Wenzhou and Fujian) in New York, Los Angeles, Paris, and Italy. On the surface, it was a result of the attraction and support from the pre-existing expatriates, but in fact, the local government looked the other way when enforcing immigration laws because the labor force was needed in order to achieve city development under the pressure of domestic short labor supply. Taking the U.S. as an example, illegal workers were engaged in labor-intensive industries which native residents were unwilling to do them, such as construction, farming, catering, and laundry services. Therefore, capitalist governments of developed countries knew that in certain instances, they had to relax control over illegal workers and illegal immigrants in order to reap the urbanization bonus. It has almost become a common practice. But any government cannot rely on this portion of the urbanization bonus for a long time, so they will, after a certain period, legalize those undocumented migrants for all sorts of reasons, including pardon and amnesty, to enable those people to enjoy the urbanization bonus created by them. When Barack Obama moved into the White House, he expressed many times the ambition to reform the immigration system, bringing hope to the 12 million illegal immigrants in the U.S. A report from the U.S. Immigration Policy Center revealed that the legalization of illegal immigration had done more good than harm to the U.S. economy. Because once illegal immigrants receive residency permits, they will step out of the shadows and earn more and spend more, and their legal employment and tax payments will inject new vitality to the U.S. economy. However, if those illegal immigrants were forcibly repatriated, it would cost the government USD206 billion in five years, about USD41.2 billion per year, equivalent to eight times the annual expenditure of

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the Department of Homeland Security. This is why several hundreds of millions of migrant workers must be turned into new urban residents. According to the statistics from Chang Xiuze, between 1999 and 2007, China’s total savings rate rose from 37.1% to 51.8%, an increase of 14.7 percentage points. Among this number, the governmental saving rate grew from 2.6% to 10.8%, 8.2 percentage points up; the enterprise savings rate increased from 14.6% to 18.8%, up 4.2 percentage points; and the household savings rate moved from 19.9% to 22.2%, up only 2.3 percentage points. In the “triple jump” growth of 8–4–2 (if just considering the integers), households were at the lower end while the government was at the higher end. This explained why the rise of China resulted in a rich country but poor people: The government occupied a considerable portion of urbanization bonus. In the 30 years since the start of the Reform and Opening Up era, farmers-turned workers have made large contributions to the prosperity of cities but they and their children were prevented from being registered as urban residents and enjoying the urbanization bonus created by them. Recently, the workers of Guangdong Honda factory staged a strike for a pay rise, and 18 Foxcoon employees attempted suicide due to their discontent over overly strict labor camp management. These incidents reflected the basic appeal of farmersturned workers for people-oriented economic development and a harmonious society. So, to realize the real urbanization with Chinese characteristics, the government has to solve the urban-rural household registration divide and offer urban welfare for the existing 100 million rural migrant workers and future rural migrants. The key is what policies the government should adopt in order to make those rural migrant workers truly become urban residents and have the economic capacity to consume cars and houses, like what Western countries did to legalize illegal immigrants. In addition to the reform of the household registration system, the government has to allow the free transfer, mortgage, and sale of rural land use rights. Rural migrant workers use the money received through transferring their land use right and village houses to settle down in cities. Like pre-existing urban residents, the new residents will also be entitled to equal employment opportunities, house and car purchases (renting first), education services to children, and urban healthcare and social insurance. Once hundreds of millions of migrant workers become new urban residents and own urban houses, it will bring about consumption growth of household equipment and appliances. At the same time, only when a large quantity of new residents drive a new round of urbanization will there be a 20-year high economic growth fueled by the automobile and housing consumption of the middle class in China.

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Urban Agglomeration Planning and High-Speed Rail Network: China’s Urbanization Marches towards a New Urban Age The future urbanization of China, according to the 12th Five-Year Guideline, is supposed to build “two horizontal and three vertical” urban agglomerations. 1. Along the Longhai Railway: Xuzhou city cluster, Central Plains Economic Zone, Guanzhong urban agglomeration, Lanzhou city cluster, and pan-Urumqi city group. 2. A l o n g t h e Ya n g t z e R i v e r v a l l e y : Ya n g t z e R i v e r D e l t a u r b a n agglomeration, Wanjiang River urban agglomeration, city clusters in the middle reaches of Yangtze River (Changsha–Zhuzhou–Xiangtan City Cluster, Wuhan City Circle, and Nanchang–Jiujiang City Cluster), Yichang–Jingzhou–Jingwen urban agglomeration, and Chengdu– Chongqing Economic Zone. 3. Along the eastern sea border from Dalian City (Liaoning Province) to Zhanjiang City (Guangdong Province). 4. Along the Beijing–Harbin Railway and Beijing–Guangzhou Railway from Harbin, Shenyang, and Beijing to Guangzhou and Hong Kong. 5. Urban agglomerations along the newly-developed western vertical line: Huhhot–Baotou–Erdos urban agglomeration (in Inner Mongolia), central Guizhou urban agglomeration (centering on Guiyang and covering Zunyi, Kaili, Anshun, etc.), central Yunnan urban agglomeration (centering on Kunming), and southern Yunnan urban agglomeration (including Gejiu, Kaiyuan, and Wenshan). Beside the above-mentioned urban agglomerations, “four vertical and four horizontal” high-speed railways were under construction. The “four vertical lines” refer to Beijing–Shanghai, Beijing–Hong Kong, Beijing–Harbin, and Hangzhou–Fuzhou–Shenzhen high-speed railways, and the “four horizontal lines” are Xuzhou–Lanzhou, Shanghai–Kunming, Qingdao–Taiyuan, and Shanghai–Wuhan–Chengdu high-speed railways. At present, the first “two horizontal and two vertical” urban agglomerations which had already been listed in the 12th Five-Year Guideline were gradually being connected to each other. The vertical line in Western China from Huhhot–Baotou–Erdos urban agglomeration, to Guanzhong urban agglomeration, then to Chengdu–Chongqing economic zone was newly

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developed. These urban agglomerations are expected to have population capacity of 50 million–100 million people at the most or 10 million–25 million at the least, and will become the major carriers of the rural-turned-urban population. The Zhengzhou–Xi’an section of the Xuzhou–Lanzhou HighSpeed Railway went into operation in 2009, the Beijing–Shanghai high-speed rail started service in 2011, and the Beijing–Guangzhou section of the Beijing– Hong Kong high-speed rail will open to traffic in 2012. High-speed railways between Chongqing and Kunming, and Chongqing and Guiyang were also under construction. The construction of the high-speed rail network will effectively connect urban agglomeration economies to social development. It was reported that the future spatial layout of urbanization would be divided into five categories: mega-urban agglomerations, large urban agglomerations, other urbanized areas (metropolitan areas, city circles, and urban belts), border or port cities, dispersedly distributed medium and small cities, and small towns. Differentiated urbanization plans will be implemented accordingly. Those five types of urban spaces will contain around 1 billion urban population and facilitate the transformation of China from peri-urbanization to urbanization. This can basically satisfy the demand for urban space when China’s population peaks at 1.46 billion in 2030 and the urbanization rate reaches 65%. Those five kinds of cities provide a clear outline for the future urbanization of both cities and towns in China. According to the estimate made by Sun Jiuwen, Head of the Research Center of Regional Economies, Renmin University of China, a one percentage point increase in urbanization rate will mean 12 million more job opportunities in cities. Following this logic, it can be predicted that the urbanization rate during the 12th Five-Year Guideline will rise two percentage points per year. The 11th Five-Year Guideline was expected to increase the urbanization rate by four percentage points during the five years, but the actual annual growth rate was 1.2 percentage points.3 A French newspaper, Nouvelles D’Europe, carried an article named “BeijingShanghai High-Speed Rail Brings about More than Just Speed” on June 15, 2011. It said, “It is an epoch-making achievement for land transportation to compress the travel time for 1,300 km into five hours. Despite the highlydeveloped global airline industry, especially in developed countries like the U.S. and Europe, the rail transportation which is less effected by the weather is more effective than airplanes considering the increasingly intensive changes of climate. The high-speed railways largely compensate for the biggest disadvantage of rails compared to airplanes (speed). Last year, the significant disruption of European air traffic was caused due to the dangers posed by

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volcanic ash drifting from Iceland, triggering the debate over the construction of high-speed rails across Europe.” The newspaper continued, “Undoubtedly, the significance and role of Beijing–Shanghai high-speed rail are profound and enormous from the perspective of a nation. The long-distance transportation capacity also reflects the strength of a country. The more people are transported per unit time and the longer the distance is, the stronger the country’s overall logistics capacity will be. In the vast territory of China, as long-distance population movements become increasingly frequent, the completion and improvement of railways, especially the high-speed railways which have a large transport capacity and a fast speed, will realize not only super-large-scale population transport but also the nationwide configuration of all kinds of production factors in the new environment.” To borrow the words of a Chinese scholar, “When China’s high-speed railways are being built along with the most large-scale urbanization in human’s history, when three world-class economic zones are connected by four to five hours travel on the high-speed railways, and when the ‘four horizontal and four vertical’ high-speed rail network links up the most of China, the changes brought about by the high-speed railways are not merely about the speed, but a shift in the concept of space and a revolution of lifestyle of the Chinese people, the formation of the world’s largest unified market, and the gradual emergence of Chinese standards in the global modernization.” The article ended with the conclusion, “It can be said that what the highspeed railways, including Beijing–Shanghai high-speed rail, bring to China is not only a faster speed, but also a deep reflection of China’s mode, standards, and road system.” 4 Therefore, there is reason to believe that the urbanization featuring high-speed railways, urban agglomerations, and metropolitan areas will usher us into a new urban age.

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Financial Globalization: Opportunities and Challenges for the Renminbi as a Global Currency

The Capital Market in China: A 60-Year Review Volume 3

Prologue: Yen Appreciation Is a Timeless Topic In the midst of today’s financial revolution, financialization of the economy, and financial globalization, the renminbi is facing opportunities and challenges as a “global currency.” Here, we have to discuss yen appreciation, a story that never gets old. Japan’s economy was in ruins after World War II. In 1949, Japan started to use a fixed exchange rate of 360 yen to 1 U.S. dollar for 22 calm years. This drove the complete recovery of the Japanese economy. In the 20 years between 1955 and 1975, Japanese industries developed rapidly. The rural population moved and the number of urban families increased by 80%. This became a great driving force behind the increase in domestic demand, the production and consumption of household appliances, and economic growth. In the 1960s, Japan’s economy developed rapidly with an annual growth of over 10%. By 1968, the GDP of Japan exceeded that of the Federal Republic of Germany. The trade surplus increased gradually. In 1971, the United States negotiated with Japan on the topic of yen appreciation. The U.S. Secretary of the Treasury requested a 18% appreciation of the yen, while Mizuta Mikio, Japanese Minister of Finance, insisted on an increase below 17%. Mizuta Mikio reasoned that when Japan readopted the gold standard in 1930, a 17% appreciation of the yen had resulted in an economic recession. The Japanese thought that the number 17 is very unlucky and it was a taboo in the yen exchange rate. Mizuta’s story may have convinced the United States, and the Smithsonian Agreement was reached by the Group of Ten at the Smithsonian Institution. Japanese appreciation of the yen was set at 16.88%. The exchange rate was based on a rate of USD1 to JPY308, with a fluctuation band of plus-minus at 2.25%. This began the first stage of yen appreciation, and the yen changed from a fixed exchange rate to a floating exchange rate. Japan’s economic growth once fell from 10.2% in 1970 to 4.3% in 1971, the year the Smithsonian Agreement was signed. However this rebounded once it reached the trough in March 1972. Japan’s exports maintained a 19% growth in 1972, and trade surplus was at USD5.1billion. The United States had not defeated its opponent in the first round, and so they tried again after two years. In February 1973, the United States announced that the U.S. dollar would depreciate 10% against the gold. Japan had to transition to a floating exchange rate for the yen. Thus, the yen entered its second stage of appreciation. Between 1973 and 1985 before the Plaza Accord, the yen gradually appreciated to a floating exchange rate of USD1 to JPY250.

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During this period, Japanese cars won a larger and larger market share due to their low cost and high quality. In 1975, Japan replaced the United States as the largest exporter of cars in the world. Japan’s trade surplus also widened every year. The amount was USD8.7 billion in 1981, and it increased to USD46.1 in 1985. Exports to the United States grew by 74%. By the mid-1980s, Japan was the second largest economy in the world, with an economic size double that of Germany. In 1985, Japan’s net foreign assets reached USD129.8 billion, and replaced the United States as the largest creditor nation. In turn, the United States became the largest debtor nation. The United States could not bear such economic “threats” and friction. In September 22, 1985, the ministers of finance from the United States, the United Kingdom, West Germany, France, and Japan signed the Plaza Accord (which the Japanese greatly regretted) at the Plaza Hotel in New York. It ruled that the U.S. dollar will depreciate 30% against the other major currencies in two years. The yen entered the third stage of appreciation, and began a decadelong cycle of appreciation, starting with USD1 to JPY250 and ending with USD1 to JPY87. In 1995, the exchange rate even went to USD1 to JPY80. An expert from the Institute for International Economics once commented that the U.S. policy was to make the Japanese cook themselves in their own pots. From the end of WWII to the beginning of the 1980s, the economic growth rate of Japan remained higher than that of the United States and major European countries. After the signing of the Plaza Accord, Japan’s economy deteriorated dramatically due to the yen appreciation and export decrease. Between 1986 and 1987, the economy of Western developed countries grew from recovery to prosperity while Japan’s economy was under the extreme appreciation of the yen (or endaka, as it was called). To reverse the economic downturn, the Japanese government switched to activating domestic demand by adopting expansionary monetary and fiscal policies. Since January 1986, the Bank of Japan successively lowered the interest rate by five times and cut the discount rate to a historic low of 2.5% in 1987 from 5%, attempting to stimulate economic growth with a loose monetary policy. Japan had already initiated three “consumption revolutions,” and household appliances, such as color television sets and air conditioners, as well as automobiles, became quite widespread. The last chance for economic growth was housing commercialization. It has to be mentioned that prior to 1985, more than 85% of Japan working-class families lived in publicly subsidized apartment units. Owing to the Plaza Accord, Japanese people earned at least 20% more than before. So, the government started to promote the large-scale commercialization of housing and commercial banks made lots of housing

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loans to citizens. At the time of a low interest rate, real estate prices kept rising and stock markets were booming. Meanwhile, a large amount of “hot money” flowed in Japan resulting from the expectation of appreciation of the yen, and the Japanese government’s intervention in the market to maintain the exchange rate by increasing money supply. Leveraging yen appreciation and the prosperity in the real estate industry and stock markets, the Japanese government set the money printing presses in motion, and in 1989 alone, the money supply saw twodigit growth. Since the Euro-yen bond market was loosely regulated, financial institutions and enterprises in Japan also raised capital at low interest rates on the international market for domestic use. With excess capital in the markets and low interest rates, it was natural that capital flowed into the real estate industry and stock markets where profits were most likely to be made. As a result, house and stock prices soared and a bubble economy was formed. Additionally, the land price rise in turn induced Japanese companies to relocate their factories to Southeast Asia and China which offered cheap labor in order to free up the land for real estate development. These companies not only reduced production costs, but also received a large amount of capital by relying on land appreciation after compensating the removal expenses. Japan’s economic bubble was at its peak in 1989. The Nikkei index was around 13,000 points in 1986 while it surged to 38,957 points by the end of 1989, a threefold increase in four years. During the same period, the land price in downtown Tokyo rose by 2.7 times. This increased the purchasing power of the Japanese who later travelled all around the world, and bought up property in places like Hawaii. Japan’s Mitsubishi Estate Company spent USD1.37 billion to acquire control over the Rockefeller Center complex (including14 large office buildings) in New York and Sony Entertainment of Japan purchased Columbia Pictures. It seemed to some that the Japanese intended to buy up the United States and this stirred serious resistance from some Americans. As a response, Sony co-founder and chairman Akio Morita, and the then Minister of Transportation and leading LDP figure Shintaro Ishihara co-authored The Japan That Can Say No: Why Japan Will Be First Among Equals in 1989. The frantic house and stock prices increase and rampant speculation pushed the Japanese government to take decisive measures. On November 25, 1989, the Bank of Japan raised the discount rate to 4.25% (further to 6% in August 1990), in an attempt to prevent banks from lending money to speculators through implementing a tight monetary policy. Unexpectedly, this move became the last straw that broke the camel’s back and it pricked the economic bubble. In the early months of 1990, the Nikkei Stock Average had dropped to JPY29,000 from an earlier high of JPY38,000. The land prices in large cities were drifting down and

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between 1991 and 1992, the residential land price decreased by 22% in Tokyo, 36% in Osaka, and 13% in Nagoya. Japan’s bubble economy had come to an end. It now appears that although the rapid appreciation of the yen was related to the pressure from the United States in the Plaza Accord, the Japanese government’s inability to deal with the appreciation pressure, the decision to substantially cut the interest rate after yen appreciation, and the adoption of an overly loose monetary policy inflated the economic bubble. Everything has two sides. Despite the fact that the Japanese people have been lamenting that the 1990s was a “lost decade,” the annual growth rate of the GDP, though lower than that of the U.S. which was 3.4%, remained at 1.3%, making Japan the world’s second largest economy. Borrowing the words of Tang Chunfeng, “There were no significant rallies in Japan’s economy in a real sense, nor were the real recessions.” After the Plaza Accord, the yen went up, bringing considerable benefits to Japan. This forced industrial capital to move towards the point where the minimum cost is determined according to the principle of comparative cost. Japan started large-scale overseas investment. Tang Chunfeng revealed a set of data in his article published on August 6, 2009, in the Global Times. The article provided us with information about the benefits of yen appreciation. In 2004, Japan’s direct export was just JPY61 trillion, but the total sales of overseas Japanese companies reached JPY155 trillion, more than 2.5 times of the former. If directly converted into GDP, those sales would contribute USD3.5 trillion, accounting for 71.85% of Japan’s GDP. Meanwhile, the foreign assets of Japan grew to USD4.19 trillion, including the land and factories brought or built in other countries. If the above two factors are all taken into consideration, the total capital owned by Japan in other countries will amount to USD7.69 trillion (adding up to USD4.19 and USD3.5 trillion). This was a conservative estimate; however, it was 1.58 times the domestic GDP of Japan. It seemed that Japan had built a wealthier “nation” overseas. In 2004, Japan’s GDP reached USD4.87 trillion. With the overseas profits-turned GDP included, the total GDP of Japan would be as high as USD12.57 trillion, outnumbering that of the United States by USD0.83 trillion (equivalent to the U.S. Treasury securities held by China up to May 2009). That is to say, Japan accounted for one third of the World’s total GDP (USD35 trillion) in 2004. The United States was not the real No. 1 economy in the world. Instead, Japan was the biggest superpower.

Here, it reminds me of a political joke. It is said that once a Japanese emperor visited Brazil and one of the welcoming Japanese emigrants told the emperor, “I am honored to report to the Majesty that your people have owned a piece of

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land larger than the area of Mainland Japan.” Being very excited, the emperor fell to his knees with tears in the eyes. It is proper to state that although the yen appreciation brought about economic downturns and the bubble economy, the industrial capital of Japan made great achievements in overseas large-scale investment.

Financial Revolution and Financial Globalization Three revolutions have reshaped the modern world’s social and economic landscape. The first was the Industrial Revolution which was marked by the transition from human production methods to machine production, along with the increasing use of electric power. This revolution led to a huge leap in productive forces. The second was the Technological Revolution during which high and new technologies, replacing general technologies, became the primary forces of production. This ushered us in the Information Age and turned what was expensive and scarce into what was cheap and common. The last one was the Financial Revolution which built upon the processes of industrialization, informatization, and marketization, and ushered in a new age of capital. People called the financial developments in the 20th century the results of a “financial revolution,” as they had shaken or subverted the order in at least four aspects: First, after the collapse of the Bretton Woods System in the 1970s, currencies were no longer pegged to gold and the gold standard was abolished. Since then, money supply would not be limited by gold reserves and the dominant positions of gold, silver, and other precious metals were overturned. Second, the rapid advances in computers and information technology in the 1980s, especially internet technology, created new currency circulation channels besides cash and notes. The creation of electronic funds realized a quantum jump in the capital market and the fictitious economy and undermined the dominance of the real economy. Third, the Soviet-led Eastern Bloc composed of Communist states in Central and Eastern Europe disintegrated in 1991 and a market-oriented reform became the new direction for global economic development. As economic globalization pushed forward financial liberalization, each country gradually relaxed its control over financial activities and this paved the way for financial globalization. Additionally, it also required strengthening international financial supervision and country risk management. Fourth, in the past 30-year development of the global capital market, asset

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securitization boosted the capitalization of money. Fund management and asset securitization constituted the basis of capital market expansion and diluted the control of the indirect finances of banking. This was the most important aspect. The advance of the financial revolution realized the transition of human society from a money age to a capital age.

Three Major Features of Current Global Economic and Financial Changes The financial revolution played a positive role in fueling the development of the modern service industry, accelerating economic globalization, and capital transfer of the manufacturing industry, and promoting financial globalization and the fictitious economy around the world. This created considerable changes in the global economic and financial landscape. The new changes contained three main features.

The specialization, socialization, and marketization of industrial production accelerated the expansion of the modern service industry, especially producer and financial services During the over 200 years of industrialization, primary and secondary industries in each country always accounted for a lion’s share of the industrialization and the percentage of the service sector remained below 55% for a long time. Since the 1960s, the tertiary industry in the United States began to occupy a larger share. Subsequently, in the early 1970s, the proportion of the service industry in the United Kingdom, France, Germany, Italy, and Japan also showed a rising trend. It signaled that the demand for material goods had been basically satisfied and the social economy entered a “post-industrial era” dominated by the service industry. At present, around 60% of the world’s GDP came from the service sector. This percentage was as high as 70% in developed countries while in middle-income and low-income countries, the percentage was 49.3% and 47.5%, respectively. In 2010, the proportion of China’s service industry only accounted for 43% of its GDP (in 2003, the percentage was 50.7% in India). It worth noting that the tertiary industry in the modern economy goes beyond the scope of traditional consumer services, such as transportation, hotels, catering, and recreational facilities. Statistics showed that the proportion of consumer services appeared to have stabilized since the 1960s in developed countries and the pulling effect of economic development on consumer service

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became less and less obvious after per capita income reached USD10,000. The more the modern industries develop towards specialized mass production, the larger proportion of producer services is in the tertiary industry. Take the United States as an example. Consumer services accounted for 60% of the entire service industry in the 1960s, but the percentage dropped to 38% in 2004 whereas producer services occupied an increasingly large share. Considering the industrial revolutions in Western countries, the modern service industry including modern financial services is constantly evolving and growing along with the deepening of the social division of labor and the specialization, socialization, and marketization of the manufacturing industry. In the history of global industrial development, the manufacturing industry was the mainstay at the initial stage of industrialization; however, the service industry gradually became the principal driving force at the middle and late stages. This was an inevitable outcome of the highly-developed socialized production. It indicated that the industrial development experienced a gradual transformation from a lower to a higher stage. The organization of production also evolved from being all-encompassing to a specialized division of labor. During early industrialization, most manufacturing factories were “comprehensive” plants which could handle the production of multiple mechanical products. Later, the advance of production and division of labor created a need for specialized, large-scale, and industrialized production. Prior to World War I, there was a trend of specialized production of a certain kind of or one particular mechanical product(s) in a factory. After World War II, machinery factories no longer produced all parts of a machine, and instead, they were only responsible for a portion of key pieces and final assembly with other parts supplied by professional parts manufacturers. Meanwhile, process specialization, represented by specialized casting, welding, heat treatment, and molding plants, also arose. Later, as the industrial chain continuously extended towards upstream and downstream industries, specialization and socialization spread to the fields of research and development (R&D), design, logistics, procurement, brand marketing, supply management, information, consulting, legal services, and auditing which resulted in the emergence of the productionoriented modern service industry and increasingly specialized producer services. Since then, the division of labor in the industrial chain moved towards a direction of being more specialized, sophisticated, unique, and innovative. In the middle and late phases of industrialization, industrial division of labor entered a period of highly-developed industrialization. The manufacturing industry posed an increasingly higher demand for producer services, and the service industry gradually evolved into the main part of industries. The

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United States conducted a survey in 1997 which showed that among the total expenditures of American companies, money spent on information technology accounted for 30%, on human resources 16%, on marketing and sales services 14%, and financial services were 11%, which in total made up 71% of the aggregate expenditure. International experience suggested that when economic growth reached a certain level, further development of the secondary industry required effective support from the service industry, which would entail the specialization and socialization of the service sector and the industry capital transfer towards the tertiary industry. At that time, two trends arose in the industrialization of producer services. One was the formation of the integrated service industry which mainly focused on the needs of industrial users. As industrial users displayed more and more diversified and personalized needs, they were not satisfied with tangible products suitable for certain targets and environments. The industrial users required increasingly extensive services, from a single machine to a complete set, from machine sets to project contracting, and from turnkey projects to project consulting, maintenance outsourcing, and financial services. This allembracing service industry will help equipment manufacturers to enhance their system design capacity, production capacity of complete equipment, technological innovation capacity, trade services, and price influence in the international market. As an emerging industry, it can also extend the industrial chain, enrich the technology, knowledge, and information content of production, and improve the added value and international competitiveness of the manufacturing industry. The other trend was the rise of the modern service industry which underlined specialized and socialized services for production. It mainly referred to sectors which offer special services for producers and which develop by relying on new and high technologies (such as information technology), and modern management philosophies, operation methods, and organizational forms. It includes technical design (R&D, product and process design, and creative design), legal services, accounting and auditing, computer services (hardware and software consulting, data processing, data application, and e-commerce), consulting services (management consulting, engineering consulting, and tax consulting), brand marketing, and sales services (brand marketing, market research, information and informationalized services, and advertising), technical services (architectural services, engineering services, and technical testing and analysis), leasing services (transportation and construction equipment rental, and office facilities rental), labor recruitment (labor recruitment and personnel rules and regulations), operational support

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(security and industrial cleaning), logistical support (logistics, procurement, cargo transportation, storage, packaging, loading and unloading, circulation processing, and distribution supply management), and other services (secretarial and translation services, and exhibition). Companies in this industry have evident advantages in R&D, technologies, business operation, and sales networking. Industrial producers can rely on the technological innovation and market development capacities of those companies to develop new technologies and products with self-owned intellectual property and brands, and transport the parts, semi-finished products and final products that are made from raw materials at the lowest cost from one link in the supply chain to another link. Those service suppliers will also expand their customer reach to include both domestic users and international outsourcing clients and form a highend service industry featuring high technology, high investment, and high knowledge content in multiple fields, thus enhancing overall competitiveness. Meanwhile, the modern service industry has developed a series of service industrial clusters in key cities, especially in the highly-concentrated central business districts (CBDs) of metropolises, for example, industrial clusters providing financial business services and other high-end services, tourism and high-end consumption-oriented industrial clusters, and arts and culture-related industrial clusters. External economic effects such as complementary and sharing effects brought about by those industrial clusters are very evident. The trends of economic development are the specialization, socialization, and marketization of industrial production and the constant expansion of the industrial chain towards the upstream and downstream. As a result, producer services will develop faster than the manufacturing industry and the costs of production and transaction will be greatly cut. This will provide the primary and secondary industries with highly efficient and sound socialized service systems and providers and promote the technological advance and efficiency increase of the two industries. Finally, the overall economic efficiency will also be improved. More importantly, with economic development, every company needs to expand its business and capital, which will pose an increasingly high demand for financial services, especially capitalization services in the aspects of corporate financing, industrial consolidation, and capital operation. Consequently, financial services will become more and more diversified and specialized and a large financial industry including commercial banks, investment banks, fund management, asset management, and all sorts of financial markets, capital markets, and financial derivatives markets will gradually come into being. At present, international service trade accounts for one fourth of the total trade, and service consumption takes up half of the

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total spending. Therefore, the focus of the world economy has shifted to the production of service products. We have moved from an era centering on the manufacturing industry to an era of service economy.

Economic globalization sped up the global capital transfer, especially that from developed countries to developing countries As the transfer of the manufacturing capital from developed to developing economies became faster, the industrial structure was hollowed out (namely, deindustrialization) in developed countries where capital markets and the fictitious economy developed rapidly. In the past 100 years, with the advance of international trade, economic and financial development also requested corresponding cross-border expansion. After World War II, Western countries had a strong demand for trade and investment. This demand encouraged a batch of developing countries to participate in the international economic system and created a need for international industrial capital transfer. By the 1980s, economic globalization started to take shape. But the North-South Divide and the East-West Conflict, resulting from the subsequent 40-year Cold War, impeded the large-scale transfer of industrial capital to developing countries. As the Eastern Bloc disintegrated in 1991, the Cold War came to an end and the new parallel world market comprised of socialist countries as opposed to the capitalist camp collapsed. Peace and development prevailed and the world economy headed towards a unified market. The economic divide between developed and developing countries was removed and the demand of developed countries to transfer their industrial capital had been satisfied. Western countries proposed economic globalization again at this time because they intended to push the Soviet Bloc and developing countries to open trade and financial markets as an outlet for surplus products and capital. Unexpectedly, this move revealed the huge price gap in production factors between the West and the East and between developed and developing countries caused by the Cold War. As a result, the content of international capital flows was no longer concentrated on product exports and capital investment in primary goods. Instead, developed countries directly relocated their manufacturing industries to developing countries. In retrospect, the Chinese government proposed utilizing foreign capital after the announcement of the Reform and Opening Up policy in 1978, but during the entire 1980s, the major source of foreign investment in China came from Hong Kong and Macau, with most money going into the real estate and consumer goods industries. Among China’s capital inflows, only 40% was invested in the

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manufacturing industry in the late 1980s. A decade later, after the end of the Cold War, external capital from Europe, Japan and South Korea invested in China largely increased and the investment targets also shifted from the real estate and light manufacturing industries to heavy and chemical industries, especially in the latter half of the 1990s. By the turn of this century, the proportion of foreign investment in the manufacturing industry grew to 65% and even exceeded 71% in 2004. China became the developing country which received the most foreign investment. Under the drive by foreign capital, China’s export structure underwent changes. In 1994, electromechanical products for the first time outnumbered textile products in export and became China’s top export. In 2004, electromechanical products created a USD22.4 billion trade surplus for China. This was a historic change and since then, China was known as “the world’s factory.” However, although the heavy industry made up two thirds to three fourths of the manufacturing sector in developed countries, the requirements for the transfer of heavy industry were much higher than for that of light industry. So, basically the heavy industry has not been transferred yet. In the future, when China upgrades the scale and technologies of its heavy industry, the capital transfer of heavy and chemical industries from developed countries to China will reach a peak. Furthermore, if China can accelerate the development of the service industry and improve the capacity to undertake the international service industry transfer, China will become not only the world’s manufacturing center but also an important base for global service outsourcing. It will transform from being “the world’s factory” to being “the world’s back office.” This will greatly enhance the international competitiveness and marketing ability of China’s industries and mark a major breakthrough in China’s transition from a large trading nation to a trading power. Another consequence of the manufacturing industry transfer will be that developed countries will constantly reduce their production of material goods and capital owners gradually move away from material production. In the search for surplus capital, multinational groups will promote the prosperity of capital markets, especially the rise of investment banking and asset securitization. The rapid development of the fictitious economy will aggravate the hollowing out of industrial structure. As to this point, I will elaborate later.

Economic financialization invigorated the global capital market and fictitious economy, and controlled the movement of industrial capital After World War II, the global economy displayed a new phenomenon, namely, economic financialization. When the modern financial and economic

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development reaches a certain level, the growth of capital markets, direct finance, asset securitization, and financial derivatives will definitely lead to the rapid advance of economic financialization and the fictitious economy. It reflects the most important achievement of civilization created based on the modern socialized production laws by human society. As we know that in the market economy, money is transformed into interestbearing capital and will generate added value during the exchange between money and commodities in the real economy. As early as 100 years ago, Karl Marx pointed out in Das Capital, “Just because the money-form of value is the independent, tangible form in which value appears, the form of circulation M ... M’, the initial and terminal points of which are real money, expresses most graphically the compelling motive of capitalist production — money-making.” Marx concluded it as, “to make money without the intervention of the process of production.” 1 This sentence disclosed the profit-seeking nature of money capital. It was the profit-seeking nature that created the value discovery and optimized resource allocation functions of capital markets and fueled the growth of the fictitious economy. Therefore, it is not hard to understand why capital groups in developed capital markets launched several waves of business mergers and acquisitions. It was a result of the pursuit of profit maximization. This revealed that the development of money capital would lead to the control over the movement of industrial capital. In the first 20 years after World War II, financial development lagged behind economic development. There were no international securities and exchange markets or large-scale capital flow until the 1970s. Financial development was restricted by the real economy and it remained in a subordinate position. International finance was still a branch of international trade and it did not qualify as an independent economic discipline. The disintegration of the Bretton Woods system in 1970 changed this situation. At first, the Euro-dollar market emerged and surplus petrodollars were recycled back into Western financial markets; and then offshore finance became prosperous in Hong Kong, Singapore, and Bahrain. After the 1980s, securities markets and financial derivatives markets in the emerging countries and regions suddenly came into the focus of attention. Since then, securitization was developed, which led to the formation of all kinds of fictitious capital; money capital was able to be divorced from the production and circulation of material goods and could move freely; and money and finance were no longer connected to the reproduction of material goods and gained their unique movements. Additionally, the development of the internet closely tied together the trade, finance, and capital flows in the world’s major markets, pushing

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forward economic and financial globalization. Especially in the past 20 years, the development of the information industry and financial computerization made the capital movement overcome the restrictions of cash and bill payments, and the electronic funds flow realized remote and timely payments which accelerated the development of global capital markets and the fictitious economy. As a result, two comparatively independent economies, i.e., the real economy and the fictitious economy, coexisted in the modern economy. As the economic globalization continued to expand, the fictitious economy developed rapidly. The experience of economic and financial development taught us that the modern market economy comprises both real and fictitious economies. It includes not only factor markets of the real economy, such as commodities, land, labor, capital, and science and technology markets, and markets of the fictitious economy, such as finance, securities, futures, and financial derivatives markets, but also intermediary markets which provide intellectual services for real and fictitious economies. The modern market economy will adjust the supply and demand and the surplus and deficiency in factor markets through price fluctuations, and give full play to value discovery, risk aversion, and resource optimization functions of markets through asset price changes in capital markets and the fictitious economy, especially the changes of all sorts of asset-backed securities and financial derivatives. Therefore, investors can discover asset value, evade investment risks, and form profit expectations based on the prices, profits, interest rates, and exchange rates of different investment tools before making investment decisions. It will solve excess production capacity and promote the adjustments of the real economy and production structure by redirecting surplus capital into new industries. The advance of capital markets and asset securitization pushed forward money capitalization and turned surplus money via all sorts of means into profit-seeking capital. In addition, the modern market economy is in nature a fictitious economy in a certain sense, because markets achieve resource allocation through capital flows and the capital flows decide both the direction of resource flows in the real economy and the scale and efficiency of resource allocation. The fictitious economy is continuously expanding into the realm of the real economy, and the real economy is constantly integrated into the fictitious economy. Economists called this process “economic financialization” or “economic monetization.” Economic financialization is mainly manifested in three aspects: 1. The financialization of social assets, namely the continuous rise of the financial interrelations ratio (FIR) which is a quotient of total financial assets and gross national product (GNP). Over one century ago, the FIR was 0.07 in the United States, 0.03–0.35 in the United Kingdom, 0.12–0.15

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in Germany, 0.16–0.20 in France, 0.20 in Italy, and 0.021 in Japan. Between 1913 and 1935, the FIR in the above countries was generally around 0.70– 0.80 (0.32–0.40 in Japan). One century later, this ratio rose above 3.20 and the difference between each country was also narrowed. In 1999, the ratio increased to 4.02 and 3.78 in the United States and Japan, respectively. Developing countries generally maintained a ratio between 0.30–1.40 with a few ones recording a comparatively higher ratio, for example, South Korea had a ratio of 4.36, Singapore 3.82, Brazil 1.13, and Argentina 0.63. This indicated that the financialization of social assets greatly improved and the financial development gap among most countries was continuing to shrink. After the Reform and Opening Up era began, China’s FIR also increased dramatically. It reached around 2.3 in 2006 with the peak being 2.34. This showed that the Reform and Opening Up had sped up the economic development in China. Although China’s capital market still needs future improvement (the equity division reform was implemented in 2005), the economic financialization has greatly advanced forward. 2. The securitization of financing and investment. The financial development in human society followed the sequence of indirect finance before direct finance and short-term financial services before long-term financial services. In a quite long period of time, the social financing system focused on indirect finance and direct finance only comprised a small fraction of the total. People called this unbalanced development “financial tilt,” which is actually a large-scale tilt towards indirect finance. However, since the 1980s, non-banking finance developed rapidly in each country, giving rise to the financial disintermediation, that is to say banks were removed as financial intermediaries. It marked a reverse of the “financial tilt” and direct finance began to make up a similar proportion of or even a larger proportion than indirect finance. 3. The financialization of economic relationships. Social economic relationships are more and more reflected in debtor-creditor, equitydividend, risk-insurance relationships and other financial relationships.2 Economic financialization is not only a simple reflection of the real economy through money and finance, but also the expansion and penetration of the fictitious economy into the real economy before the fictitious economy finally gets the control over the real economy. At present, economic globalization propels the cross-border expansion of production factors and economic activities, and economic financialization develops intensively to blend with economic globalization. This provides international capital formation and its structural

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evolution with directions and promotes the economic integration of each country. Because of this, economic financialization, which develops markedly, became the primary characteristic of today’s economy. Financial development advances much faster than economic development. In 1947, shortly after World War II, the global trade volume was USD45 billion. But half a century later, the trade volume grew to USD6.1 trillion in 1997, plus USD1.2 trillion generated by service trade, an increase of over 160 times over 50 years. At the turn of this century, the global annual GDP was around USD4.5 trillion while the volume of currency trading around the world reached approximately USD1,000 trillion, 100 times the value of international trade. This was largely attributed to the rapid development of international financial derivatives. Now, the total value of the world’s financial assets greatly outnumbers that of the real economy, and the world’s economy is to a large extent reflected in the operation of global financial capital. According to the statistics from the International Monetary Fund (IMF), in 2006, the world’s total GDP was USD48.2 trillion, the market capitalization of global stock markets was USD50.8 trillion, the total assets of global financial institutions was USD190.4 trillion, and the total market value of global financial derivatives markets was USD485.7 trillion, respectively, equivalent to 105%, 385%, and 1,000% of the world’s GDP. The size of the U.S. derivatives products in 2010, according to Barack Obama’s State of the Union address, was as high as USD598 trillion. Based on the estimate of Wang Jian, the total value of global financial products including financial derivatives amounted to thousands of billions of U.S. dollars, tens of times of the world’s GDP. According to statistics, in the past 10 years, especially the past 5 years, the world’s real economy was growing at a rate of 5%, the growth rate of financial development was 20%–30%, and financial derivatives were increasing at a rate of 70%–80%. Coupled with the proliferation of low-interest dollars, this caused the worldwide excess liquidity and rapid advance of financial assets. The size of risks of financial markets greatly overshadowed the improving and adjusting functions of financial markets towards the real economy.

Reexamine the International Economic Imbalance from the Prospective of Economic Globalization Here, we have to clarify a concept. Under the framework of the WTO, almost every country participates in economic globalization. But up to now, every member country is a sovereign state. According to the traditional international economic and trade theories, people always form an opinion about a country’s

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economic and financial development, economic growth rate, trade surplus or deficit, foreign reserve size from the perspective of a single sovereign state. According to the traditional international economic theories, the saving surplus of a country represents its economic strength. It is often the case that developed countries export capital to underdeveloped countries and at the same time exploit the resources of the latter. Traditional economic common sense taught us that when a country’s trade surplus of deficit continues to expand, it must be caused by insufficient saving or saving glut. This reflects the internal and external economic imbalance of a country, which may evolve into a crisis in severe cases. If judged merely from the traditional economic theories, the trade surplus or deficit and the capital export of a single sovereign state can only be concluded as a serious “international economic imbalance.” This “international economic imbalance” will first show in the huge trade surplus or deficit of each country. Some countries maintain a large trade deficit, for example, the current account deficit of the United States reached USD700–800 billion, which means it needs the same amount of net capital inflow each year to sustain economic operation, while other countries record a trade surplus, for example China maintained “double trade surpluses” in its trade and capital accounts since the early 1990s. Based on the previous analysis, it may easily lead to the conclusion that both the United States and China go against the common sense of the traditional economic theories. In fact, the United States witnessed an adverse trade balance since the mid1980s, and the deficit in the U.S. current account corresponded to the sum of the trade surpluses of the Federal Republic of Germany and Japan. After the 1990s, its unfavorable balance of trade widened further, and the U.S. trade deficit was equivalent to the combined trade surpluses of China, Association of Southeast Asian Nations (ASEAN), Russia, Saudi Arabia and other oilexporting countries in addition to the surpluses of Germany and Japan. This “international economic imbalance” lasted for more than half a century with an increasingly larger scale. Economists repeatedly predicted global economic crises based on the traditional international economic and trade theories, but neither the U.S. economy nor the world economy has collapsed, except for the global financial crisis in 2008 which was triggered by subprime mortgages and financial derivatives rather than international trade imbalance. What puzzled economists then about the “international economic imbalance” was how developed countries suddenly shifted from capital and goods exporters into importers of capital and goods whereas developing countries evolved into manufacturing powers and goods and capital exporters. How did this reverse happen? Why did capital get exported from less developed

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countries to more developed ones? What continues to perplex economists is that, at present, it is emerging countries which often run current account surpluses. This was first seen in Germany and Japan, then in South Korea, ASEAN countries, and China, instead of in the economically powerful United States. Undoubtedly, it is a generalization to assess a single country’s economic and financial development without taking consideration of economic globalization. But the “international economic imbalance” formed based on the traditional international economic and trade theories became the theoretical tool used by the politicians of some large countries to provoke trade protectionism among domestic unemployed workers and put pressure on the exchange rates of surplus nations. The fundamental problem is that in the era of globalization, the imbalance of an individual country has been replaced by a new global equilibrium relationship and it will be meaningless to ask a country to maintain an internal and external balance. Therefore, there is a need to reexamine the world’s economy and the economies of sovereign countries from the perspective of globalization. The real concern of a country should be whether this imbalance is beneficial to itself and also conducive to its long-term sustainable development. It should be noted that economic and financial globalization brought about fundamental changes to the world’s economic pattern. 1. T h e e c o n o m i c d e v e l o p m e n t i n d e v e l o p e d c o u n t r i e s l e d t o t h e transformations of industrial structure. At first, the specialization and socialization of manufacturing industry increased enterprises’ expenditure on service. Then, the specialization and socialization of the service industry promoted the transfer of industrial capital towards the service sector. In the last 10 years, as the capital of the manufacturing industry was transferred to developing countries, Western countries started to concentrate on the financial industry. Economic globalization and financialization resulted in the gradual departure of capital from material production in developed countries and the rapid advance of capital markets and the fictitious economy. Currently, the competitiveness of the United States lies in human capital- and R&Dintensive industries and the modern service industry rather than the manufacturing industry. Examples of the R&D-intensive industries are the defense industry, pharmaceutical industry, information technology industry, and bio-engineering industry. The high-end service industry includes the R&D of the most advanced science and technologies, and financial, cultural, and recreational services provided by high-caliber

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personnel. Participants of these industries cover not only universities, hospitals, research institutions, information service providers, publishers, media and network companies, and various art centers, but also securities, futures, foreign exchange, and financial derivatives markets and financial institutions, venture capital firms, asset management companies, and financial intermediaries. Relying on these industries and facilities, the United States became the world’s knowledge and technological innovation center. By constantly injecting its economy with enormous vitality, it plays a leading role in the global market. The capital groups of developed countries continued to reduce material production in pursuit of larger benefits from capital markets and the fictitious economy. It might be the primary reason for the constant decrease of material goods production and the shrinking of related industries in developed countries which gradually lost their advantages in the production of material goods and ran long-term trade deficits. In 2010, the global trade volume was USD15 trillion and the annual turnover in the foreign exchange market was between USD1,000–USD1,400 trillion. The world’s GDP was around USD60 trillion while the volume of global financial transactions reached USD2,000 trillion. At present, the financial sector is the most important industry in the U.S. economy. To borrow the words of Xie Guozhong (2008), “It secures the dominance of dollars in global trade and as a settlement currency. Under the U.S. current account deficit, the benefits brought about by the U.S. dollars as a world currency account for 3% of the nation’s GDP. The special status of the dollars has created USD10 trillion economic value for the country.” Comparatively speaking, the trade deficit of the United States is a reasonable price to pay in exchange for the commanding height in the world economy. 2. Capital always moves towards the lowest cost in accordance with the principle of comparative cost. It is this rule that promotes the large-scale transfer of manufacturing capital from developed countries to developing countries and fosters the trade advantage of emerging countries. In the early 1990s, the end of the Cold War discontinued the economic estrangement between the East and the West and the huge gap in the prices of production factors resulting from the Cold War was fully revealed. The principle of comparative cost immediately took effect. The capital groups of developed countries, taking advantage of lower production factor prices and low-cost human resources in developing countries, propelled the industrial capital of developed countries to the least cost location and massively relocated the manufacturing industry to developing countries.

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For example, the average land price in the urban areas of the United States was around USD500 in 2006 while the price in China was less than USD300. For another example, it will cost Wal-Mart USD5 to acquire a pair of Nike shoes manufactured in China, but it can sell the shoes at USD170 in the U.S. market. It reflected the price squeeze and crucial exploitation of transnational capital. In fact, the actual cost for producing a pair of Nike shoes in the United States would be USD170, because the high levels of technology and productivity and a high standard of living determined the high wages of workers. Thanks to the economic globalization, the industrial capital of developed countries is able to manufacture the same products at the lowest cost by leveraging the low land price and low-cost labor in developing countries. It is the primary reason for developing countries to have obtained unprecedented strong trade growth. During the major industrial transfers in the world, such as the transfer of the textile industry from the United States to Japan, then to Southeast Asia, the transfer of the iron and steel industry from the United States to Japan, and the transfer of the automobile industry from Europe and the United States to Japan which later outsourced the parts manufacturing to Southeast Asia, what played a decisive role was the principle of comparative cost in the cost-benefit analysis. 3. The industrial transfer of developed countries changed the income structure of their residents. Taking the United States as an example, its high consumption did not totally rely on high income but the accumulation of family assets and the income from the assets. Stephen S. Roach called this an “asset-dependent economy.” For quite some time, people believed that American consumers were the primary engine for global economic demand. The proportion of U.S. personal consumption to GDP was 67% between 1975 and 2000 and since the beginning of 2002, the ratio averaged 71% before climbing to 72% in 2007. By comparison, the percentage was 58% in Europe, 55% in Japan, and 42% in China. But as was said previously, the U.S. consumption was not supported by its income. In the past six years (2002–2007), the income growth of the American people gained from work was relatively low and the ratio of net national savings to national income decreased from 1.4% to a negative value. The change was that as the middle- and high-income groups comprised the majority of the American people, property became the most popular carrier of wealth. More than 90% of the U.S. families held or invested in stocks or funds. Among the disposable income of the U.S. residents, property income constituted approximately 40%. Saving was no

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longer a priority for the American people. Consequently, the country has been suffering a long-term shortage of domestic savings and has to import foreign savings. The U.S. gaping current account deficit has absorbed around 75% of surplus global savings. In contrast, the consumption-deficit countries showed high personal saving rates: 8% in Japan, 14% in Europe, and 35% in China. But, considered from the perspective of economic globalization, the shortage in the U.S. net national savings was on the surface, and in depth, the United States owned a large portion of wealth under the item of residents’ assets. Therefore, to import surplus global savings is like to make bank loans by pledging assets after one spent all the earnings. Roach’s contribution was to summarize the U.S. affluent economy as an “asset-dependent economy.” For that reason, he believed that the imbalance in the U.S. economy reached an unprecedented degree, and the savings and consumption mode which overly relied on assets must be replaced. With the bursting of asset bubbles and the normalization of interest rates and the real estate market in the United States, there is reason to believe that American consumers will return to the income-oriented consumption mode. The share of the U.S. consumption in GDP will go back to the long-term 67% from current 71%. I suppose the “property income-based economy” may be a more proper name. However, this property income-based economy is possibly a common characteristic of affluent societies when their middle classes are continuously expanding and the proportion of property income is growing. In light of such a prosperous global financial market and fictitious economy, as long as the transnational transfer of industry and manufacturing capital in developed countries does not stop, the capital movement from material production to the capital market and fictitious economy will not end and the high-income of financial practitioners and property income of residents will continue to grow. Therefore, residents of developed countries will continue getting richer and richer, and the proportion of affluent class will also expand. Under such a circumstance, it is not realistic for American people to go back to the income-oriented consumption. But, isn’t the “property income-based economy” a dream pursued by all the developed countries and emerging countries? 4. The commodity and capital exports from developing countries to developed countries are a result of the relocation of the manufacturing industry to developing countries. Developing countries may suffer from a shortage of resources but have a dense population, so they can rely on their low-cost land and labor to manufacture products, but due to

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weak domestic spending power, they have to squeeze themselves into the international market. As a result, those developing countries earned a large sum of foreign exchange and since there is no corresponding product in the counterpart countries for those foreign exchange earners to trade in exchange, the foreign exchange was used to purchase government bonds or other financial products from importing countries. This capital export is in fact a transfer of surplus savings to developed countries at a moderate price. It should be said that developing countries have been supporting the U.S. industrial capital transfer from material production to financial industry with low-cost capital and inexpensive commodities for many years. Therefore, I agree with Guo Shuqing’s conclusion that the United States has enjoyed the low-cost capital and cheap commodities of developing countries over the years, which is perhaps a reason for the unprecedented prosperity of its economy. Is the U.S. economy an imbalanced one? Although there is a substantial deficit in the U.S. current account, there is also an equal surplus in the capital account. So overall, the international balance of payments is balanced in the United States. In the past 20 years, multinational corporations and global ordering were highly popular and the crossborder transfer of manufacturing capital became commonplace. The capital account surplus of a country has a large chance to be a result of investment from foreign companies and at the same time the trade surplus of a country is also most likely created by foreign-owned enterprises. Guo Shuqing concluded this in an implicit way: “It is hard to tell by intuition who creates the trade surplus, who will benefit from the surplus, and who will be the largest beneficiary.” But what Bo Xilai, Minister of Commerce of China, said in 2007 brought out the crucial point: “The trade surplus is in China while the profits are in the United States.” Under the prospect of economic globalization, surplus saving is no longer a feature of economic prosperity as stated in traditional economics. At present, countries with surplus savings can transfer their savings to those with inadequate savings as easily as domestic residents use consumer credit to purchase a product in the market. Taking the United States and China as examples, China is running a saving surplus while the United States suffers from a savings deficiency. Now, China has exported goods to the United States, but instead of receiving cash in full, China has to purchase a bunch of long-term government debts or other financial assets at suitable interest rates. Statistics said that foreign investors now hold USD16 trillion in the U.S. financial assets. This partially discloses the

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secret of the transfer of surplus savings between countries. Now, we can have a clear picture about the trade surplus in China and the trade deficit in the United States: The capital groups of the United States relocated the manufacturing industry to China through investment, which resulted in a surplus in the U.S. capital accounts; the manufacturing factories produced consumer goods by leveraging low-cost land and labor force in China, but due to the low purchasing power of Chinese farmers and farmer-turned workers, China had to export those goods at low prices; American residents purchased the cheap products exported from China but paid the producers the low-cost money absorbed by selling the U.S. government bonds to China, and although China transferred its surplus savings at a reasonable price to the United States, the U.S.-funded enterprises in China contributed a trade surplus to China. The trade deficit in the United States grew so large that the U.S. government debt reached the ceiling of USD14 trillion. With a constantly weakening dollar, can any other country, such as those in the European Union, replace the United States in the world economy? According to research by Guo Shuqing and Wang Jian, the Euro area as a whole is balanced; although there is a big deficit country in the non-Euro zone, i.e., the U.K., Switzerland, Sweden, and Norway run large trade surpluses; even if Russia is not included, the rest of Europe records a surplus in its current account; so, it is not practical, at least at the present stage, to count on Europe to replace the United States. Now, major capitalist countries are constantly widening the negative trade balance with principal developing countries and the European Union and Japan follow the development route of the United States; therefore the strong Euro cannot be sustained for a long time. The closer the economic pattern of Europe is to that of the United States and the more capital is transferred to the fictitious economy, the less powerful is the Euro. The competition between the Euro and the U.S. dollar for dominance in the world’s market will continue, but in the long run, the Euro cannot replace the dollar as the world currency.

Financial Globalization: Challenges and Opportunities for the Renminbi as a Global Currency Financial globalization and economic financialization, marketization, and liberalization have made up an irresistible trend. In the past 20 to 30 years, competition among the great powers has gradually shifted from military to

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financial fields. The Asian financial crisis brought about long-term financial weakness in the region and Asian countries were subject to the financial hegemony of economic superpowers. Therefore, the rise of China must depend on the tremendous support and push from the financial development for the economy. China must not only come up with a financial development strategy to build up its financial strength, but also seize every opportunity to turn the renminbi into a fully convertible currency of the world. In the 20th century, the United States grabbed the financial hegemony from the hands of the old colonial empire, the United Kingdom. In addition to its enormous economic and financial strength, the new hegemonic power owned the world’s most developed financial market system, which could effectively allocate financial resources among different countries or regions around the world. Besides assuming the position of a global currency, the U.S. dollar became the first choice for each country as the settlement and reserve currency. Thus, the United States was entitled to seigniorage. Lastly, the United States was able to use international institutions as a power tool to reinforce and maintain its financial hegemony. This clearly shows that financial strength assumes equal strategic importance and influence as military strength. Deng Xiaoping once said, “Finance is the core of the modern economy.” Since China’s Reform and Opening Up era began in 1978, and especially in recent years, financial reforms and development have advanced markedly. Now, the problem faced by China is that although economic globalization has contributed to the rapid rise of China and China has surpassed Japan to be the second largest economy in the world, indirect finance still comprises a large portion in China and this results in financial weakness and incomplete and underdeveloped financial markets of China. Chronic financial weakness is likely to be accompanied by bullying from powerful countries who have financial hegemony. As China continues to accumulate its economic and financial strength and integrate itself into the world at an increasingly fast speed, it will be faced with more and more competition between large powers. Despite all the risks and setbacks, China will definitely contribute to changing the current global economic and financial landscape and become a power in reshaping the world’s economic and financial order. In light of this, China needs to both raise the awareness of the risks and possess the courage to take part in the competition. In the times of the global financial crisis, not many currencies can be trusted against depreciation. Since the renminbi is a strong currency, it should evolve into a global currency and gain the initiative in international currency affairs. The Chinese government has to achieve full convertibility of the renminbi as soon as possible and establish the international standing of its currency. The strategic target of renminbi

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internationalization is not only promoting the status of the Chinese economy in the world, but also improving the stability of the global economy and making China benefit from it. In fact, under financial globalization, the renminbi faces both opportunities and challenges in becoming a global currency. Actually, China is now undertaking the internationalization of the renminbi. In 1994, full convertibility on the current account was realized with only the capital account being under control. The best benefit from capital account controls was that China was guarded against massive speculative capital inflows and outflows during the 1997 Southeast Asia financial crisis, and during the 2008 global financial crisis trigged by the U.S. subprime mortgages. But capital controls delayed the full convertibility of the renminbi, and prevented the renminbi from becoming a global currency and being widely used in international economic transactions. This allowed financial superpowers to put pressure on the exchange rates of the renminbi in trade negotiations. To cope with these disadvantages, China has successively signed bilateral currency swap agreements with South Korea, Malaysia, Belarus, Indonesia, Argentina, Iceland, and Singapore, with the swap size reaching RMB803.5 billion (around USD120 billion). The renminbi trade settlement pilot scheme between Mainland China and Hong Kong was implemented in July 2009. The cross-border trade settled in renminbi has totaled RMB1 trillion and the Renminbi deposits in Hong Kong have exceeded RMB500 billion. The current problem is that the bilateral currency swap and the renminbi cross-border settlement bring about unexpected side-effects. As the renmimbi has become a hard currency and its exchange rate is expected to rise, many central banks and foreign enterprises are only willing to receive the renminbi instead of paying it. Statistics show that the amount of renminbi held by foreign central banks through currency swaps totaled almost USD100 billion. Apparently, these countries were attracted by the expectation of unilateral appreciation of the renminbi. Similarly, the World Bank issued renminbi-denominated bonds in Hong Kong capital markets in early 2011. The two-year fixed rate bonds with a coupon of 0.95% turned out to be a success for people who eyed the annual appreciation rate of 3%–5% of the renminbi. Therefore, Yu Yongding concluded that the advance of renminbi settlement reduced the exchange rate risk of not so much Chinese enterprises as foreign companies. Another side-effect was the covering up of all sorts of legal and illegal arbitrage. It is said that recently a foreign group asked its Hong Kong subsidiary to borrow dollars at a low interest rate with its renminbi deposit as collateral in order to pay for the goods produced by its Mainland China subsidiary. This probably can be called legal arbitrage in trade activities. However, there are also

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illegal renminbi cross-border flows operating under the guise of international trade. According to bankers and analysts, some enterprises took advantage of the high interest rate of the renminbi in Mainland China and the low interest rate of dollars in Hong Kong to perform interest arbitrage. The profits from each trade can be as high as hundreds of billions. The speculative and arbitrage funds transferred between Mainland China and Hong Kong without real trade contracts are what people usually called “hot money.” Furthermore, cross-border settlement has increased rather than decreased the exchange reserves of China. It was contradictory to the goals of the renminbi trade settlement pilot scheme. According to the statistics of China’s Central bank, China’s foreign reserves increased by USD1.53 trillion to reach USD3.2 trillion in the second quarter of 2011. The growth in the foreign exchange reserves obviously added difficulties for the Chinese government to press down on inflation. In the previous period, the inflation rate of China surpassed 6%. More foreign exchange reserves mean that the Central bank has to print more money to offset dollar inflows into China. To go a step further, the renminbi internationalization will mitigate domestic inflation as the renminbi will be held by other countries’ governments as a reserve currency for one thing; for another, the Chinese government will be able to absorb domestic and foreign savings in capital markets to fund banks and government debts. However, delayed internationalization of the renminbi will centralize the passively supplied money in the domestic financial system and the less developed financial markets cannot fully soak up the excess liquidity. Too much money and too few assets will easily lead to the inflation of goods and assets. The failure to turn the renminbi into a global currency will bring China more foreign exchange reserves, which will inflict the exchange rate risk on China due to the appreciation of the renminbi and the depreciation of reserve currencies. At the same time, foreign exchange assets purchased by those foreign reserves also probably face a drop in value as the global inflation rate rises. Due to a lack of full convertibility of the renminbi, China’s Central bank has to increase its money supply to purchase foreign exchange, which will lead to a growing risk of domestic inflation. Even though China can still hedge against the risk by issuing central bank bills, making foreign exchange swaps, and adjusting renminbi reserve ratio and interest rates, these actions will add to operational costs. Statistics showed that between 2003 and 2010, the hedging costs of China’s Central bank exceeded RMB1 trillion. The increase in the deposit reserve ratio is also a kind of tax levied on commercial banks. It will decrease the profitability and competitiveness of financial institutions to a certain extent and encourage the removal of intermediaries in the capital supply.

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For China, opportunities coexist with challenges. The priority is to deepen the reforms of the financial and exchange rate policies. I agree with Lou Jiwei that China is well positioned to realize full convertibility on the capital account. At the initial stage, China still can impose some regulations over foreign debts, short-term capital flows, and money laundering. After the full convertibility of the renminbi is realized on the capital account, it is very likely for the renminbi with such a large economic scale to achieve internationalization, thus stabilizing the global economy. When exchange controls were substantially reduced on the current account in 1994, China’s foreign exchange rate reserves only totaled USD16.6 trillion. Although many people doubted this exchange rate reform, China succeeded in introducing a managed float system and relaxing exchange controls. In contrast, today China possesses USD3 trillion dollar reserves, banks are more powerful than at that time, and the government’s financial status is sound. China’s enterprises also become more responsible than they were before as a result of ownership reforms. That is why I believe China has better conditions to achieve full convertibility of the capital account. The renminbi internationalization is a request based on real demand and also the road that China must take. China will neither go back to the days of the fixed exchange rate as used during the Southeast Asia financial crisis, nor adopt a linked exchange rate as Hong Kong does. So the question then is how to decide an appropriate exchange rate to allow full capital account convertibility before achieving a floating exchange rate. The whole world is looking forward to this reform. It probably will not be a smooth process and China may have to deal with the sudden inflows and outflows of speculative capital after the reform. But, the key is to improve the exchange rate formation mechanism. Most importantly, the government must set a proper exchange rate and ensure the exchange rate fluctuates with market demand instead of letting the unilateral appreciation dominate the market. If China loses this current opportunity and allows the appreciation expectation to accumulate in the market, the future reform will be more difficult and China may fall into a vicious circle of fighting with speculative capital betting on the renminbi appreciation.

Accumulating Financial Strength to Cope with the Games between Superpowers As I have stated previously, under economic globalization, the competition between superpowers has moved from the military field to the financial one. We know that the Bretton Woods system was a set of institutional systems

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and rules formed under the lead of the United States to establish the U.S. financial hegemony and the dollar dominance. In fact, the United States dominated the operation of the International Monetary Fund (IMF), the World Bank, and the General Agreement on Tariffs and Trade (GATT). During the Southeast Asia financial crisis in 1997, the IMF claimed to give financial support to the countries struggling in the crisis with the condition that those recipient countries had to open trade and financial markets. It reflected the same interests shared with the United States, but the IMF’s proposal was firmly rejected by Malaysia and South Korea. Since the Southeast Asia financial crisis, all sorts of forces in the international system appealed in different ways for fundamental changes in the existing international financial system and closer coordination and cooperation in international financial regulations and supervision. But a radical reform in the outdated international financial system is a kind of worldwide institutional innovation. The questions are who will lead the reform, namely, which countries will be the principal participants, and what kind of basic rules should be followed in the reform. During the previous major financial crises in the 1990s, including the European currency crisis, Mexico’s financial crisis, and Southeast Asia financial crisis, almost every crisis began with speculative capital from large economies and ended up with business mergers and acquisitions. Japan, already in an economic recession, eventually received a great deal of worldwide attention after the start of the 1998 Southeast Asia financial crisis. In the summer of that year, I met in Singapore and Hong Kong the regional presidents for Asia of several large investment banks and what they talked most was the undergoing acquisitions of Japanese enterprises. This showed that in an era of the internet and financial globalization, it was common to use financial capital to control industrial capital. According to the estimate of the IMF, the Japanese bank industry lost as much as USD750 billion in the crisis. Under economic globalization and economic financialization, when financial development significantly elevated the economic resources allocation capacity and efficiency of a country, it also rapidly accumulated its own systematic risks. But the precautionary and control measures against financial risks usually lagged behind financial expansion. International supervision and coordination made up the weak link in the global financial development. In the previous financial games, developed countries had obvious advantages and benefits while developing countries found themselves in a disadvantageous position and could not avoid losses. Therefore, for a long time, people entertained an illusion that financial crises would never break out in developed countries. Certainly, developed countries had a high degree of financialization.

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They were ahead of developing countries in reversing the financial imbalance between indirect and direct finance and were the places where major financial centers were located. Their financial regulation was comparatively sound and effective. In developed countries, the credit expansion impulse was strictly restricted, the quality of credit assets was generally better, and the excessive development of financial resources seldom occurred. Therefore, compared to developing countries, developed countries were less likely to precipitate a financial crisis. But the problem was that as securities markets, futures markets, and financial derivatives markets advanced dramatically in developed countries, these markets obviously tended to generate bubbles. The prices in the global securities market rose by seven to ten times in the past decade, largely breaking away from the performance and growth rate of the real economy. In addition, the 2008 financial crisis resulting from the U.S. subprime mortgages and related derivatives showed that the financial institutions, financial staff, and credit rating agencies during the U.S. financial development were so confident and optimistic that they contributed to the massive expansion, high leverage ratio, and rating defects, and regulatory loopholes of several high-risk innovative financial products, such as collateralized debt obligations (CDOs) and credit default swaps (CDS) during multi-layered securitization of financial innovations and their globalization. It led to high speculation and widespread bubbles of derivative products. The economic financialization pushed people to closely follow these steps. Since the fictitious economy developed rapidly around the world, if China lagged behind in economic financialization, it would have to be subject to powerful economies and miss this excellent opportunity of development during the adjustment of the global financial landscape. In particular, as the U.S. subprime crisis had evolved into a global financial crisis and impacted the restructuring of the U.S. financial industry and the United States shifted its attitude towards sovereign wealth funds from being vigilant to seeking help, this created both opportunities and challenges for a rising power like China. Although people now often talk about the recession and crises of the U.S. economy, we must clearly realize that the U.S. economy remains the most powerful economy in the world. The United States stepped out of the manufacturing industry in the 1980s, but still maintained absolute competitiveness in knowledge-intensive industries, especially the financial service industry. The U.S. financial industry, especially the investment banking industry, gathered financial elites from all over the world and will not easily give up its financial hegemony. Therefore, during this global financial structure reform, China should not rely on sheer luck and aim too high.

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In the face of the global financial crisis, while stimulating the economy and expanding domestic demand, China has to establish the strategy of rejuvenating the country through financial development to accumulate financial power and respond actively to the games of financial superpowers. 1. To establish the strategy of rejuvenating the country with financial development. China should set up medium- and long-term plans for financial reform and economic opening up in order to serve its core goal of the rise of China. It is necessary to create conditions for building a larger and stronger domestic financial industry, and strengthen the industry’s ability to resist risks. China has to open the trade and financial markets, develop the capital market and the fictitious economy, and expedite economic financialization. The Chinese government should encourage the domestic economy to grow in competition with international capital and seize every favorable opportunity to develop while the government has to familiarize itself with and master the law of motion of industrial capital in order to steer and control the economic development at the appropriate time. 2. To build Shanghai into a top modern international financial center and make the best use of the existing international financial center Hong Kong and its highly open and free markets. In March 2009, the State Council decided to turn Shanghai into an international financial center and international shipping center by 2020. This was not only a long-cherished dream of Shanghai’s but it also was an adaptation to the demands of China’s political and economic development. In the 19th and early 20th centuries, the international financial center was London. This corresponded to the colonial economy of the “British Empire on which the sun never sets” and the international status of the British pound. Since the rise of the U.S. economy, U.S. dollars soon became the world’s currency and New York replaced London to be the international financial center. Although China is still a developing country if judged from the per capita figures in its economic development, it has evolved to be the world’s second largest economy, next only to the United States considering comprehensive national power. For this reason, China must have the international financial centers, matching its economic strength and the international status of the renminbi. Besides, Shanghai was the international financial center of the Far East before the liberation. So, it is absolutely necessary to push forward the development of the modern

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service industry and advanced manufacturing industry in Shanghai and gradually restore the city’s status as an international financial center. Whether Shanghai can become an international financial center depends on whether it can rapidly realize the economic transformation during the Reform and Opening Up era despite the challenging economic environment. Shanghai was the world-known financial center prior to 1949 and it still maintains a higher level of financial awareness than the rest of the country. The decline of Shanghai in the financial field resulted from four factors. First, after the founding of New China, the planned economy was implemented. It repelled markets and the market economy and paid little attention to financial development. Second, imperialist countries imposed an economic blockade on China. Third, the Chinese government adopted the wrong policy of transforming consumer cities into production cities. Lastly, after the implementation of the Reform and Opening Up policy, Chinese enterprises still did not get used to market competitions, the financial markets did not developed comprehensively, and the Chinese government was overly strict in economic and financial management without giving sufficient freedom to the opened-up fields. To build Shanghai into an international financial center and restore its status in the world to what it was before China’s liberation, the government has to make great efforts in urban environment, market construction, transportation network, exchange of information, and economic and financial management. As to the challenges to build Beijing, Tianjin, and other large cities into financial centers opened up to the world, I believe that it will do more good than harm to open up more financial cities to the world as we have to cope with the games of superpowers anyway, and by doing so, we can better advance the socialist cause with Chinese characteristics and the socialist market economy. At the same time, we should be aware that China’s advantage lies in that it has Hong Kong. Hong Kong is known for its high degree of openness and freedom, which is unparalleled by other Chinese cities. It has supported and promoted the previous stage of the Reform and Opening Up era of China in a sea of capitalism. In the days of closed financial markets, Hong Kong actually acted as the international financial center of China. Considering present international and domestic economic and financial situations, none of Shanghai, Beijing, or Tianjin is ready to play the role of being an international financial center. So, the priority is to make the best of Hong Kong, the available highly open and free international financial center, and use Hong Kong as the forefront to

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effectively allocate financial resources to China’s advantage and flexibly cope with the competition among great powers. Even when Shanghai is built into an international financial center, the status of Hong Kong in China’s economic and financial fields can only be reinforced rather than weakened. Before the liberation of China, Hong Kong was not counted as a financial center. The economic development of New China and the economic blockade against China by Western countries contributed to the current status of Hong Kong and turned it into an international financial center. Meanwhile, during China’s Reform and Opening Up, the high degree of freedom and openness of Hong Kong greatly supported the growth of China’s economy in external trade, economic cooperation with foreign countries, and the absorption of foreign investment. After the regime shift, Russia and many Eastern European countries also wished to have a highly free and open city like Hong Kong. Now, the rise of China makes this international financial center assume more responsibilities of innovation and openness. For Mainland China and Hong Kong, it means both opportunities and challenges accompanied with the rise of China. Mainland cities can strive to be financial centers but they also should be willing to play a supporting role for Hong Kong for a certain time during the Reform and Opening Up era. 3. To properly handle the relationship with the United States while strengthening the international cooperation against global financial crises. China’s Premier Wen Jiabao once said, “For China and the United States, cooperation benefits both while contention hurts both.” It was a farsighted guiding principle complying with the fundamental interests of people in the two countries. American consumers are the primary source of global demand and China is a major producer of global consumer goods. Although experiencing the financial crisis, the United States is still irreplaceable by any other country in the world. As the United States and China are, respectively, a large consuming country and a large producing country, the economic cooperation between the two is inevitable. The strategies of cooperation can be categorized into three kinds. The best choice is to enter into a trade security agreement based on which the United States can significantly reduce the controls over both technology exports to China and the mergers of American companies by Chinese enterprises in exchange for not only financial cooperation with China but also more exports and less trade deficits. The second best plan is to stick to the status quo for the time being, but it will inevitably lead to a continuous trade decline and worsening trade frictions. Certainly, China

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has to boost its domestic demand, especially domestic consumption, and gradually shift its economic growth mode. But if China suddenly stops purchasing the U.S. government bonds, narrows trade deficits by reducing imports and exports to the United States, and totally replaces trade with domestic demand, it will end up in a loss on both sides. This is the worst option that the two countries should avoid. 4. To unite emerging markets to participate in the reform of the international financial system. The international economic organizations should be reformed at an appropriate time to enhance the voice of emerging countries. Meanwhile, the world’s reserve currency system should be reformed to diversify the global currency and break the hegemony of the U.S. dollar. China must guard against financial risks and strengthen financial supervision to prevent the financial aggression by economic superpowers with financial hegemony. As the current financial crisis spread to the whole world, the asset prices of each country dropped to a level that has the best investment value. So China must seize the opportunity to invest in the desperate financial conglomerates in order to be integrated into the global economy and benefit from the global market. 5. To return to industrial production and properly arrange the proportion between finance and industry. An important lesson from this global financial crisis is that the development of financial markets and the fictitious economy cannot be separated from the real economy. The solution is to return to the industrial production and reshape the proportion between finance and industry. At present, even American President Barack Obama has emphasized a smaller proportion of the financial industry in the future U.S. economy in order to take the financial sector back to the state it was in in the 1970s and the 1980s and no longer be half of the economy. Therefore, China should also not overlook the role of industry. The financial sector was too big in the United States but too weak in China. In China, both financial and service sectors should be developed, but they have to be proportionate to the industrial sector. High-end financial and service industries cannot be blindly developed with the hope of overtaking the United States and other developed countries. China must learn from the lessons drawn from the mistakes of the United States and focus on expediting heavy and chemical industrialization and urbanization, upgrading the industrial structure, and promoting the cross-border transfer of manufacturing capital from developed countries to China. The Chinese government has to attach importance to the development of the real economy and

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lead the reasonable growth of physical investment whether during the revitalization of Northeast China, the development of Western China, the rise of Central China, or the development of metropolitan areas and county-level economy. To revitalize the nation through financial development is the pressing task for the Chinese government under the new situation of the rise of the great powers. China has to build up solid financial and economic strength, timely and steadily open its financial markets, seize every opportunity to turn the renminbi into a global currency, and participate in the reform and restructuring of the international financial system. It should both guard against the attacks of speculative capital on financial markets and calmly deal with the games among financial superpowers during the economic financialization and financial globalization in order to learn to prevent, control, and manage risks in the course of financial opening and development. Financial regulators have to familiarize themselves with the rules of capital flow, especially the common practice of speculative capital, and impose strict financial supervision to prevent the financial shocks from the massive capital flows to China’s economy and finances after the full convertibility of the renminbi. Most importantly, it is vitally important to let financial markets and the fictitious economy serve rather than impair the real economy and truly make China’s financial sector bigger and stronger.

To Accelerate the Production-Oriented Modern Service Industry, Especially the Modern Logistics Services A major characteristic of current global economic development is that a large share of the service sector is linked to GDP. The proportion was 73% in developed countries while the world average was 69%. According to China’s 11th Five-Year Guidelines, the ratio between the service industry and GDP was expected to reach 43.3%, but in fact the ratio was 43.0%, 0.3 percentage point smaller than stated in the plan and 30 percentage points less than that of developed countries. China’s service sector — no matter if compared to developed countries, middle-income countries, or even some low-income countries — still belongs to the backward group. Therefore, China has to not only grow its financial service industry but also expedite the production-oriented modern service industry, especially the modern logistics industry.

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Shortly after the Reform and Opening Up era began, the Chinese government proposed to develop the tertiary industry. But why did the modern service industry still lag behind? This was related to the rapid development of industrialization, delayed urbanization, the deepening of economic globalization, market entry restrictions of private capital, and many other factors. In particular, too many institutional obstacles and overly extensive government intervention limited the development of the service sector. However, the root cause for the sluggish development of the service sector did not lie in the service industry itself, but the insufficient specialization, socialization, and marketization of the manufacturing industry. As the upstream and downstream companies in the manufacturing industry have not yet realized specialization, the modern service industry cannot go deep into the upstream and downstream of the industry chain to provide comprehensive and convenient socialized services. Besides, the fast growth of China’s industry was attributed to the adjustment of the global manufacturing pattern. If excluding the manufacturing exports, the proportion of China’s service industry will be up nearly five percentage points.3 In the mid-1980s, China’s National Machinery Committee introduced a reform of production specialization and socialization in the manufacturing industry to transform a group of small but all-embracing manufacturers into specialized factories in cities and separated a large batch of specialized and socialized casting and forging, plating, welding, machine repair, heat treatment, and tool and die factories from those all-inclusive manufacturers. This was the first reform in the industrial structure aimed at specialization and cooperation during China’s industrialization. Despite being carried out in an administrative rather than market manner, this industrial reform actually solved the high consumption with low efficiency and low productive capacity with high pollution in urban industrial production to achieve higher asset efficiency and make production be more cost effective, efficient, and environmentally friendly. Later, as the National Machinery Committee was abolished, the reform towards specialization and socialization in the manufacturing industry stopped. Additionally, the monopoly of state-owned enterprises and numerous systematic defects in corporate governance made most enterprises prefer comprehensive production and diversified operation rather than specialization and collaboration which were beneficial to the deepening of the division of labor in the upstream and downstream industry chain and the society as a whole. Since there are not many highly specialized manufacturing enterprises in China and the existing ones pay little attention to reforming operation flow and promoting business outsourcing, the tertiary industry built upon the extensive

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social division of labor and market provision of services to reduce transaction costs can hardly develop. Another problem in the modern service industry is that production-oriented modern services develop slowly. The two problems are interrelated and interact on each other. The competition in the modern industrial economy has shifted from between different enterprises to between supply chains. Enterprises strive to obtain competitive edges for sustainable development through improving their relationship with the upstream and downstream enterprises and consolidating and optimizing the information flow, knowledge flow, material flow, service flow, and capital flow in the supply chains. In the global competition, supply chain logistics management has become a core topic for business decisions. The mainstream trend of modern logistics management is to extend towards supply chain management and service chain management. The focus is to consolidate logistics operation from market projection and order management to storage and stock management and from raw material transport to finished product distribution and product maintenance and recycling, and integrate logistics into the service chain. This enables enterprises to fully exploit and utilize external and global resources, technologies, and capacities to enhance their own core competitiveness by outsourcing logistics and supply chain management and other unrelated businesses. It should be noted that during the development of the modern service industry, logistics and manufacturing industries were highly related to each other. Among the global total logistics income, 88.8% was contributed by the industrial goods transport. However, logistics has not fully displayed its value in China. The logistics industry did not develop in China until this century. The understanding of most Chinese companies about logistics still centered on the integration of transport and storage and their industrial ideas still lingered in the traditional logistics age when the focus was on the transporting of finished goods from producers and sales networks. As the transportation during the production of manufactured goods was absent, it resulted in a lack of the inbetween logistics services whose size was a multiple of the existing delivery of finished goods. At present, developed countries have generally adopted supply chain management and basically realized zero stock or near-zero stock. Goods are always in circulation and will not stay in warehouses for more than 24 hours. In contrast, China’s logistics remains at the level of the 1980s and continues the habit of maintaining large inventories. Many Chinese cities relied on heavy and chemical, coal, and grain industries and the factories both purchased and produced huge quantities of materials or goods to be stored in the warehouses. As the land prices went up, the storage costs constantly

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increased. Many products were manufactured in the west and processed in the east before being sent back to the west for sale. During this process, it would add to a great deal of logistics costs. This indicates that the sluggish development of China’s logistics industry is related to not only the delayed revitalization and growth of itself, but also insufficient understanding towards industrial companies and the backward reform of the industrial system. Therefore, reforms should be carried out in at least two aspects. First, industrial producers have to update the traditional understanding of logistics. They should recognize the needs to divorce logistics management from main businesses to be handled by third-party logistics providers, and integrate logistics outsourcing into supply chain management in order to improve their core competitiveness. Second, the logistics industry must upgrade its services by developing towards intelligent logistics. All sorts of costs can be minimized if production, storage, delivery, and sales are smoothly connected via the internet. Only in this way can industrial customers and logistics service providers form long-term win-win partnerships. Then, logistics enterprises can expand the business scope, improve value-added services, and grow larger and stronger. After entering the 21st century, China’s logistics industry moved into the fast lane of development. At present, there are nearly 100 logistics enterprises with a business size of above RMB1 billion, and the business income of large ones even surpassed RMB100 billion. This was hard to imagine a few years ago. Overall, China’s logistics companies are large in quantity and rich in variety but small in scale and poor in quality, and they generally face the problems of low efficient logistics tools, extensive logistics management, and low-level application of logistics informatization. In 2010, the total social logistics costs in China amounted to RMB7.1 trillion, accounting for 18.1% of the GDP, doubling the percentage (round 8%) of developed countries like the United States and Japan. According to the estimate by the United Nations Development Programme (UNDP), the logistics costs for industrial products made up roughly 20% to 40% of the product costs in China; however, the proportion was 9% to 10% in developed countries. A research report from the World Bank in 2007 asserted that as it was affected by high toll rates, China had one of the highest logistics costs in the world. China charged the highest toll rate, but had the lowest toll affordability. Information said that among the 140,000 km toll roads in the world, around 70% (100,000 km) is in China. The National Development and Reform Commission (NDRC) of China also admitted, “The charging standard for expressways in China is too high and the tolls on roads and bridges account for one third of transportation enterprises’ costs.” Some experts pointed out that when taking into account

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traffic fines, the proportion could be as high as above 50%. This explains why road and bridge operators topped the list of profiteering industries. In 2009, the average gross margin and net margin of 14 listed toll collecting companies in Shanghai and Shenzhen was 64.2% and 36.6%. This clearly shows the wealth transfer effect. One obvious example is that during the 2008 Chinese winter storms, the government waived the tolls of travelling roads, bridges, and tunnels for vegetables and other farm products. This would save RMB2,000 per truck for transporting chilies from Hainan to Wuhan province, which would reduce chili wholesale prices from RMB4 to RMB2.2 per jin (0.5kg). Although this preferential policy was temporary, it showed that curbing monopoly played a decisive role in improving logistics efficiency and reducing logistics costs, especially transport costs. When the world’s manufacturing industry became more and more specialized, socialized, and market-oriented, and constantly spun off production-oriented modern services, the modern service industry, including the above-mentioned services, grew to be more and more professional. But, China lagged behind in this regard. For example, engineering design has already adopted scale management or professional management internationally, but China is still held back by the separation between departments and policy constraints. Likewise, the well-known big four accounting firms are very competitive in the global market with their businesses ranging from accounting and auditing, tax consulting, corporate mergers and restructuring; at the same time, some small- and medium-sized accounting firms which have a professional division of labor and offer powerful socialized services can also generate high profits; however, most Chinese accounting and auditing firms are neither large enough to achieve economies of scale nor small enough to be professional and they are short-sighted in business development. In still another example, bill discounting, credit card marketing, and the urging of the clearance of debts are generally outsourced to specialized financial service providers in foreign countries, whereas in China, large banks monopolize those businesses and leave no chance for the service industry. To go one step further, the development of the modern service industry and that of the financial service industry can affect and reinforce each other. Take the field of modern logistics as an example. Logistics companies have to provide financial services for supply chains. However, it is hard for most small- and medium-sized companies in the upstream or downstream of a supply chain to get loans due to the lack of the forms of collateral and sound financial statements required by traditional commercial banks. The capital shortage will severely impair suppliers’ capacity to fulfill orders and the

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quality of orders completed and so slow down the sales and product turnover of retailers. It will further impact the smooth operation of the entire supply chain and even restrict the competitiveness of core enterprises. By contrast, in foreign countries, the financial services provided by banks can meet enterprises’ demands for supply chain management, either from purchase-order financing which happened when producers placed orders with suppliers, to the factoring business through which accounts receivables are sold to factoring companies, or from the pledge of movables and warehouse receipts during logistics process to policy financing established based on the credit of insurance companies. Banks are able to provide a series of financing service products, including purchaseorder financing, movable property financing, warehouse receipt financing, factoring, accounts receivable financing, policy financing, corporation overdraft, confirmed warehouse financing, and e-commerce financing, throughout each link and the whole process of a supply chain. By offering the supply chain financing business, banks can not only lower risks from the loan business, but also promote the development of upstream and downstream enterprises in the logistics or supply chain and strengthen the cooperation between banks and core enterprises. For China, the growth of core enterprises and the effective, smooth, rapid and sound development of the entire supply chain can be achieved, if banks are able to create innovative supply chain financing products to both fulfill customers’ needs and achieve risk control, regard these products as an important carrier and platform of liquidity support provided to enterprises, and offer tailored comprehensive supply chain financial solutions based on the features and demands of each customer. Therefore, to advance the specialization of the manufacturing industry, boost business outsourcing, develop production-oriented service industry (especially logistics services), and provide systematic financial innovation services, enterprises, governmental departments, and banks have to renew both their knowledge and management and implement in-depth reform towards intensive economic growth instead of simply updating the businesses. It should be specially pointed out that one of the main sticking points for inadequate specialization of the manufacturing industry and the absence of a production-oriented modern service industry is the hindrance from the existing tax system to the development of the service industry. During the 2011 National People’s Congress (NPC) and the People’s Political Consultative Conference (CPPCC), known as the “two sessions,” Xu Shanda, member of the national committee of the CPPCC and former Deputy Director of the State Administration of Taxation, said that the failure to meet the targets of the 11th Five-Year Guideline by the service industry had much to do with excessive high taxes and fees.

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The Chinese turnover tax system is currently composed primarily of value-added tax (VAT) and business tax (BT). The manufacturing industry is subject to VAT while the service industry is subject to BT. The tax base is the total volume of business turnover. However, this tax system contains three problems. First, the BT of the service industry is levied on the gross income rather than the value-added part as practiced in the manufacturing industry, so this has caused double taxation. The more the division of labor extends, the heavier the BT is. As the division of labor is increasingly specialized, the commodity turnover involves more steps. Therefore, duplicate taxation becomes more and more severe. It inhibits the subcontracting and outsourcing among service providers and distorts the allocation of market resources. Second, since different taxes are applied to the manufacturing and service industries and the BT levied on the service industry is not deductible, it cuts off the deduction chain. This has not only prevented the production-oriented services from divorcing from the manufacturing industry, but also limited producers’ demand for outsourcing services, inhabiting the development of the producer service industry. It will encourage industrial business groups to develop internal service supply and give up purchasing services from outside, thus impeding the development of service outsourcing. Third, VAT is the premise for export rebates. As the service industry is subject to BT, the export of services cannot claim a tax refund. It harms the expansion of the trade in services. This is a typical example where superstructure severely hampers the development of productivity, the adjustment of economic structure, and the transformation of development mode. The most notable flaw in the Chinese tax system is double taxation. As a typical case, Guangzhou Hongfeng Logistics Company shipped nearly 1,000 tonnes of steel from Guangdong Panyu Cargo Terminals to Haikou City, Hainan Province, the total freight costs were RMB19,902. The company paid RMB688.34 for tax on shipping charges when the steel was loaded onto a ship. But when the ship arrived at the Haikou dock, the logistics company had to pay another RMB657.35 handling tax for outsourcing the unloading business to the Haikou dock which was an independent legal entity. Since all the taxes paid around freight terminals could not be refunded, the company’s gross profit was reduced to RMB216, after deducting freight and handling charges. During this process, the logistics company was double taxed RMB657.35, almost half (48.87%) of the total taxes (RMB1,345) paid and 3.04 times the gross profit.4 People from the China Society of Logistics expressed that currently railroad and sea-road intermodal transportation was the sector that was hardest hit by double taxation.

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The negative impact from the current tax system on the service industry is also obviously reflected in financial leasing. As we have mentioned previously, the high tax levied on the aircraft leasing business was an example of the hindrance from uncoordinated fiscal and taxation systems to the modern service industry. In the long run, governmental departments and banks in China have to reinforce investigation and research in order to formulate a whole set of policies and measures concerning market access, tax breaks, financing, corporate mergers, and industrial consolidation for promoting the specialization and socialization of industry chains and the development of financial services. Meanwhile, the investment banking industry has to be developed based on the practices and experience of Western markets to provide tailored financial services for the formation and consolidation of the domestic emerging service industry. As far as I can remember, during the reform of the manufacturing industry towards specialization in the 1980s, there was also a problem of an incongruous tax system. At that time, the government encouraged specialization and cooperation in the manufacturing industry, but the tax system levied higher taxes on all-embracing factories than specialized ones. And the more cooperative links there were, the higher the taxes paid and the lower the profits. This reversed the reform direction to indulge the development of “big and comprehensive” or “small but all-inclusive” companies. Later, this mistake was corrected after China Construction Bank (CCB) conducted a survey to report the problem to the relevant authorities. From here we can see that to promote China’s tax reform by adding the service industry into the scope of VAT reform will greatly boost the development of the modern services. It is reported that Xu Shanda, former Deputy Director of State Administration of Taxation, suggested that the next step after unifying corporate income tax rates for domestic and foreign-funded businesses, and introduction of the VAT reform, should be a BT reform, and the BT should be replaced by the VAT in the service industry to accelerate the development of the service sector. The Outline of the 12th Five-Year Guidelines (draft) required the speeding up of “the development of producer services.” It specifically stated that the government should “enhance the division of labor based on specialties, accelerate innovation of service products and service models, and facilitate integration of producer services industry and advanced manufacturing industry, thereby promoting the accelerated development of the producer services industry.” The government must “systematically expand the financial services sector, vigorously develop the modern logistics sector, cultivate and develop the high-tech service sector, and standardize and improve the commercial services

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sector.” It is really a targeted development plan. Information from the official website of China’s Central government said that Wen Jiabao, Premier of the State Council, chaired the State Council Executive Meeting on June 8, 2011, to study and plan the tasks for the sound development of the logistics industry. The meeting underscored the need to formulate complete supporting policies and measures to facilitate the sound development of the logistics industry, based on the problems found in policies that restricted the logistics industry development since the Adjustment and Revitalization Plan of the Logistics Industry was issued by the State Council in March 2009. The meeting put forward eight measures to counteract those problems. 1. Effectively alleviate the tax burden of logistics companies. Relevant departments shall improve the pilot measures for the balance payment of business tax by logistics enterprises, further expand the scope of pilot program, and comprehensively popularize the pilot measures. 2. Increase policy support for logistics land use. Approvals should be given to logistics industry development that makes use of obsolete factory sites, old warehouses, and unused or insufficiently used land. 3. Facilitate passage for logistics transportation. Tolls for bridges and highways should be reduced. 4. Relax the rules for business qualification and administrative licensing, gradually reducing the administrative approvals and improving processing efficiency. 5. Encourage the integration of logistics facilities and resources. The government should support large advantageous logistics enterprises to integrate logistics facilities and resources and encourage small- and medium-sized logistics enterprises to form alliances. It will also guide storage and transport facilities in the industry to carry out communitybased logistics services and support the development of a joint distribution trade for commercial transportation. 6. Promote innovation and high tech application in the logistics industry. 7. Increase investment in the logistics industry. Governments at all levels should increase investment in infrastructure, and actively guide the banking financial institutions to increase credit support for logistics enterprises and expand financing channels for those enterprises. 8. Promote the logistics industry for agricultural products. Direct distribution between farms and supermarkets, farms and schools, and farms and enterprises should be vigorously developed. The government must improve the agricultural VAT policies and encourage large-scale

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enterprises to engage in agricultural logistics. The establishment of a cold chain logistics system for key species and in key areas should be accelerated. Government investment and policy support for the agricultural wholesale markets and farmers markets should also be increased. Policies of green channel delivery of fresh agricultural products and of vehicles 24 hours a day in the city’s traffic system, with convenient docks, must be strictly implemented. The development of the modern logistics of food and cotton will be accelerated.5 .

Media reported on this meeting by stating, “The State Council works hard to combat the chronic diseases in the logistics industry.” The meeting urged all localities and departments concerned to strengthen the organization and coordination and detail the policies and measures before seriously implementing them. It can be expected that the modern logistics and service industries will be largely improved. International experience shows that when the per capita GDP of a country or region exceeds USD3,000, its urbanization and industrialization will speed up and its industrial structure and consumption pattern will also dramatically change. The per capita GDP of USD3,000 is a turning point in economic development, and passing that point, consumption will be more active. At present, China’s per capita GDP has crossed the USD4,000 mark and therefore the expedited development of the service industry becomes a top priority. According to the Outline of the 12th Five-Year Guidelines (draft), the share of the value added from the service sector in GDP is expected to reach 47% in 2015, with an annual growth rate of 4%. Although remaining lower than the world average, this percentage denotes lots of room for the future development of the modern service industry and the financial industry which provides financial support for the former.

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Prologue: An Anecdote about When to Implement Communism Sometime around 1950, there was story widely repeated in Shanghai. It was said that during the first Chinese People’s Political Consultative Conference (CPPCC) in Beijing, a capitalist asked Liu Shaoqi, the Party leader: “When will the Party implement communism?” Liu replied wittily, “When workers live the same way as you capitalists do, it will be the time for communism.” At that time, Shanghai had just been liberated by the Chinese Communist Party (CPC) and workers participated in the revolution by upholding the banner of “Workers of all lands, Unite!” But, the kind of life the workers should live after the CPC took power had not been carefully considered. The conversation between the capitalist and Liu Shaoqi was passed on by word of mouth and it generated much speculation among the communist cadres. People wondered whether capitalists would worry about communism if workers really lived the same way as capitalists — having fish and meat three times a day, living in townhouses and villas, equipping their houses with refrigerators and washing machines, using diesel engines to keep warm in winter (back then, there was no heating system in Shanghai) and air coolers to cool down in summer (air conditioners were not introduced then), and getting around by car. Later, as Mao Zedong criticized the consolidation of the New Democratic social order and the bourgeoisie, the anecdote was forgotten. However, Liu’s answer was still a beautiful and ideal vision in my mind. I always feel that the future life of workers should be as affluent as capitalists’, otherwise what is the meaning of revolution? Certainly, after experiencing all kinds of political movements and a series of “permanent revolutions,” I for one would rather continue the present simple life than dream about workers and cadres leading a “luxury” life the same as the bourgeoisie. Not coincidentally, Yanhuangchunqiu magazine published an interview with an unemployed worker in the United Kingdom by Wang Zhen in 2008. At the end of the 1970s, China’s Vice Premier Wang Zhen paid a state visit to the United Kingdom. He was very surprised when hearing that in the U.K., most workers, office clerks, intellectuals, and the petty bourgeoisie, accounting for 70% of the country’s population, were able to own private houses and family cars, and take yearly holidays abroad. This seemed ostentatious to the Chinese people. To show that he cared about the poor and the suffering, the Vice Premier requested to visit an unemployed worker. The Chinese Ambassador to the U.K., Ke Hua, accompanied the Vice Premier to the house of an unemployed British worker. It was a two-story building of over 100 m 2 with a separate dining

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room and living room. The living room was furnished with a sofa, television, and decorated silverware cabinet. At the back of the house, there was a small garden of approximately 50 m2. The worker was out of work and so exempted from taxation and he was also entitled to free medical care and free compulsory education for his children. After seeing this, Wang Zhen got mixed feelings. He was astonished that unemployed British workers who he originally thought should strive against poverty in fact lived better than the Chinese Vice Premier. Ambassador Ke Hua told the Vice Premier, “Once a cleaner told me he could earn GBP100 per week, and an elevator operator told me his weekly wage was GBP150.” According to the then exchange rate of GBP1 = RMB5.91, their respective weekly incomes equaled to RMB591 and RMB886. Wang Zhen was a rank-five senior government official and he earned around RMB400 per month. His weekly income was less than RMB100, equivalent to one sixth of that of a British cleaner and one eighth of that of a British elevator operator. Yu Ri, the Economic and Commercial Counsellor at China’s Embassy in the U.K., wrote in his article, “Living 10 Years In the United Kingdom: Rediscover Capitalism”, that when asked about his impressions of the United Kingdom, Vice Premier Wang Zhen answered unexpectedly, “I think the British government has done a good job; material wealth is greatly abundant, the gaps between workers and peasants, rural and urban areas, and manual and mental labor have basically been eliminated, social justice and public welfare are given due attention; and if it were the Communist Party which was in office, the United Kingdom would be an ideal model of a communist society.” The above two stories all talk about workers. The first is a revolutionary vision while the second is the reality of British workers (in particular, unemployed workers) in the eyes of Wang Zhen. As a side note, I visited France in 1981. During that time, China was still suffering from the extreme shortage of consumer goods and commodities were supplied by ration coupons and queuing. By contrast, Paris and Lyon were abundant in material wealth and prioritized social welfare, as Wang Zhen said. The workers of the factories visited by me even owned private cars and around 20 workers’ cars were parked in each yard of those factories. The President of China Construction Bank Jiangxi Branch from our delegation said with surprise, “These factories have as many cars as our provincial government!” To minimize foreign exchange expenditures, our delegation stayed at the Embassy of China in France and had chicken and hairtail for lunch — these were rare and delicious things in China during that time. But the chef of the embassy called these “food of the third world.” Later, when attending the reception banquets and business luncheons held by some banks in France, we found out that neither chicken nor

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hairtail were served and instead, there were only some other kinds of fish, beef, duck, and goose. My first impression of the material abundance in France came from the scenes of everyday life: Cement was used in roads and buildings, glass was used in automatic doors of hotels and shops and in the aluminum windows in high-rise buildings, and paper, instead of rags, was used when cleaning. Even the packaging was more luxurious than that of our commodities. At that time, I thought that even with such material abundance, capitalist France was still not qualified for socialism, let alone China. The reason why I related those stories is because I will now go into a serious topic: turning workers into men of property and creating the conditions for increasing the property income of the masses. The above stories can serve as a lead-in to the discussion of more serious matters. Now let us cut to the chase. The proletarian party upheld the banner of “Workers of all lands, Unite!” during the revolution and the reason why workers (proletarians) followed the communist party to join the revolution was by no means for continuing poverty and forever being proletarians but to get rid of poverty and become the masters of the world. So when the revolutionary party came into power, it had the responsibility to turn the workers into men of property, upgrade low-income earners into middle-income ones, and create conditions to make more people have income from property. This is crucial for building socialism with Chinese characteristics and the socialist market economy in China.

Turn Workers into Men of Property In the economic life of China, workers are being transformed into men of property. This is a major change in Chinese society. This change is multifaceted and progressive. Originally, Deng Xiaoping Theory allowed “a group of people to get rich first” after the Reform and Opening Up policy was launched. But as the State Council issued the document to reform the housing system, workers suddenly owned the property right of their houses. In this way, workers were really transformed into being men of property which thus led to some fundamental changes in the material life and ideological field of China. In 2000, I wrote an article named “To Turn Workers into Men of Property,” discussing the four aspects of changes in the transformation of workers into men of property. After the shareholding system was introduced on a pilot basis in 1990,

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workers were allowed to invest in stocks. The new kind of stock was called individual shares, which could be further classified into employee shares and social individual shares. Before going into this issue, we have to mention a premise: Socialism follows the principle of distribution on the basis of labor. But there is both simple labor and complex labor. The latter is also expanded to include technical innovation and management innovation, which is now referred to as “human capital.” The problem is that in the real world, the quantity, quality, and reward of labor vary greatly among different people, so does one’s consumption. Therefore, there is a possibility of workers delaying their consumption, which is the source of the dozens of billions of urban and rural household saving deposits. The saving deposits reached more than RMB6 trillion in 2000, RMB17 trillion in 2007, RMB21.8 trillion in 2008, RMB26.08 trillion in 2009, and RMB30.33 trillion in 2010. The funds from delayed consumption that we are now talking about are also the capital source of workers to purchase stocks. We know that when Marx expounded the future socialism, he once assumed that the means of production would be owned by the society whereas the means of consumption would be owned by individuals. However, he did not discuss whether the fund from delayed individual consumption could be transformed into a production fund and how the transformation would be realized. At the initial stage of New China, workers were allowed to put their funds from delayed consumption into banks and receive interest in return. But the left-wingers in the Cultural Revolution opposed this practice and criticized that interest was income from exploitation. So they proposed to abolish interest and introduce interest-free deposits. This was self-contradictory: Since there is no interest, then why bother to make deposits? After this new policy was implemented for a while, deposits sharply decreased, thus impairing credit balance and control. As a result, the practice of interest-bearing deposits resumed. The theoretical explanation was that interest on deposit was a kind of reward given to workers for supporting the construction of socialism by postponing consumption. Similarly, the theoretical basis for allowing workers to purchase stocks in the pilot scheme of stock markets was also deduced from the above logic. Now that the interest received by workers from saving their delayed consumption funds in banks which will lend out the money for developing production was not regarded as exploitation, stock dividends received by workers through bypassing banks and directly investing their labor income into stock markets for developing production should also be inferred as a kind of reward for delayed consumption.

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Science and technology personnel were allowed to contribute their scientific and technological innovations as equity investment. At the beginning, investment in the form of proprietary technology was limited to 20% of the total registered capital, and could not exceed 40% under special circumstances, according to the policy during the pilot project of joint-stock companies. Later in the Company Law, the maximum proportion was redefined as 20%. In late 1999 when the National People’s Congress (NPC) Standing Committee modified the Company Law, it decided to extend the proportion of technology investment in high technology companies, and the specific measures shall be prescribed by the State Council. To permit technology investment is not only an acknowledgement of technology as complex labor but also recognition of the primary productive forces of science and technology being able to be invested like material capital, despite the term of “human capital” having not come up yet at that time. In such a way, science and technology personnel would share profits according to their contribution of technology investment and become men of property. At the moment, no one worried that a class of men of property would be formed accordingly, because those who contributed technology were also workers, in particular talents of technologies, and their number was definitely small. The pilot program of incentive compensation and managerial ownership was approved at the Fourth Plenary Session of the 15th Central Committee of the CPC in 1999. It was the first time that the Chinese government had allowed managers to enjoy the property rights of companies with their excellent management and equated management with material capital in the income distribution. This proposal was further confirmed in the Report of the 16th Party Congress in 2002: Technological knowledge and managerial skills could participate in the distribution of income according to their respective contributions the way other factors of production (such as labor) do. A more updated term for the technological and managerial investment is “human capital.” The last change was the reform of the housing system. The housing system reform started to be discussed at the end of the 1970s and after many years of discussion, no serious policy was implemented, except the housing provident fund scheme. After all, if the capitalization of housing distribution cannot be really put into practice, the housing system reform can hardly go anywhere. However, in 1999, the State Council ordered to abolish the welfare-oriented public housing distribution system and replaced the housing distribution in kind with housing distribution in money (cash allowance). It for the first time turned the years-long discussion into a radical reform by capitalizing the public housing distribution to enable workers to own their own property.1 In this way,

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starting from 2000, Chinese workers who had dedicated half of their lives to their work were able to receive a large amount of housing allowance based on their respective length of service; therefore with just a few additional savings, they could manage to buy a house and become men of property. This reform was not impeccable, for it did not fully realize the capitalization of housing distribution, thus it was unable to truly activate the secondary market of real estate. But it successfully turned millions of workers into men of property and accumulated experience in building up a mass basis. Of course, this has nothing to do with exploitation and the underlying principle remains distribution according to labor. The above four changes, especially the housing system reform in 1998, transformed the Chinese proletarians who had seized power into men of property, 50 years after the socialist revolution in China. However, this has nothing to do with privatization. The reform neither privatized the stateowned assets of state-owned companies, nor made private capital to exploit the Chinese proletarians. Instead it allowed Chinese workers to use their work (including excellent intellectual work) and earned income to become men of property through either improving consumption conditions or postponing consumption. Therefore, I ended my article with the following sentences: To turn workers into men of property will be a significant and profound power for breaking away from the shackles of thoughts. It again proves the truth in Deng Xiaoping Theory: Poverty is not socialism, and development that is too slow is not socialism either. The objective of proletarians to call for “Workers of all lands, United!” is by no means to continue being havenots, and by doing so, “the proletarians have nothing to lose but their chains; they have a world to win.” 2 For this reason, the government has to first lift workers from poverty, create better living and consumption conditions, and turn men of no property into middle-income earners and owners of their own earned income. Meanwhile, to develop too slowly is not socialism. A socialist country must mobilize all the positive factors and constantly encourage workers to put temporarily unused consumption funds in investment. All the citizens should get engaged in the lifelong pursuit of socialist construction and ensure a rapid growth of socialist economy. To turn workers into men of property is not a socialist utopia, but a reality for socialism with Chinese characteristics.

As a side note, the phrase of “the Chinese proletariat who has seized power” mentioned above is a common way to express the idea, but in fact it

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was not precise. Because when the Chinese revolution achieved a victory in 1949, the proportion of the industry sector accounted for less than 10% and the industrial population made up less than 5% in 1950. So China had no typical proletariat as was described in the classic theories of Western countries. Strictly speaking, after the victory of the revolution, it was the working class based on the alliance of workers and peasants and with Chinese characteristics rather than the proletariat who seized power in New China. After the revolution, a land reform was implemented to realize “land to the tiller” and the entire countryside became a society of small property owners who were the owners of their respective land. Overall, the movement of “turning workers into men of property” in China had been in place since the land reform in the 1950s and was reinforced during the implementation of the contract responsibility system (namely, to fix farm output quotas on a household basis). Following that, the technology investment in the 1980s, the opening of stock markets and the introducing of manager stock ownership in the 1990s, and the housing system reform in 1998, jointly enabled China to finally step into an ideal society where workers are men of property.

Expand the Middle-Income Group, and Unite All Builders of Socialism with Chinese Characteristics In 2002, the Report of the 16th Party Congress proposed to “bear in mind the objective of common prosperity, and try to raise the proportion of the middleincome group and increase the income of the low-income group.” This was the extension of the revolutionary practice of leading workers to become men of property by the ruling party and its priority was: to turn workers into men of property, upgrade the low-income group to the middle-income one, and constantly enlarge the proportion of middle-income earners. But, who belongs to the middle-income group? Except for the working class, with the intellectuals as part of it, and peasants whose income has been increased, the report clearly stated, “Emerging in the process of social changes, entrepreneurs and technical personnel employed by non-public scientific and technological enterprises, managerial and technical staff employed by overseas-funded enterprises, the self-employed, private entrepreneurs, employees in intermediaries, free-lance professionals and members of other social strata are all builders of socialism with Chinese characteristics.” 3 I think “all builders of socialism with Chinese characteristics” comprise not only high-income earners but also a larger percentage of middle-income earners.

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It was for the purpose of advancing the progress of history, especially for the purpose of “bringing all positive factors into full play and bringing new forces to the great cause of rejuvenating the Chinese nation” that the 16th Party Congress declared those people to be “builders of socialism with Chinese characteristics.” Accordingly, the meeting advocated, “We must respect work, knowledge, competent people and creation; and this should be an important policy of the Party and state to be conscientiously implemented in society at large,” and claimed to “unite with the people of all social strata who help to make the motherland prosperous and strong, encouraging their pioneering spirit, protecting their legitimate rights and interests and commending the outstanding ones in an effort to create a situation in which all people are well positioned, do their best and live in harmony.”4 It is worth noting that the report put forward “the principle that labor, capital, technology, managerial expertise and other production factors participate in the distribution of income in accordance with their respective contributions, thereby improving the system under which distribution according to work is dominant and a variety of modes of distribution coexist.” This was an important innovation in theory. Certainly, Marx discriminated between simple and complex labor and between physical and mental labor. But, workers were not well educated at that time, and complex and mental labor have never been more common than they are today, nor have they played a larger role in the society. In the age of Marx, since electricity had just been discovered, the impact of science and technology on the economy was not obvious. The contribution rate of science and technology in economic growth barely reached 5% in the early 20th century. After World War II, metallurgy, machinery, and chemical industries developed and the average contribution rate increased to 49% between the 1950s and 1970s. After the 1980s, owing to the rapid advances of electronic technology and information technology, the contribution rate soared to 80%. Science and technology truly became the primary productive force and made an outstanding contribution to economic growth. Management was just divorced from production in the times of Marx and capitalists evolved into being “coupon clippers.” However, the real scientific management did not make any significant contributions to the expansion of production and circulation and the improving of efficiency and earnings until the 1980s. Capital was described as a product stained with blood in Das Kapital. Now, we have to accept the contribution of capital in the construction of socialism with Chinese characteristics and establish the principle of distribution according to work. Although the Report of the 16th Party Congress did not clearly state the specific contribution of capital as a factor of production, it admitted capital’s role in

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production and circulation. People ought to acknowledge the contribution of capital and “all legitimate income, from work or not, should be protected.” In fact, Marx later specially mentioned in the Communist Manifesto, the “bourgeoisie, during its rule of scarcely 100 years, has created more massive and more colossal productive forces than have all preceding generations together.” Besides, Marx held different views towards different kinds of capital. He once believed that in the cooperative factories of the laborers themselves, “the antithesis between capital and labour is overcome within them, if at first only by way of making the associated labourers into their own capitalist, i.e., by enabling them to use the means of production for the employment of their own labour.”5 Marx considered share capital as “capital of directly associated individuals,” and thought that as share capital assumed a social nature through the socialization of capital, it manifested itself as a social power and product. He called share capital “the most perfected form (turning into communism).”6 From here we can see Marx admitted the positive contribution of share capital to the social production. Having confirmed the principle of production factors participating in the distribution of income in accordance with their respective contributions, the 16th Party Congress clearly stated in the report that “It is improper to judge whether people are politically progressive or backward simply by whether they own property or how much property they own…. It is necessary to foster notions and form a business mechanism in conformity with the basic economic system in the primary stage of socialism and create a social environment in which people are encouraged to achieve something and are helped to make a success of their career, so as to unleash all the vitality contained in work, knowledge, technology, management and capital and give full play to all the sources of social wealth for the benefit of the people.” If we say that Deng Xiaoping proposed the idea of “letting some people get rich first,” then the 16th Party Congress set up a mechanism to encourage and support a part of people to get rich first and turned Deng’s idea into a concrete measure for “raising the proportion of the middle-income group.” When the 16th National Congress of the CPC was convened in 2002, the proportion of the middle-income earners in China was still low. According to Dong Furen, the percentage was around 16%, Lu Xueyi estimated the proportion to be between 15% and 20%, and Xiao Liang suggested the percentage in urban areas was only about 10%. However, under the influence of the policies of the 16th Party Congress, the middle-income group would experience an “explosive growth.” At that time, I wrote in one article that in order to build China into a moderately prosperous society in an all-round way, the proportion of the middle-income group should be raised up

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to 30%–40%. Only when an olive-shaped society is formed, can we conform with the basic economic system in the primary stage of socialism. With the deepening of Reform and Opening Up and economic and cultural development, this part of the people, together with the constantly growing working class, will become important forces for promoting the development of advanced productive forces and all-round social progress in China. Generally speaking, based on the international experience, when a country’s per capita GDP reaches USD2,000–USD3,000, its middle class or middle-income group will significantly expand. If middle-income earners become the majority in a society, they will play a role of being a social stabilizer and at the same time, the government’s burden to subsidize the vulnerable group will be lessened. The experience of Nordic countries has proven that such a social structure is beneficial to social stability and lasting prosperity. The middle-income group proposed by the 16th National Congress is basically similar to the middle class in Western countries. The only difference is that the middle-income group is defined based on the income level whereas the middle class is classified based on household property. According to the authorities of the Ministry of Finance and National Development and Reform Commission, China’s urban households (a family of three) whose average pretax income was between RMB60,000 and RMB200,000 belong to the middleincome group. In other words, if the average per capita income in a dual-earner family is above RMB30,000, the family can be categorized as the middle-income group. Here, the middle-income group is decided by sustainable earning power rather than consumption level or the amount of property. Western countries have the tradition of consumption on debt and consumption credit service enables their citizens to sustain a high level of consumption on the basis of credit. Under credit consumption, the credit limit for the German middle class can be 2.5 times their income. The middle-income families in Western countries do not have full property rights to all of their property and most Western countries allow personal bankruptcy. Therefore, we should be prudent in the analysis of the consumption and property of the middle-income group. What did it mean by making “the middle-income earners become the majority in a society”? An idea proposed by the Policy Research Office of the CPC Central Committee once was that “55% of the population will be middle class whose annual household income exceeds RMB60,000 by 2020, with 78% of city dwellers and 30% of those in rural areas reaching that status, and 2% of the population will record an annual household income of over RMB200,000.”7 According to the Annual Report on Urban Development of China No.4 released by the Institute for Urban and Environmental Studies Chinese Academy of

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Social Sciences, China had 230 million middle-income residents in cities in 2009, making up 37% of the total urban population. Families with their Engel’s coefficient, or the proportion of income spent on food, standing between 0.3 and 0.373 were considered as middle-income residents, according to the report. It also showed that the proportion of lower-income residents of China’s urban population was still too large. Despite dropping below 60% since 2005, the proportion remained above 50%. The expected olive-shaped society has not been formed. However, the report predicted that the number of middle-income dwellers in Chinese cities would rise 2.3% annually from 2010 to 2025; their proportion would approach 47% by 2020 and it is likely to pass 50% around 2023; and in 2019, the urban middle-income group would for the first time outnumber the urban lower-income group, namely the so-called “olive-shaped society” would first appear.

Properly Deal With “Distribution According to Capital” China has implemented the income distribution system in which distribution according to work is dominant and a variety of modes of distribution coexist at the primary stage of socialism. Here, the “variety of modes of distribution” includes distribution according to capital. The 16th National Congress of the CPC in 2002 further stated, “We should establish the principle that labor, capital, technology, managerial expertise and other production factors participate in the distribution of income in accordance with their respective contributions, thereby improving the system under which distribution according to work is dominant and a variety of modes of distribution coexist.” It clearly classified capital as a kind of production factor which must “participate in the distribution of income in accordance with their respective contributions.” The Report of the 17th National Congress of CPC in 2007 put forward, “We will adhere to and improve the system whereby distribution according to work remains the predominant mode and coexists with various other modes; we will improve the distribution system to allow factors of production such as labor, capital, technology and managerial expertise to have a rightful share according to their respective contribution” in the section of “deepening reform of the income distribution system.”8 Compared with the Report of the 16th Party Congress of CPC, this report changed the wording from “establish” to “adhere to and improve,” which indicated this distribution principle had gained a foothold in Chinese society. In this section, we will specifically talk about “distribution according to

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capital.” There was a misunderstanding about this concept in the past, namely to regard “distribution according to work” as the sole principle of income distribution in a socialist society while considering “distribution according to capital” as a non-socialist mode and equating it with income from exploitation. This is wrong. It should be clarified that capital in “distribution according to capital” includes not only the capitalized surplus value of capitalists but also the capitalized household property of workers. First, workers can also use the money and materials converted from the past materialized labor as capital in the search for profits through investment. Second, the investment capital of workers (in stocks, for example) which is converted from past materialized labor is the surplus of labor income and the subsequent returns on investment (such as stock dividends or money from stock appreciation) is a kind of non-labor income received following the principle of “distribution according to capital,” but the income, the same as interest on deposits, is the reward from socialist countries to encourage their workers to support socialist construction by postponing their consumption. Third, to practice “distribution according to capital” in order to encourage workers to dedicate the capital from their past materialized labor to investment is a necessary distribution method for mobilizing socialist workers. To perform income distribution according to work is not merely to abolish exploitation, but to arouse the enthusiasm of workers when there are neither capitalists nor exploitation. We oppose the “iron rice bowl” and “eating from one big pot,” namely, the equalitarianism in income distribution, because it does not appear conducive to arousing but even harming the enthusiasm of workers. But socialist production has to mobilize not only the living labor of workers, but also the capital and materials from materialized labor. To allow distribution according to capital is to encourage socialist workers to contribute parts of their consumption funds to socialist construction at the expense of delayed consumption, which can mobilize the materials and capital from materialized labor. In order to mobilize socialist workers, a socialist society not only practices “distribution according to work,” but also is willing to give financial support to workers who participated in socialist construction through carrying out “distribution according to capital.” It is not only acceptable but also necessary for socialism at its primary stage to perform “distribution according to capital.” Now that we can tolerate and maintain the practices of capitalizing surplus value and “distributing according to capital” for both domestic and foreign capital at the primary stage of socialism, we ought to reward and encourage workers who contribute their surplus labor income by postponing consumption

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to support socialist construction through “distribution according to capital.” It is in nature a practical and realistic policy formulated based on the reality of the primary stage of socialism.

Foreign Experience: How Did Western Countries Create a Middle Class? People’s focus on the 12th Five-Year Guideline is around the government’s goal of “making people rich,” namely to turn the present “rich country, poor citizens” into “strong state, wealthy people.” Here, an important question is how to create a middle class. I will start with the lessons from Western countries. The rise of the middle class in the United States can be attributed to Roosevelt’s New Deal. Now when people talk about the New Deal, they usually focus on the policies of state-centralized investment and work relief which stimulated investment and consumption demands, implemented in response to the Great Depression in the 1930s. Later, some people questioned the effect of the two policies and argued that it was World War II that brought about investment and consumption demands and the revitalization of the U.S. economy. But what cannot be ignored is that the Roosevelt administration implemented a series of policies and measures to narrow the wealth gap and promote equality, leading to the expansion of the middle class. On the one hand, Roosevelt issued many policies to improve people’s livelihood and guarantee the basic lives of ordinary people, such as affordable public housing, freedom of association and unions to workers, price control over key commodities against inflation, control over the wartime gains of workers in many key industries, medical insurance, unemployment insurance, social security for the retired, etc. On the other hand, he raised taxes on the rich. First, the federal tax levied on company profits was increased. Later, statistics showed that the average tax rate grew from less than 14% in 1929 to 45% in 1955. Second, the income tax was raised. The top rate was only 24% in the 1920s, but grew to 63% during Roosevelt’s first term in office and further rose to 79% during his second term. Third, the estate duty was also added. The top rate of estate tax successively went up from 20% in 1929 to 45%, 60%, and 70% before finally reaching 77%. One of the outcomes of those policies was that wealth was significantly decentralized and the middle class accounted for a larger share in the society. The richest 0.1% of the American population controlled about more than 20% of the nation’s wealth in 1929, but the percentage decreased to around 10% in the

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mid-1950s. Another change was that the real income of middle-income families had basically doubled since 1929. For example, only one third of American families had installed a home telephone in 1936; by 1955, 70% of families had a home phone and most families owned a car, while 70% of households had access to a fixed telephone line and most families owned a car. In a word, Roosevelt’s New Deal had turned the country with a huge rich-poor divide in the 1920s into a middle-class society after World War II.9 Japan was another case. Liu Di once wrote an article to introduce the middle class in Japan. He said that the Japanese economy grew rapidly after World War II, and from 1950 to 1973, Japan’s Gross Nation Product (GNP) increased at the rate of over 10%, creating a miracle in the world economic history at that time. From 1955 to 1975, the Japanese people who thought themselves “middle class” increased from 42.5% to 77% while those who deemed themselves “lower class” decreased from 57.4% to 21.8%. By the end of World War II, around half of the Japanese population lived in rural areas but now 86% resided in cities. Liu Di believed that Japan achieved urbanization and turned farmers into citizens in the space of one generation and it was the long-term large-scale postwar urbanization movement that formed the middle class and middleclass consciousness in Japan. On the one hand, Japan built an olive-shaped society through its taxation system. In Japan, even though you are a president in a company with an annual income of JPY30 million, it is impossible for you to lead a luxurious life due to the heavy tax duty. In contrast, an ordinary staff member (who belongs to the middle class) with an annual income of JPY5 million is able to raise a family of four. Although not affluent, the middle class can still afford houses, cars, and eating out and almost every family lives in a flat with two or three bedrooms and a living room. On the other hand, during the rapid growth of the economy, massive amounts of farmers flooded into the cities. Municipal authorities took accommodating farmer-turned citizens as their priority. At that time, each city strove to expand residential building areas, for example the urban area of Tokyo constantly stretched westwards accompanied by the relocation of universities and other cultural facilities. In addition, local governments issued various policies of low-rent housing and large cities like Tokyo and Osaka built a few new towns to solve the housing shortage. Governments also erected lots of collective apartments as government-owned low-rent houses which solved the housing problem of millions of Japanese. Liu Di said, “Japan did not completely deprive the richest, but knew to push the middle class to the foreground and made them to play a leading role in politics in order to stabilize the political system. As to the business tycoons, they have to display their industrious entrepreneurship in order to win a place in the

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society.” SoftBank Corp founder Masayoshi Son and Uniqlo founder Tadashi Yanai are the best examples. Certainly, there are rich people in Japan, but their wealth is bound by social responsibilities and society and social media keep a close eye on the rich. It is very likely for a rich man to bring disgrace and ruin upon himself, if he uses his money to achieve a malicious intent. For this reason, rich people can hardly cause a stir in a society with such a powerful middle class.10 Equally important, after the Great Depression in the 1930s, Keynesianism prevailed, and leaders in the U.S. and Europe advocated using public construction projects to solve unemployment in the hopes of addressing market failure by active government intervention. Meanwhile, labor-management coordination successively appeared in the U.K., Germany, France, Sweden, Norway, and the U.S. on a national scale and class compromise replaced class confrontation. Subsequently, business owners in developed countries shared a portion of profits with workers and adopted stock ownership plans, such as technology investment, employee stock ownership, and managerial ownership, as incentives to management and technical personnel, greatly easing the conflict between labor and management. After World War II, as the capitalist production advanced, Western countries promoted national welfare, namely, governments use the transfer payment to establish and subsidize public utilities, implement and improve a set of social welfare policies and systems, and intervene in social and economic activities in order to regulate and ease class conflicts and ensure social order and the functioning of economic life. Those countries claimed to be welfare states. In the second half of the 20th century, the ideas of the welfare states were promoted to other European countries, especially the countries where the Social Democratic Party or the Labor Party formed the government, to become the basic system and the zeitgeist of Western societies. Among them, the most typical were Nordic countries and they were regarded as showcases of welfare states. For example, Sweden was a typical welfare state which adopted an economic pattern of “using equal and equitable distribution to integrate economic growth with private ownership. Since then, middle- and high-income population increased and a middle class which Marx failed to predicate was created as a result. It has been 60 years since the founding of New China. In the last 30 years of the Reform and Opening Up era, China’s socialist market economy maintained its high growth with an annual growth rate of over 9.7%, but its middleclass families only accounted for 23% of the national population. Among the 607 million of the urban population, around 160 million was rural migrant workers. They made a huge contribution to China’s industrialization but were

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excluded from the urban population and the working class. They received low wages and were deprived of social security and welfare benefits, such as access to public housing, medical care, and local schools, and thus were unable to be parts of the middle class. As a socialist country, China is now building a moderately prosperous society, but it has not yet turned the majority of workers into the middle class and formed an olive-shaped society. Although China is already a strong country, its people are still not wealthy. Therefore, the Chinese government has to formulate policies to solve the important issues, as to how the 12th Five-Year Guideline should lead the reform of the income distribution system, make people rich (namely, to increase the income of workers), turn the 160 million and future migrant workers into urban dwellers, and create a middle class and an olive-shaped society in China.

The Property Income of Chinese Citizens There are two premises for property income. First, allow people to own property. This is no longer a problem anymore. The Report of the 17th Party Congress in 2007 stated a goal of enabling “more citizens to have property income.” Here, property includes both movable and immovable property. Bank deposits and securities are movable property while houses, land, and collectibles belong to immovable property. Property is the premise of property income. You have to first have surplus money before you can have or buy property. To allow people to have property, the key is to protect private property. Otherwise, people will be unwilling to accumulate property and there will be no property income. During the planned economy, China adopted the system of people’s communes whose characteristic was being “large in size and collective in nature,” and private plots were even requested to “cut off the tail of capitalism.” People were scared of talking about “private ownership” and all housing was owned by the state. At the end of 1978, the savings deposit balance of rural and urban residents was just RMB21.06 billion. Considering the total population of 962 million at that time, the savings deposit per capita was merely RMB21.82. People owned no other private property, not to mention property income. In 2002, the 16th National Congress of the CPC stressed to improve the laws to protect private property, and the Property Law later came out as a result. The law was officially launched in 2008 after rounds of discussions. Approximately 58 years later, New China finally gained a law for protecting the property of individuals. Second, allow people to use property to gain income, including income

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derived from the transfer of the right to the use of their property. It is not helpful to frequently call for “cutting off the tail of capitalism.” This is also not an issue any longer. The so-called property income refers to dividend income from property operation, and interest, rent, and appreciation gains received from the transfer of the right to the use of property, for example, interest on deposit and national debt, income from renting houses, bonus from stock investments, profits from stock appreciation, and capital gains from the transfer of houses. Currently, there are three main characteristics of residents’ property income in China: First, the property income of urban and rural residents increased substantially, but the property income of most residents is still very limited. It has not been very long since the Chinese people began to accumulate their property. In the first 40 years of New China, people barely owned any private property except a small amount of personal savings. The government bond market was not opened in China until the 1980s. The opening of its stock market was even later in 1990. In the mid-1990s, the housing provident fund system was implemented and the sales of commercial housing were permitted. The real housing system reform was not put in place until the welfare-oriented public housing distribution system was abolished in 1998. After that, people were able to accumulate a large amount of household or private property. Based on the above analysis, Chinese people have accumulated property for less than 20 years. According to the National Bureau of Statistics of China, the per capita property income of urban residents reached RMB520 in 2010. Compared with the data in 2005, it was an increase of 169.7% with an average annual growth rate of 22%. The per capita property income of rural residents was RMB202, RMB114 higher than in 2005, an increase by 1.3 times with an average annual growth rate 18%. The property income of both urban and rural residents grew faster than the country’s GDP. Therefore, the five years during the 11th Five-year Plan was a booming period for the property accumulation of the Chinese people. Among Chinese residents’ property, the most important ones are real estate, financial assets, and land (mainly rural land). The respective proportions are: Real estate accounts for 60%, financial assets 20%, and land 10%, and they totally make up 90% of residents’ property. However, most residents have limited property income. For one thing, property income largely centers around rich people. In 2006, around 18.2% of households owned property income. Among them, the per capita property income of the top 10% of households was RMB1,279.28, while that of the bottom 10% of households was only RMB35.29.

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For another, most housing and rural land belongs to property of necessity, namely something that is necessary for living. In 2007, the property for living accounted for 71.4% of total family property while the investment-oriented property only comprised 26.9%. Taking Guangdong Province as an example, there was just 14% of urban households who owned more than two houses and only 9.4% of families had houses for rent. Second, compared with the international figures, the proportion of property income in the total personal income of Chinese residents is still very small. In the United States, the property income accounted for around 40% of the disposable income, and more than 90% of citizens owned stocks, funds, and other securities. In the disposable income of Chinese residents, approximately 70% was from the wages or salaries and income from property constituted only a small fraction. According to the data of the 11th Five-Year Plan, the proportion of income from wages or salaries of urban residents in total income was 68.9% in 2005 and that number dropped to 65.2% in 2010, a decrease of 3.7 percentage points; the proportion of net operating income was 8.1% in 2005 and it rose to 10.2% in 2010, an increase of 2.1 percentage points; and the proportion of property income was 1.8% in 2005 and it further grew to 2.5% in 2010, an increase by 0.7 percentage points. Overall, the contribution of property income to the income of China’s residents is still very small, not only lower than that of net operating income, but also far lower than that of either transfer income or income from wages and salaries. Third, the national income gap and property gap tend to continue expanding. According to the commonly used indicator for measuring income inequality — Gini coefficient, inequality in China stood at around 0.3 in 1987. Although the international standard considered below 0.3 as “perfect equality,” the principal challenge in wealth distribution for China was to correct the egalitarian practices of the “iron rice bowl” and “eating from one big pot” at that time. In 1993, China’s Gini coefficient closed to 0.4, but was still within the reasonable range (between 0.3 and 0.4). In 2002, the Gini coefficient rose to 0.447 in China, exceeding the international warning line of 0.4. As a result, the 16th Party Congress diverted more attention to equality. Afterwards, China’s Gini coefficient tended to stop expanding and even shrink. The five years between 2002 and 2007 were a period of steady and fast growth of rural residents’ income. However, statistics of 2007 showed that China’s Gini coefficient grew to 0.47, and the income gap significantly widened. In addition, according to the statistics from the World Bank, China passed the Gini coefficient warning line of 0.4 after 2000 and showed an upward trend year by year. The indicator rose to 0.496 in 2006 and reached 0.48 in 2007 (above 0.6 was considered “high

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inequality”). The World Bank’s report also indicated that the ratio between the average income of the richest 20% of the population and that of the poorest 20% was 10.7 in China, while the ratio was 8.4 in the United States, 4.5 in Russia, 4.9 in India, and 3.4 in Japan.11 Since the calculation of the Gini coefficient is very complex and there is no standard calculation method, the National Bureau of Statistics of China currently does not include the indicator into its statistics and the Gini coefficient from each research division and expert is quite different. In 2010, the Jiusan Society, one of the eight legally recognized political parties in China, submitted a proposal on improving national income distribution structure to the National People’s Congress and Chinese People’s Political Consultative Conference. The proposal mentioned that China’s Gini coefficient reached 0.41 in 2010, going beyond the warning line and about 10% of Chinese households owned 45% of the total property of urban residents. But according to another report, the Gini index in China approached 0.5 based on the investigation of the Chinese Academy of Social Sciences (CASS).12 The income disparity in different industries is much more obvious. According to the statistics released by the National Bureau of Statistics of China in 2010, the wages in China’s securities industry were six times higher than the average wages of the society and the income gap between the industry with the highest average income and that with the lowest average income reached 11 times. Later, according to the statistics from the Institute of Labor and Wage Studies in the Ministry of Human Resources and Social Security, this gap was further expanded 15 times. If the securities industry is calculated together with the financial industry, the income gap between different industries was still as high as 6 times. In other market economy countries, the income gap between the highest-paid industry and the lowest-paid industry between 2006 and 2007 was around 1.6–2 times in Japan, U.K., and France, and 2.3–3 times in Germany, Canada, the U.S., and South Korea. Judged from existing data, the income disparity between different industries in China is the largest in the world.13 People pay close attention to the yawning income gap and Western economists generally considered that a Gini coefficient above 0.4 signaled economic stagnation. After 2004, China’s Gini coefficient surpassed the internationally recognized warning line, but China still maintained rapid economic growth. According to Zhao Renwei’s research, the reason for a high Gini coefficient lied in that China was on its way towards urbanization and industrialization, the urban-rural dual economic structure had not been completely changed, and the urban-rural income gap had always been large due to historical reasons. In fact, if calculating the income gap in urban and

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rural areas separately, neither of their Gini coefficients reached the warning line of 0.4. Therefore, Zhao Renwei concluded that to simply apply the warning line of 0.4 to China during the country’s urbanization and industrialization was not practical and the severity of income disparity should not be exaggerated. However, Zhao Renwei also thought that the Gini coefficient of income distribution displayed a downward trend while that of assets distribution was on the rise in China. China’s Gini coefficient of income inequality surpassed that of developed countries and it was likely to cause the further widening of the assets disparity. As income and assets are interrelated, it should be noted that current high income inequity will lead to the fast growth of assets disparity. According to the preliminary study of the Institute of Economics of the Chinese Academy of Social Sciences (CASS), in 2007, the Gini coefficient of asset distribution was around 0.55, 10 percentage points higher than that of income disparity which was 0.45 based on its calculation. According to international experience, the asset inequity is generally larger than the income inequity in developed countries. The Gini index of income distribution was 0.3 in Western Europe, 0.4 in the United States, and 0.2 in Northern Europe, but the Gini index of assets distribution is usually higher than 0.55 and may reach 0.6–0.7 or even higher. Assets and income distribution are interactive. Policymakers should prevent the vicious circle of income inequality deteriorating assets inequality. At the present stage of China, as the system of socialist market economy needs to be further improved, the gap after the primary distribution of national income is, to a large extent, not a result of market competition. It is necessary to deepen the reform and give the full play of the basic role of the market in resources allocation in order to narrow and eliminate the urban-rural income divide resulting from the dual economic structure, the regional income gap due to ideological and institutional factors, the income disparity among different industries caused by administrative monopoly, and the individual income inequality arising from the unsmooth flow of labor. Some analysts believed that by 2020, if the proportion of the middle-income group reaches over 50% in China, its Gini coefficient will at least decrease to 0.36 (0.44 in urban areas and 0.31 in rural areas).

To Increase the Labor Income of Residents Is the Prerequisite for Increasing Property Income For most residents, the formation and accumulation of property is based on surplus labor income. Accordingly, the proportion of property income is closely

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related to the level of labor income or wage income. The general rule is that the higher the wage income of residents is, the larger proportion of property income is in their total income. To raise property income, the Chinese government must narrow down the income distribution gap and increase labor income such as salaries and wages. At present, the growth of residents’ income lags behind if compared with that of the country’s economic aggregate. Although the mean value of residents’ income has been improved significantly, the majority of residents still receive a relatively low income. Statistics showed that the proportion of workers’ pay in GDP, namely, the income distribution ratio, was above 50% in most Western countries with market economies (58% in the United States, for example). However, the income distribution ratio was obviously low in China, just between 15% and 20%. This is also a reason for the low property income of Chinese residents. Generally speaking, there are eight measures to increase the labor income of Chinese residents. 1. Establish a sound mechanism of regular pay raises for workers. The Report of the 17th National Congress of the CPC stated, “Vigorous efforts will be made to raise the income of low-income groups…. We will gradually increase the share of personal income in the distribution of national income, and raise that of work remuneration in primary distribution…. A proper balance will be struck between efficiency and equity in both primary distribution and redistribution, with particular emphasis on equity in redistribution.” 14 The Chinese President Hu Jintao pointed out in his speech at the Meeting Commemorating the 90th Anniversary of the Founding of the CPC, “We should ensure that development is for the people and carried out by the people and that they share in the fruits of development,” and “[we will] make more efforts to regulate income distribution, [and] pursue prosperity for all.” 15 Therefore, only when the Chinese government increases the income of the low-income group via various means and steadily improves the labor income of workers on the basis of creating more employment opportunities, can surplus labor income be turned into property. Only when a mechanism of regular pay raises is established, can the share of work remuneration in primary distribution and the share of personal income in the distribution of national income be increased. To this end, the government has to build relevant laws and strengthen institutional construction to ensure constant pay raises and the income surplus of workers. Only in this way can the workers become prosperous and receive more property income.

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The so-called “Income Doubling Plan” of China must target the core of the conflict by comprehensively readjusting the distribution of profits. But it cannot do that without a series of solid institutional guarantees, such as the forthcoming Guidance on Strengthening the Regulation of Income Distribution and Wage Ordinance. It is of particular importance to link wage growth to the rise of consumer price index (CPI), raise pensions and subsistence allowances for the retired and the poor, improve the minimum wage, integrate collective enterprises which have not purchased insurance into the basic old-age insurance program, and limit high wages in monopoly industries. Since the above reforms involve the interests of all parties, it has caused frequent delays in the announcement of relevant laws and regulations, but the Chinese government must overcome all difficulties to provide the institutional guarantees for the reforms. 2. Raise the income of farmers. Farmers belong to the low-income group. Currently, the income of three farmers can only equal that of one urban dweller. Therefore, it is crucial to improve the income of farmers (including farmers-turned workers) to allow more people to own property. The per capita property income of rural households is significantly lower than that of urban households in China. In 1997, the per capita property income of farmers was RMB23.61 while that of urban residents was RMB124.39, with the ratio of the two being less than 19%, the lowest in history. In 2002, the per capita property income of farmers arrived at RMB50.68 while that of urban dwellers dropped to RMB102.2, and the ratio between the two was 49.63%, the highest in history, but it remained below 50%. Between 2003 and 2007, the growth rate of property income of urban residents was 2.44%, 2.86%, 11.05%, 12.87%, and 15.25%, respectively, faster than that of rural residents. The property income gap was gradually widened. To enlarge the proportion of the middle-income people, the Chinese government must speed up urbanization, and continuously narrow the income gap between urban and rural residents. It is hard to imagine a society of common prosperity where more than 50% are in rural population. Many experts suggested promoting and deepening the land system reform and, above all, regard the regulating of land transfer as an important means to raise the property income of farmers. I believe that there are two key aspects in increasing the income of farmers (including farmers-turned-workers): First, to reform the household registration system and help the 160 million farmers-turned-workers to settle down

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in cities and receive the same treatment as urban residents; and second, on the basis of promoting the transfer of land use rights, scientific farming, and large-scale operation of agriculture, to build a new socialist countryside and increase the agricultural production and income. The pork price surges in 2008 and 2011 resulted from the low degree of largescale production, specialization, and factory farming in the pig raising industry, which led to cyclical price fluctuations (“pig cycle”) in pork production. It was reported that the large-scale pig farming accounted for 80% in the United States. In China, the annual hog production is more than 500 million head, with over 60% being free-range pigs, which explains why the “pig cycle” is shortened and pork price frequently jumps. It is clear that the small-scale peasant economy is suitable for neither capitalism nor socialism. 3. Curb monopoly. The wages of monopoly industries are generally higher than the wages of general industries. However, the high wages come from neither high management skills nor high production efficiency, but the monopoly position of some industries. The Research Report on Income Distribution in China edited by Department of Employment and Income Distribution of National Development and Reform Commission (NDRC) showed that one third of the revenue of administrative monopoly industries was generated from all kinds of franchises. Therefore, a policy of dual control over total payroll and wage scales in those industries must be implemented in order to narrow the income gap between different industries. High and illegal charges, low service quality, and poor production efficiency still exist in some monopoly industries. To solve these problems, the Chinese government has to first establish a cost control mechanism and second, reform the price formation mechanism. On the basis of these, supervision and inspection of fees charged by monopoly industries should be strengthened and once unauthorized price hikes or illegal charges are discovered, relevant institutions or companies must be seriously punished. The most fundamental solution is to accelerate the reform of stateowned monopoly industries and relax the control over basic industries (such as railway, telecommunication, and power), service industries (such as banking and publishing), and parts of urban public utilities in order to cut off the relationship between local governments and stateowned enterprises. The Central government should gradually reduce its holdings in the state-owned enterprises which are unrelated to the

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public interest, before finally transforming these enterprises into profitoriented modern enterprises controlled by social capital. For state-owned enterprises involving public interest, the Chinese government has to own the direct control but will not seek profits. 4. Strengthen the role of taxation in adjusting income distribution. The Chinese government has to intensify the regulation on high-income earners and relieve the burdens on middle- and low-income groups. The individual income tax threshold is too low and tax collection and administration methods are not sufficient. The income tax on salaries makes up a comparatively large proportion in the total individual income tax and the tax’s role as a lever has not been given full play. Statistics showed that at present, 80% of the individual income tax in China came from the working class, and the rich who occupied over 40% of the social wealth often evaded their taxes. According to the estimate by the Organization for Economic Co-operation and Development (OECD), the ratio of tax paid to tax payable of the individual income tax was only around 50% in China whereas the ratio in some developed countries such as Sweden and Germany was close to 100%. Tax evasion is illegal with no exception. Therefore, the government must strictly put in place the legal system of taxation, intensify the punishment for tax evaders, and allow full play to the role of taxation in regulating income distribution. It is necessary to raise the individual income tax threshold and improve the law on and strengthen the collection of individual income tax. At present, the income inequality among urban residents is predominantly reflected in the differences in wealth ownership, and the individual income tax plays a limited role in regulating income distribution. Real estate, returns on financial assets, and the inheritance and transfer of property must be taxed by creating appropriate tax types and tax rates to lower the excessively high income. In addition, the individual income tax system should be reformed by replacing the schedular income tax with the unitary income tax. Not long ago, Lou Jiwei said in the 16th World Congress of International Economic Association (IEA) that most Western countries adopted the unitary income tax, and only China in the BRICS implemented a scheduler income tax. He added that currently China’s individual income tax consisted of 11 taxable items which worked like 11 independent income taxes; and only income from salaries was taxed on the basis of a progressive tax rate, and all other individual incomes adopted a flat tax. Lou Jiwei thought that China should also introduce the unitary income tax system and the major

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obstacle was not the formulation of the tax law but the complexity in tax collection and management which required sufficient knowledge and powerful measures in this regard. As a former Vice Finance Minister, Lou Jiwei has a say in this issue. 5. Speed up the improvement of the social security system and increase the transfer income of urban and rural residents. This is not only beneficial to bridging the income gap but also to consolidating the middle-income group. The social security system mainly includes old-age insurance and medical insurance. At the present stage, China’s social security system targets urban residents and its coverage in rural areas is small with a low benefits level. The social security system lacks legal protection and has weak mutual aid capability. It is even difficult to maintain the sustainable development of the rural cooperative medical service. The old-age insurance is usually managed by the Central or federal government in Western countries; however in China, it is part of the responsibilities of local governments from county-level and municipal governments to provincial ones. Although there is a unified planning about the old-age insurance at the provincial level, the management still rests upon lower-level governments. Capital arrangements, balance of payments, and standards of insurance policies are in the hands of provincial governments. The defects in this management system are the inconsistency in policies of different provinces and the separated arrangement of capital, especially the prohibited transfer of insurance accounts making the old-age insurance very unfair for migrant rural workers. Therefore, China’s Central government has to unify, with great determination, the management of nation-wide welfare systems, like the old-age insurance, to ensure the consistency in policies and unified arrangements of capital. 6. Enlarge the input in people’s livelihood and equalize basic public services. Basic public services can provide the most fundamental protection to the majority of residents, especially the low-income group. They are the most effective means of governments in regulating income distribution through transfer in kind and perform the function of redistribution. The proportion of government consumption in China’s GDP, if compared to that of other countries, basically conforms to the present development stage of China. But the consumption on public services only accounts for a small share in government spending in China. This is related to the lagged transformation of government functions. Therefore, it is necessary

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to accelerate the formulation and implementation of basic public services standards, increase public services investment in backward and rural areas, and continuously improve the accessibility and equality of basic public services. To improve the accessibility and equality of basic public services, it is important to pay attention to the reform and development of the education system, vigorously develop science and technology, and improve the quality and ability of low-income earners. These are effective measures for enlarging the middle-income group. Among them, to develop education, especially the higher education, and improve the training of human capital is a decisive factor. As the economic development enters the later stage of industrialization and the age of informatization, factors such as technology and management play a more and more important role in production and take an increasingly larger share of profits from the hands of traditional capital owners, becoming a major source of income increase. This is what we called “distribution according to productive factors.” Therefore, the Chinese government has to enlarge its investment in education and increase all sorts of material support and institutional arrangement for workers to receive higher education in order to ensure equal and effective training to the all new labor force. Yang Yiyong mentioned in one of his articles that the 2000 Nobel Laureate James J. Heckman, the Henry Schultz Distinguished Service Professor of Economics at The University of Chicago, pointed out when giving a speech in Peking University that China’s investment on human capital was lower than the world average and even lower than some of the developing countries; the imbalance between the input in physical capital and that in human capital would retard the economic development in China; human capital was the ultimate decisive factor of China’s wealth; and if the Chinese government could improve the education level of its residents and enable them to adopt to modern technologies, China’s potential would be given full play. Yang Yiyong also cited statistics from World Bank’s World Development Report 2006: The world average public expenditures on education as a percentage of GDP was 4.8%, and Sweden and Germany spent more than 8% of its GDP on education. China’s education budget accounted for only 3% of the country’s GDP in 2003. Some scholars used the statistics of education and health investment as the total investment on human capital and found that every additional RMB100 million investment in human capital would bring about a

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nearly RMB600 million GDP increase in the following year, while every additional RMB100 million investment in physical capital would only generate about RMB200 million GDP growth. According to Heckman, in 1995, China, at all levels of government, spent about 2.5% of its GDP on investment in schooling. At the same time, roughly 30% of its GDP was devoted to physical investment. In the United States, those figures were 5.4% and 17%, respectively. In South Korea, they were 3.7% and 30%. The ratio of physical investment to human capital investment was 12 : 1 in China, 8 : 1 in South Korea, and 3 : 1 in the United States. China was far below average in its expenditure on investment in human capital.16 To promote the equal availability of basic public services and enlarge the investment in people’s livelihood, the government also should increase its spending on rural infrastructure and give priority to the projects with direct economic rewards. By increasing financial provision and credit supply to rural areas, the rural consumption environment will be improved, agricultural and rural economic structures will be adjusted, and the income of farmers will be raised. At the same time, the Chinese government also needs to improve its services in the labor market and increase public investment in labor skills and in-service training. The mechanism of transforming and upgrading human capital should be established for the unemployed and educational security should be regarded as an important part of social security in order to improve workers’ quality and adaptability to changes in job roles and safeguard the interests of workers by enhancing market vitality. It is necessary to strengthen and expand competency-based education and technical education and offer all sorts of vocational training and education for farmers in addition to the general education. 7. Encourage indigenous innovation and self-employment, create external conditions to stimulate people’s enthusiasm for entrepreneurship, and expand the channels for increasing the wealth of the masses. The government has to establish measures to protect the lawful incomes and private property of residents and entrepreneurs in the distribution system and the wealth created via legitimate and reasonable means should be respected and protected in order to raise people’s enthusiasm to create material wealth. Incentive mechanism in income distribution should be implemented in all enterprises, a reasonable distribution system where income is distributed according to productive factors should be built, and the reform in primary distribution should be promoted. The government

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must pay special attention to preventing equalitarianism in the public ownership system, improving the market economic system, encouraging the income distribution according to productive factors such as labor, capital, technology, and management, protecting all legitimate income, from work or not, and raising the proportion of the middle-income group. 8. Choose the right path for urbanization and accelerate the process of urbanization, especially the expansion of middle-sized cities. Cities with a population of 300,000 and 500,000 will be expanded to accommodate 500,000 and 1,000,000 people, respectively, within 5 to 10 years. The government authorities should promote the integration of rural and urban productive factors in middle-sized cities, which will become great incentives to national economic growth and create new middle-income earners. Additionally, it is also necessary to regulate the income distribution order. First, an income monitoring system should be built to prevent tax evasion; second, the government should raise the minimum wage, establish a collective wage negotiation system, and promote the implementation of Labor Law and Labor Contract Law to protect the legitimate rights of workers. Special efforts should be made in preventing wage arrears for migrant rural workers, which ought to be an important part of regulating urban income distribution order. Overall, to raise the labor income of residents is the precondition for increasing property income in China. The Chinese government has to made active efforts in regulating not only redistribution, but also primary distribution. It must strive to improve the Socialist market economy and standardize the order of income distribution. Efforts should be made to not only deepen the distribution reform and overcome market distortion and malfunction, but also solve the market generalization and failure and the transformation of government functions in order to make the invisible hand of the market and visible hand of the government play their due roles in a coordinated way.

Conditions Will Be Created to Enable More Citizens to Have Property Income An important task highlighted in the Report of the 17th National Congress of the CPC is “to create conditions to enable more citizens to have property income.” Many experts called it a significant innovation in the traditional income

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distribution theory. In capitalist countries, “to create conditions to enable more citizens to have property income” is part of governments’ responsibilities. To call it an innovation is because the traditional socialist theory did not acknowledge private property in the past, let alone income from property, but now the Chinese government not only legalizes property income but also creates conditions to let more people to own property income. “To create conditions to enable more citizens to have property income,” the focus is “to create conditions.” Conditions should be made in every aspect from ideological understanding to the legal system and the market environment. But how to “create conditions to enable more citizens to have property income”?

To develop a correct view of money The Central government must insist on the basic principle of “development is the hard truth,” help people to form a healthy attitude towards wealth and devote themselves to growing property income, and enable Chinese citizens to share the economic benefits from the country’s economic growth. In the 60-year history of New China, the Chinese people received the traditional education of “taking class struggle as the guiding principle” for more than 30 years and were prohibited from speaking of capital for over 40 years. To help people to end all the debates about whether the reforms are capitalist or socialist and form a right attitude towards wealth, the government has to clear up all the confusion and set things right. People should no longer be afraid of speaking of capital but understand that the socialist society also has capital. In the past, people only knew how to make ends meet and pinch pennies, but now they have to learn how to make money beget money and convert money into capital to produce profits. The concept that becoming rich through investing one’s accumulated wealth is as glorious as doing it through hard work should be established in the society. To enable people to abandon their jealousy and hatred towards the rich, the government should first urge people to earn higher pay through legal means and gain property income, and encourage them to become middle- or upper-income earners and contribute to raising the proportion of the middle-income group. The Chinese government has to enrich residents’ financial knowledge and foster their multi-channel investment awareness. Investing and financing knowledge should be popularized through newspapers, the internet, and other channels to enable ordinary citizens to gradually understand how to make investments and manage money and switch from saving to investing. The government should let the residents know that besides the interest from saving,

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they can also obtain dividends, a bonus, and appreciation of assets through purchasing bonds, stocks, funds, insurance, and other financial products and increase the value of their property through buying or renting houses as well as other real estate investments.

To provide sufficient financial products and investment channels The Chinese government has to deepen the financial reform and encourage banks and financial institutions to provide more financial products as well as financing and investing channels to each group of people for them to allocate their assets based on their wealth and risk preference. Currently, the varieties of financial products in China’s financial markets are not sufficient enough to meet people’s demands for gaining property income. Apart from some of the middle class and the high-income group who can afford high-risk and high-return stocks, funds, trust plans, and other financial products, the low-income earners and working class have to put the majority of their income into housing despite their rising disposable incomes. But housing belongs to the property of necessity, namely something that is necessary for living. If people live in instead of rent their houses, there will be no property income. Even though their house prices go up, they cannot sell the houses for profit. Besides, there are also many restrictions on selling houses in cities, such as houses built on collectively owned rural land are not allowed to be sold. At present, the investment composition of urban residents is mainly comprised of bank saving, supplemented by insurance, funds, and stocks investment. However, the yield on deposits is pretty low. In early 2010, the oneyear deposit rate was 2.25% and the CPI rose by 3.3% in that year; from October 2010 to February 2011, the one-year deposit rate reached 3% after the Central bank raised the interest rate three times, but compared to the CPI increase of 4.9% recorded in January 2011, bank deposits could not offset inflation and showed a negative interest rate. The development of personal investment and finance services provided by financial institutions lags behind, and there is no suitable comprehensive financial market for the low-income group. At the same time, investment channels and structure are not well developed and the threshold for investment and financial management is too high. Among the financial products of banks, the minimal requirement for investment is RMB10,000 and some products even require more than RMB50,000. It discourages the participation of the middleand low-income earners and aggravates the unfairness in income distribution at the starting point.

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Therefore, banks and financial institutions should be encouraged to speed up financial product innovation, open more investment channels, and lower the investment threshold. It is imperative to create some basic financial products targeting ordinary investors who lack investing experience, and offer a wide range of financial services including saving, investment, and risk management. As the saying goes, “If you leave “Managing Money” alone, Money will manage to leave you alone.” Therefore, it is necessary to improve people’s personal finance skills and create more financial channels to enable people to preserve or increase the asset value. Common prosperity will be achieved if more and more families learn to manage their money. On the basis of being fully aware of investment risks, the Chinese residents should establish a right attitude towards wealth and understand that personal finance does not mean the pursuit of the highest returns but the search for the most suitable financial plan according to their family structure, risk tolerance, and asset lifecycle. Financial institutions should highlight the differences between different financial products and introduce investment instruments and channels with stable returns and small risks for the low- and middle-income groups in order to enable all the citizens, no matter how little income or property they have, to gain property income through asset management. This is also a requirement for making “more citizens to have property income.”

To actively promote the sound development of the capital market and build a more open and transparent investment market The capital market, as an important platform for the masses to increase property income, can create opportunities for general investors to grow their wealth. In recent years, China’s stock markets realized significant breakthroughs and fundamental changes through constant reforms. At present, the A-share market has approximately 130 million accounts, but excluding the 30 million idle accounts and 30 million–40 million fund accounts, there was only 60 million active stock accounts. So, by far, the capital market is still exclusive to the minority. This requires the Chinese government to make more people realize the significance of the capital market and encourage them to gain property income through participating in the capital market. It should also be pointed out that due to the distortions in the early system of China’s capital market, some policies and regulations overly focused on the financing function without paying sufficient attention to developing and realizing the full potential of the capital market, which resulted in many historical problems and systematic defects. For example, timeliness and

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reliability of information disclosure by listed companies still needs to be improved; many listed companies have the bad habits of prioritizing financing over restructuring and investment over returns; and there was an imbalance between stocks and bonds in the market structure. These are also the reasons for the low confidence of investors and the long-term weak market in recent years. Under the new historical background, “to create conditions to enable more citizens to have property income” requires the government to develop the capital market into an important platform for the masses to increase their property income. Efforts should be made in improving the basic functions of the capital market. First, the government has to develop a series of basic financial products including stocks, bonds, financial derivatives, and other fixed-income products and establish a multi-layer market system to fulfill investors’ demands for not only diversified investment products, trading systems, and trading methods, but also hedging instruments and investment portfolios, in order to turn the capital market into an attractive and comprehensive market which can “enable more citizens to have property income.” Second, it is necessary to encourage enterprises to improve their management and competitiveness and urge listed companies to operate in full compliance with applicable laws and regulations, strengthen good-faith construction, and increase the asset quality. Basic systematic construction and constant deep reforms should be implemented to improve the market competition mechanism and increase the efficiency of resources allocation, thus stabilizing the confidence of the participants of the capital market. Third, the financial authorities have to intensify the compliance management towards securities institutions for the sake of ensuring the sound operation and sustainable development of these institutions, foster high-quality resources for listing, and propel the capital market to offer better services for “enabling more citizens to have property income.” Fourth, the government should take protecting the interests of investors, especially the legitimate rights of medium and small investors, as the primary target of the capital market reform. It has to raise the personal finance skills and risk resistance capacity of citizens through education while ensuring equality, fairness, and openness in the market by cracking down on illegal activities and improving the financial services to investors. Relevant systems and mechanisms should be set up to provide constant protection to investors and make sure that people have the confidence to enter the market and engage in long-term investment.

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Fifth, the government has to strengthen the supervision of the capital market, improve relevant laws and regulations as well as the market discipline mechanism, and prevent power rent-seeking in order to push forward the steady and healthy development of the capital market.

To develop investment funds markets After 12 years of fast-track growth, China’s fund industry has developed 62 fund management companies with over RMB3 trillion in assets under management by the end of 2010. Among them, 657 mutual funds managed RMB2.51 trillion, social security trust funds RMB3.15 trillion, enterprise annuities RMB106.7 billion, and separately managed funds for specific clients RMB112.4 billion. Although developed very rapidly, China’s fund industry remains small in terms of the total assets under management. The size of the U.S. mutual funds was approximately 1.5 times that of personal savings in 2005. However, the assets under the management of investment funds (RMB2.51 trillion) in China only equaled to 8% of the saving deposits of urban and rural residents (RMB30.3 trillion) in the same period. Statistics showed that the assets managed by the entire fund industry in China only accounted for 1.7% of the world total, and China ranked No. 10 in the global asset management list. It was inconsistent with China’s status (the second largest) in the world economy. Considering China’s future economic development, the speeding up of urbanization, and the fact that the country will not enter into an aging society until 2030, the wealth of Chinese residents will rapidly increase, thus bringing about a larger space for the development of the fund industry. The major task of the fund industry is to manage wealth for others, that is, to continuously provide more and better services to “enable more citizens to have property income.” In particular, financial institutions should improve the services offered to tens of millions of individual investors who are mostly salaried workers. They have limited capital, time, and investment experience, and cannot tolerate high risks. Many of them focus on short-term gains and tend to blindly follow suit, indulging speculation and blind investment in the stock market. This is a major reason for the high turnover rate and high speculation in China’s stock market. To solve the problems, financial supervision authorities have always been encouraging financial institutions to develop investment funds in the securities market as vigorously as commercial banks developed savings deposits in the financial market in order to turn investment funds into a professional investment vehicle which can unite tens of millions of individual investors and manage the wealth for them. As a result, mutual funds developed rapidly in recent years

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and became the most popular investment products for Chinese residents. The proportion of open-end investment funds held by individual investors grew from 52.98% at the end of 2005 to 74.21% in 2006. After 2007 this proportion remained above 99% and even reached 99.88% in 2009. At the present stage, if we want to “create conditions to enable more citizens to have property income,” it is imperative to vigorously develop mutual funds. First, encourage the competition among fund management companies in product variety, product quality, and service quality. Once people’s demand for product varieties is basically satisfied, they will raise their demand for product quality. Only when people or fund clients improve their taste and discernment in personal finance and are able to discriminate between good and bad financial managers and service suppliers, can unreliable fund managers and poorly performing companies be eliminated from the market and the fund industry move to a new height. At present, many fund companies only look for big clients and focus on separately managed accounts (or segregated account management) with one or multiple owners. But these companies should not forget that small clients of mutual funds are the basis of their businesses, and “to create conditions to enable more citizens to have property income” should be their target. In short, pursue returns and profits. Only when the funds of a fund company generate high returns, will the size of the funds grow; and only when the fund company displays a good overall performance, will the company be able to develop more funds. Second, push fund companies to pay attention to corporate governance. Investment funds are the best representative of the trust business. Compliance, professionalism, and integrity are the foundations of the fund industry. Only when fund companies make great efforts in standard management and honest operation and place “protecting the interests of fund holders” above all other things, can the companies and the industry at large have a bright future. Otherwise, the funds will be discredited let alone the fund companies. Third, strengthen supervision. As the former President of China Securities Regulatory Commission, Shang Fulin, has said, we have to stick to three bottom lines: No institution or people are allowed to get involved in rat trading, unfair transactions, or tunneling; and once found guilty, those involved will be punished.

To enliven the real estate market Currently, among residents’ personal property, housing takes up about 60%. Most houses are the property of necessity and cannot be sold or rent for cash,

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thus they are unable to generate property income. In 2010, around 6 billion m2

out of 13.2 billion of the total floor space of residential buildings in urban areas

were built as a response to the target of “getting out of the housing plight” before the housing reform from the early 1980s to 1998. This large amount of

residential housing is the main body of the present housing reform (which also includes the houses built in the cities of the old industrial base areas in the 1950s

and the makeshift houses erected during the decade-long Cultural Revolution).

But according to Chen Huai,17 buildings constructed at that time can no longer

meet the needs of people for better living conditions, in terms of either housing

layout or dwelling size. These residences have to be rebuilt in the next 15 to 20 years. On the basis of this, some people predicted that among the residents

who had purchased a public house, 80% wanted to buy a new one to expand their living space. Therefore, the future development of the real estate industry should not only enable low-income workers to be able to live in low-rent or

affordable housing, but also adapt to the upgrading of the housing consumption to make people be able to replace their “pigeonholes” of welfare housing with larger dwellings.

An alternative is to ask the public utilities department to buy those buildings

which need to be rebuilt and renovated them into low-rent housing before tearing down for reconstruction.

Of course, it is essential to improve the regulations on house transfer and

lease, and standardize house trading and leasing activities in order to enable

residents to receive legitimate property income from investing in real estate. Here, what is inevitable is that cities have to modify their laws to allow houses

built on collectively owned land in suburbs, such as houses with limited property rights, to be sold or rented.

In Western countries, banks offer a service called “reverse mortgage.” It

is a loan available to retired homeowners to enable them to receive a regular stream of income from commercial banks against the mortgage of their homes

in order to pay for their living expenses as well as travel and entertainment

spending. After the homeowners pass away, banks will consider the residual value of the mortgaged houses as inheritance and demand the heirs pay off the loans. This transforms the immovable house property into income-generated

capital to satisfy the consumption needs of the retired. The Shanghai Municipal

government planned to conduct a pilot project of this service earlier on. Banks

in other provinces should also be encouraged to make relevant exploration and innovations to enable senior citizens to have property income.

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To advance land reforms in rural areas The Central government has to carry forward the rural land system reform and promote the capitalization of land in order to enable farmers to increase their property income through the land reform and land transfer. At present, there are about 160 million migrant rural workers who are prevented from being registered as urban residents due to the urban-rural household registration divide, and more than 100 million mu (66,667 km2) rural vacant land, equivalent to approximately 1/18 of the nation’s total arable land.18 As a result, most of the traditional agricultural area became dilapidated and high-quality farmland was abandoned and lost, which hampered the large-scale development of agricultural production and reduced farmers’ income. Here, the key solution is to capitalize the land-use rights transfer, namely, to allow more flexibility to rural land-use right, and facilitate the land transfer and the conversion of land into cash on the basis of guaranteeing farmers’ long-term land-use right over their contracted land. First, to allow farmers to turn the land-use right of their contracted land into a stable stream of income through subcontract, transfer, or mortgage, and the subsequent income can be used as the seed capital for migrant rural workers to settle down in cities. Second, to clearly define the property rights of rural house sites, innovate the transfer and replacement methods of house sites, and allow farmers to share the benefits from land appreciation. Third, to encourage private capital from industrial and commercial sectors to set up large-scale farms (such as pig farms) or enterprises of agricultural and sideline products, especially the enterprises integrating agricultural production, processing, and sale, and allow these enterprises to take over the land-use right of rural contracted land from farmers or directly absorb farmers’ land-use rights as capital stock. Fourth, to encourage banks to offer mortgages on the land-use right of rural contracted land. What changes will the capitalization of the rural land-use right transfer bring about? Supposing that each of the 160 million migrant rural workers owns 0.6 mu or 400 m2 (96 million mu in total, close to the 100 million mu vacant rural land) and the price for per mu land is RMB10,000, these migrant rural workers will get approximately RMB1 trillion from the capitalization of the land-use right transfer as seed capital. On the other hand, large-scale farming can be developed on the 100 million mu vacant rural land. However, the above calculation is just based on 160 million migrant rural workers and 100 million

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mu vacant rural land, and if we take into account 674 million total rural population and 1.8 billion mu (1.2 million km2) arable land, both urban and rural economies will grow by leaps and bounds and the millennium-long small-scale peasant economy will be completely reshaped. In this way, China will be able to have modern large-scale agriculture with features of scientific farming and intensive cultivation and Chinese farmers will truly receive stable property income from the capitalization of land.

Respect and Protect People’s Rights to Own and Control Capital In the previous parts, we talked about the recognition of workers’ (including intellectual workers’) ownership of capital and their participation of income distribution according to capital as well as the motivating of socialist workers to make investment, namely to devote parts of their consumption funds (as well as the goods and money from their materialized labor) to support socialist construction by delaying consumption. Now, we will move on to the topic of the rights of capital. We know that the socialist revolution imagined by Marx and Engels in the Communist Manifesto in 1847 was like those that happened in developed capitalist countries, such as the United Kingdom, in the 19th century. The ruthless exploitation by the capitalist class gave rise to the polarization between the rich and the poor and the expansion of the proletariat. The proletariat has to unite to overthrow the existing rule of the bourgeoisie and “will use its political supremacy to wrest, by degree, all capital from the bourgeoisie, to centralize all instruments of production in the hands of the State, i.e., of the proletariat organised as the ruling class; and to increase the total productive forces as rapidly as possible.”19 The problem is that as science and technology made remarkable progress and the capitalist productive forces developed rapidly, economies in developed countries became more prosperous and the governments adopted a series of policies and measures to reconcile class conflicts. Consequently, the extreme inequality anticipated by Marx and Engels did not appear and a huge middle class, which Marx and Engels failed to predict, arose instead. So, there was no violent socialist revolution in the countries where productive forces were highly developed, nor were there precedents for how to deal with the bourgeoisie after the workers came to power. However, Russia, after its revolution in the early 20th century, lagged behind in industrial development and capitalism was not fully developed there. China was a semi-colonial and semi-feudal society before 1949. Due to the double oppression

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from colonists and bureaucrats, the formation of national bourgeois capital and the private capital of the society as a whole were damaged and squeezed, social credit was not adequately developed, and the efficiency of capital formation was very low. After the successful revolution in 1949, China adopted a policy of “using, restricting, and transforming” towards capitalist industry and commerce. The rights of capital were greatly harmed since the government of New China announced the transition from new democracy to socialism, especially during the decade-long “Cultural Revolution” for the purpose of preventing the restoration of capitalism. After the founding of New China, the basis of the national economic system was the ownership by the whole people; but it was the state who exercised the power of capital formation and workers received low wages and practiced egalitarianism. They have not become the subject of capital accumulation and formation. Moreover, the system where the state acted as the subject of capital formation implemented in public-owned enterprises was admittedly very inefficient. After the Reform and Opening Up era began, the CPC advocated emancipating people’s minds, seeking truth from facts, keeping up with the times, and realizing inclusive growth. It implemented a policy of “letting part of the people get rich first,” allowed workers to become men of property, admitted that capital, the same as labor, technology, managerial expertise and other production factors, can participate in the distribution of income in accordance with their respective contributions, and clearly stated the necessity to “encourage, support and guide the development of the non-public sectors,” “create conditions to enable more citizens to have property income,” and “enlarge the proportion of the middleincome group.”20 The Constitution of the CPC passed during the 17th National Congress of the CPC not only claimed that “The Communist Party of China is the vanguard of the Chinese working class…. The realization of communism is the highest ideal and ultimate goal of the Party,” but also made it clear that the Communist Party of China is also the vanguard “of the Chinese people and the Chinese nation; It is the core of leadership for the cause of socialism with Chinese characteristics and represents the development trend of China’s advanced productive forces, the orientation of China’s advanced culture and the fundamental interests of the overwhelming majority of the Chinese people; and The Communist Party of China takes Marxism-Leninism, Mao Zedong Thought, Deng Xiaoping Theory, the important thought of Three Represents and the Scientific Outlook on Development as its guide to action.”21 Although the leftist thinking frequently triggered the discussion about whether the social and economic reforms were socialist or capitalist in the first 30 years of New China, the CPC and the Central government have made necessary preparations in major policies, the legal system, and public opinions to pave the way for workers to become men of

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property and advance steadily toward the goal of common prosperity. Currently, a noticeable phenomenon is that there is a wave of mass migrations of private entrepreneurs form China. According to China Private Wealth Report 2011 co-published by China Merchants Bank and Bain Capital in April 2011, among the large business owners with more than RMB100 million in investable assets, about 27% had completed investment immigration while almost half (47%) were considering submitting an application; and nearly 60% of Chinese high-net-worth individuals whose personal assets surpassed RMB10 million surveyed had either completed investment immigration, applied for investment immigration or were considering it.22 Not coincidently, in October 2011, Bank of China and Huren Research Institute released the Private Banking White Paper of 2011, and it showed that 14% of China’s wealthy had already emigrated overseas or were applying to do so, and 46% were considering moving abroad; and the percentages of people who had completed or were applying for emigration in the south, east, north, and west were 27%, 24%, 11%, and 9%, respectively, and those of people who were considering it in the four regions were 46%, 46% 50%, and 41%.23 The two reports reflected similar alertness of banks towards the loss of wealth. In fact, as early as May 24, 2011, People’s Daily published an article named “Remain Calm with the New Emigration Wave” authored by Qu Zhehan, Xu Zhifeng, and Tian Junrong. Why was there a new emigration wave? According to Ye Tan, there were mainly three reasons: Children’s education (58%), wealth security (43%), and preparation for retirement (32%). Other factors motivating investment immigration included: convenience for overseas investment or business development (16%), being easy for travel abroad (7%), to have more children (6%), and lower tax rate (6%). 24 It indicated that Chinese high-net-worth individuals were not satisfied with domestic education environment and worried about their property security and old age, whose causes were considered by Ye Tan as “three institutional defects in China.” Later, Xin Lijian added another defect — an unsound legal system, which led to businessgovernment collusion and incomplete and inaccurate information disclosure. First, based on their analysis, the educational defect is an inevitable result of the rigid education system. If the elementary education of China can still be expected to be competed internationally, its higher education has lost completely. As a result, current education in China cannot foster the elites who combine the merits from both Chinese culture and Western culture. Only by being roughly trained in China, further educated overseas, and introduced back to China, can Chinese students become the elite talents equipped with both knowledge of contemporary management concepts and market essentials.

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Second, property insecurity is the lingering shadow of the Chinese affluent class as well as a direct reflection of the lack of property rights regime in China. The wealth class is not only deterred by anti-rich movements in the Chinese history but also worried about the facts that the Ministry of Housing and Urban-Rural Development of China has outlawed the transfer of houses with limited property rights, local demolition authorities do not abide by law, the land-use right of residential building will expire after 70 years, and the Shanxi government has expelled coal mines speculators. So the rich Chinese choose investment immigration for fear that there will not be a property rights regime in China to protect their property. Third, although old-age pension schemes are not satisfactory everywhere in the world, Chinese high-net-worth individuals believe that developed countries can provide them with not only higher pensions to sustain a respectable life but also cleaner and fresher water, air, and food. This is the so-called natural environment premium. Fourth, the craze for Civil Service Examinations and the speculation fever in China reflect people’s worship of power and wealth while the unsound legal system and business-government collusion make the rich worried about the accuracy and completeness of information disclosure. Ye Tan thought that this emigration wave was a result of “the pursuit of wealth security and respectable lives on the basis of the recognition of domestic working opportunities; and certainly, immigration may not necessarily bring about respect or dignity, but immigrants could enjoy considerable freedom in thoughts and movement.” Ye said that emigration should not to be feared, “Taiwan also experienced mass migrations during its development, and when its economy picked up, many emigrants returned to Taiwan in search of personal development; and mass migrations also appeared in India and South Korea, and no fundamental harms were seen in these countries.” She added, “What should be of concern is that the majority of Chinese people, especially the elite class and the family members of corrupt officials, tend to live abroad, which reflected a huge rift between wealth and wealth protection and oversight mechanisms.” Therefore, Ye Tan drew a conclusion that “When more and more people or even over half of high-income earners have to search for security in other countries, it only indicates that the deficiencies in China’s basic system have shaken the foundation of academic freedom, fair distribution of wealth, and independence of property rights.” Her acute analysis is a wake-up call for us. Recently, mass migrations attracted more and more attention. Tao Dong commented, “Collective anxiety arises among Chinese entrepreneurs and their feeling of insecurity creeps up. This has a direct bearing to the current economic and social surroundings. China is a large country and we should not worry

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about the leaving of some people, but we must know clearly why these people decide to leave. If it is related to the defects in the country’s system, the Chinese government has to correct the wrongs immediately.” Han Zhiguo held the view that “The lack of sufficient legal protection aggravated the business environment in many places of China. The outflow of millionaires takes away a large amount of cash and if the money cannot circulate back to China due to the global economic recession, China will face the threat of economic collapse, which the Chinese government has to be alert to.” According to Feng Liguo, “Wealth outflow is a kind of voting with feet.” He explained that Deng Xiaoping encouraged “a group to get rich first and then help others achieve common prosperity, but now more than half of these who get rich first are transferring their wealth overseas, which Deng Xiaoping has never expected.” Therefore, policy-makers must first establish a system to protect the property owned by those who get rich first. Most views attributed the current mass migration to the defects in the country’s basic system, problems in economic and social mechanisms, and the lack of necessary legal protection, and demanded to build a property rights institution to protect the wealth of those who get rich first. Of course, we have no reasons to undermine our confidence in building a socialist society with Chinese characteristics just because of the temporary mass migration. But in view of many violations of the rights of capital in the Chinese history, there is a need to respect and protect the rights of capital. In 2002, the Report of the 16th National Congress of the CPC clearly announced that builders of socialism with Chinese characteristics included not only the working class, with the intellectuals as part of it, and the farmers whose incomes had ready increased, but also “emerging in the process of social changes, entrepreneurs, and technical personnel employed by non-public scientific and technological enterprises, managerial and technical staff employed by overseas-funded enterprises, the self-employed, private entrepreneurs, employees in intermediaries, freelance professionals and members of other social strata.”25 In reality, many self-employed and private entrepreneurs have heaped up a fortune and become high-net-worth individuals. But the continuity of the monopoly by state-owned enterprises, the blocking of the entry of private capital in several industries, the rent-seeking of some government departments and local officials, the suppression of private capital, and the use of torture towards private entrepreneurs as well as the illegal confiscation of their property are threats to capital security. Moreover, as China is now still at the primary stage of socialism, we have diversified capital owners, including not only owners of foreign-funded companies, Sino-foreign joint

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Socialist Workers and Capital

ventures, and domestic private companies, but also workers who became rich through their excellent work or patent inventions, managers who received stock ownership with their outstanding management skills, ordinary people who get rich through hard working and life-long accumulation, as well as individual investors who profited from investing in stocks, bonds, and real estate. It is imperative to further clarify the rights of capital, respect, protect and defend all the legitimate rights of capital owners in capital control, remove the resentment against the rich formed under the class-struggle education during the 30-year planned economy, investigate and redress unjust cases concerning the oppression of private capital, forced confession by torture towards private entrepreneurs, and illegal confiscation of personal property, and crack down on and strictly punish people who violate the rights of capital in order to provide solid ideological, theoretical, and legal bases for eliminating all wrongdoings towards the wealthy. Furthermore, the socialist society with Chinese characteristics that we are building now is one towards common prosperity. While the productive forces are highly developed, it is necessary to constantly expand the proportion of the middle-income group. Once China with a dual economic system advances beyond the primary stage of socialism and becomes a country where the middle class or medium- and high-income groups are the majority and the target of common prosperity is achieved, it still has to complete the task of respecting, protecting and defending the rights of capital. Of course, in theory, Marx pointed out that in the cooperative factories of the laborers themselves, “the antithesis between capital and labour is overcome within them, if at first only by way of making the associated labourers into their own capitalist, i.e., by enabling them to use the means of production for the employment of their own labour.” Therefore, in a socialist society where common prosperity is achieved and to constantly expand the proportion of the medium-income group becomes a characteristic of the middle class-dominated society, the antithesis between capital and labor will also be overcome as Marx has predicated. Just like in a cooperative factory, men of property will become the capitalists of their own, they will “use the means of production for the employment of their own labour.” For this reason, socialist countries should not only mobilize and give full play to the initiative of socialist workers in investment, encourage and arouse the enthusiasm and creativity of all men of property including workers to play the role of the subject of capital formation, and respect, protect, and defend all legitimate rights of the workers who own property in capital control. While leading workers towards common prosperity, socialist countries also have the responsibilities to respect and protect the rights of people to own and

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control capital in order to enable them to achieve great success in starting or operating a business. Feng Liguo posed a question concerning this mass migration: Did Deng Xiaoping expect that those people who get rich first would choose to emigrate? This is a good question. I think that the reason why the revolutionary party call for “Workers of all lands, Unite!” is by no means to make them continue being have-nots, but to lead them to achieve common prosperity by hard work and become men of property with medium or high incomes. Therefore, it is necessary for the revolutionary party to reiterate the importance of respecting and protecting the rights of people who get rich first to own capital and regard it as important as “defending the fruits of revolution.” The third and fourth generations of Chinese leaders after Deng Xiaoping have the responsibility to safeguard the fruits of revolution — ”let some people get rich first” and “common prosperity” — which Deng Xiaoping advocated and fought for the rest of his life. When I was ending this book, on November 29, 2011, the Xinhua News Agency carried a report about the Central Work Conference on Poverty Alleviation and Social Development. The Central authorities decided to raise the poverty threshold to RMB2,300 in terms of a farmer ’s annual net income, which marked a 92% rise from the RMB1,196 standard in 2009. It meant more low-income people would be qualified for government subsidies. Statistics indicated that this revision would boost the number of people deemed poor to 128 million by the end of 2011, accounting for 13.4% and 9.55% of the rural population and the country’s population, respectively. This act showed the determination of the Central government to improve people’s livelihood and achieve common prosperity. Through raising the poverty line, more low-income people would be able to share the benefits from the reforms. The objective of the Chinese government is to build a moderately prosperous society, but now the low-income group takes up around 70% of the total population, far from a country where the middle class is in the majority. China has become the second largest economy in the world and it is a collective achievement by the people all over the country, with low-income earners as a part of the contributors. How to bridge the gap between the country’s wealthy and poor classes should be a starting point for improving the income distribution policy in the near future as well as a central topic in the 18th National Congress of the CPC.

226

Notes Chapter 14 1.

According to the definition from Wikipedia, an “asset-backed security” is sometimes used as an umbrella term for a type of security backed by a pool of assets, and sometimes for a particular type of that security — one backed by consumer loans or loans, leases, or receivables other than real estate. Here it is used in the first case.

2.

Liu An, “The Latest Development and Contributions of Global Derivatives Markets.”

3.

“Andrew Sheng’s an Asian View of the Global Financial Crisis.”

4.

Shi Shiwei, “Crises Provoked Changes in the Global Economic Pattern.”

5.

Gorton, “Questions and Answers about the Financial Crisis.”

6.

Zhang Yuzhe, “How Far Is Asset Securitization?”

Chapter 15 1.

Cao Erjie, “Less Uncertainties and More Cushions — Views on the ‘327 Incident’ from another

2.

Enterprise bonds are a much larger and more actively traded sector of the Chinese bond market

Perspective.” compared to corporate bonds. Enterprise bonds are bonds issued by institutions affiliated to Central Government departments, enterprises solely funded by the state, state-controlled enterprises and other large-sized, state-owned entities. Enterprise bond issuance is subject to administrative approval for a quota from the National Development and Reform Commission (NDRC). On the contrary, corporate bonds can be issued by any company. Corporate bond issuance requires verification and approval from China Securities Regulatory Commission (CSRC).

Chapter 16 1. Kuhn, Investment Banking: The Art and Science of High-Stakes Dealmaking. 2.

Jiang Zemin. “Hold High the Great Banner of Deng Xiaoping Theor y for an All-Round Advancement of the Cause of Building Socialism with Chinese Characteristics to the 21st Century.”

3.

Huang Ming was a Professor of Finance at Johnson Graduate School of Management at Cornell University and Professor of Finance at the Cheung Kong Graduate School of Business. He also serves as an Associate Editor for The American Economic Review.

Chapter 17 1.

The World Bank, “China: Long-Term Development Issues and Options.”

2.

Qin Hui, “Residency Right of the New Urban Poor.”

227

Notes

3.

Xiao Ming, “National Development and Reform Commission Is Planning an Urban Agglomeration Layout of ‘Two Horizontal and Three Vertical Lines’.”

4.

Nouvelles D’Europe, “Beijing-Shanghai High-Speed Rail Brings about More than Just Speed.”

Chapter 18 1.

Marx, “The Circuit of Money Capital,” Chap.1 in The Process of Circulation of Capital, Vol.2 of

2.

Bai Qinxian, “Challenges and Inspiration from Economic Globalization and Economic

Das Capital. Financialization”; Ye Chusheng, “Economic Globalization and the Theoretical Development of Development Economics.” 3.

Guo Tongxin, “Relevant Issues on the Statistics and Proportion of the Service Industry in China.”

4.

Wang Xianzhi, “The Logistics Industry Is Burdened with Double Taxation, and the Reform of Business Tax Allows No Delay.”

5.

The English version is from the website of The Guide to P.R.C. Government Agencies, “Premier Wen Jiabao chaired a State Council executive meeting on June 8, which discussed and made plans to further increase financial investment in education and to promote healthy development of the logistics industry,” accessed April 14, 2014, http://test5.71online.com/html/fuwuye/3746.html.

Chapter 19 1.

Under the old housing system, housing was distributed directly to workers by their employers according to seniority and size of family. The workers were only expected to pay a low rent. However, the housing was owned either by the state, an enterprise, or a collective. See China Development Research Foundation, Constructing a Social Welfare System for All in China, 161.

2.

Marx and Engels, “Position of the Communists in Relation to the Various Existing Opposition Parties,” Chap. 4 in Manifesto of the Communist Party.

3.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

4. Ibid. 5.

Marx, “The Role of Credit in Capitalist Production,” Chap.27 in The Process of Capitalist

6.

Marx, “Letter from Marx to Engels on April 2, 1858,” Marx-Engels Correspondence 1858.

7.

Kasriel, “Chinese Consumers in 2020: A Look into the Future.”

8.

Hu Jintao, “Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for

Production as a Whole, Vol.3 of Das Kapital, 497–498.

New Victories in Building a Moderately Prosperous Society in all Respects.” 9. Krugman, The Conscience of a Liberal. 10.

Liu Di, “How Did Japan Create the Middle Class?”

11.

Wang Hongru, “The Income Distribution Reform Started Again.”

228

Notes

12.

Chen Guangjin, “Experts from Chinese Academy of Social Science: The Income Gap Is Widening

13.

Song Xiaowu, “The Income Gap Ratio between Industries Has Expanded to 15 Times, the Highest

and the Gini Coefficient Reached 0.5.” in the World.” 14.

Hu Jintao, “Hold High the Great Banner of Socialism with Chinese Characteristics and Strive for New Victories in Building a Moderately Prosperous Society in all Respects.”

15.

Hu Jintao, “Speech at the Meeting Commemorating the 90th Anniversary of the Founding of the

16.

Heckman, “China’s Human Capital Investment.”

17.

Chen Huai, “Real Estate Development and China’s National Conditions.”

18.

Li Xingwen, Li Song, and Zhang Xingjun, “The Total Area of China’s Arable Land Approaches the

CPC”; the English version is from http://www.kouyi.org/conference/1650.html.

1.8 Billion Mu Warning Line, and the Rural Vacant Land Exceeds 100 Million Mu.” 19.

Marx and Engels, “Proletarians and Communists,” Chap 2 in Manifesto of the Communist Party.

20.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

21.

Constitution of the Communist Party of China.

22.

China Merchants Bank and Bain Capital, China Private Wealth Report 2011, 37.

23.

Bank of China and Huren Research Institute, Private Banking White Paper of 2011.

24.

Ye Tan, “Three Institutional Defects Impelled the Migration Wave.”

25.

Jiang Zemin, “Build a Well-Off Society in an All-Round Way and Create a New Situation in Building Socialism with Chinese Characteristics.”

229

References Chapter 14 Chinese materials: “2008: Shijie jingji yu Zhongguo jingji mianlin de xin tiaozhan” 2008：世界經濟

與中國經濟面臨的新挑戰 (New Challenges Faced by the World’s Economy

and China’s Economy). Economic Herald 經濟導刊, January 14, 2008.

Ba Shusong 巴曙松. “Jianshe geng ju tanxing, geng kang chongji de chuangxin xing jinrong shichang: Ba Shusong jiaoshou lun Meiguo ciji zhai fengbo de

jiaoxun” 建設更具彈性、更抗衝擊的創新型金融市場——巴曙松教授論美

國次級債風波的教訓 (Building a More Flexible and More Shock-Resistant

Innovative Financial Market: Lessons Learned From the U.S. Subprime Mortgage Crisis). Sina Blog of Ba Shusong 巴曙松博客, September 23, 2007.

“Ci dai weiji yi zhounian: Qingsuan Gelin sipan” 次貸危機一周年：清算格林斯潘 (The First Anniversary of Subprime Mortgage Crisis: Examine Greenspan’s Performance). Xinmin Weekly 新民週刊, April 09, 2008.

Jiang Jianqing 姜建清 , and Li Yong 李勇 . “Guanyu shangye yinhang zichan

zhengquan hua” 關於商業銀行資產證券化 (On Asset Securitization of Commercial Banks). Financial News 金融時報, November 09, 2004.

Liu An 柳岸 . “Quanqiu jinrong yanshengpin shichang de zuixin fazhan ji qi gongxian” 全球金融衍生品市場的最新發展及其貢獻 (The Latest

Development and Contributions of Global Derivatives Markets). Futures Daily 期貨日報, April 16, 2007. http://www.federalreserve.gov/

BoardDocs/Speeches/2002/200209253/default.htm (accessed January 02, 2014).

“Meiguo ci dai weiji chuandao luxian tu” 美國次貸危機傳導路線圖 (The Roadmap of U.S. Subprime Mortgage Crisis). Globe 環球, March 2008.

Qiao Xiaohui 喬曉會, Hu Caiping 胡采蘋, Jin Yan 金焱, and Liu Bo 劉波. “Huaerjie

chong su misi” 華爾街重塑迷思 (Reshape the Math of Wall Street). Caijing Magazine 財經, (18) (2010).

Research Group of Subprime Mortgage Crisis. Ci dai fengbo qishi lu 次貸風波

啟示錄 (Subprime Mortgage Crisis). Beijing: China Financial Publishing

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Shen Liantao (Andrew Shen) 沈聯濤. “Quanqiu jinrong tixi yu shiti jingji yijing

tuojie” 全球金融體系與實體經濟已脫節 (The Global Financial System Has Been Divorced from Real Economy). Caixin.com 財新網, May 20, 2011

Shi Hanbing 時寒冰 . “Ci dai yu jinrong paomo de zhongjie” 次債與金融泡沫 的終結 (Subprime Mortgages and the End of Financial Bubbles). South

Reviews 南風窗, April 2008.

Shi Shiwei 史世偉 . “Weiji cushi quanqiu jingji geju bianhua” 危機促使全球經

濟格局變化 (Crises Provoked Changes in the Global Economic Pattern).

China Economic Times 中國經濟時報, February 11, 2011.

Tang Shisheng 湯世生. “Cong Meiguo ciji daikuan wenti kan Zhongguo jinrong

chuangxin zhilu” 從美國次級債問題看中國金融創新之路 (To Consider

the Path of China’s Financial Innovations from U.S. Subprime Mortgage Crisis). Modern Bankers 當代金融家, March 2008.

Wang Qishan 王岐山. “Zhiyan jinrong weiji yuanzi tanlan” 直言金融危機源自貪 婪 (Financial Crisis Originated from Greedy). Address at the Celebration

of the 80th Anniversary of Bank of China London Branch. Chinanews. com 中國新聞網, May 12, 2009.

Wang Zhaoyang 王昭陽. “Ju zhe you qi wu” 居者有其屋 (Home Ownership for All). Century Weekly 新世紀, (17) (2010).

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Wu Xuean 吳學安 . “Ci dai fengbo yubo wei liao” “次貸風波”餘波未了 (The

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經濟時報, April 24, 2008.

Xie Guozhong 謝國忠 . “Xia yi chang fengbao 6 yue kaishi” 下一場風暴6月開

始 (The Next Crisis Will Come in June). Caijing Magazine 財經, March 31,

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Xin Qiaoli 辛喬利, and Sun Zhaodong 孫兆東. Ci dai weiji 次貸危機 (Subprime Crisis). Beijing: China Economic Publishing House, 2008.

Yin Jianfeng 殷劍峰. “Meiguo ciji anjie daikuan zhengquan fengbo pouxi” 美國 次級按揭貸款證券風波剖析 (Dissect the U.S. Subprime Mortgage Crisis).

China Securities Journal 中國證券報, August 13, 2007.

Zhang Yuzhe 張宇哲. “Zichan zhengquan hua haiyou duoyuan” 資產證券化還有多 遠 (How Far Is Asset Securitization?). Century Weekly 新世紀, (31) (2010).

Zhong Wei 鐘偉 . “Meiguo ciji zhai shichang de xianzhaung jiqi shenyuan

yingxiang” 美國次級債市場的現狀及其深遠影響 (The Status Quo and

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Zhu Xiaohuang 朱小黃. “Ci dai weiji: Huo qi ganggan shikong” 次貸危機：禍 起杠杆失控 (Subprime Mortgage Crisis: Originating from Out-of-Control

Leverage). In Lin yuan jie wang 臨淵結網 (Take Actions at the Very Last

Moment). Beijing: Economy and Management Publishing House, 2008.

English material: Shen Liantao (Andrew Shen) 沈聯濤 . “Andrew Sheng’s an Asian View of the

Global Financial Crisis.” Malaysia Finance Blog, http://malaysiafinance. blogspot.hk/2009/03/andrew-shengs-asian-view-of-global.html (accessed January 02, 2014).

Translated materials: Goodman, Laurie S., and Frank J. Fabozzi. COD de jiegou yu fenxi COD的結構與

分析 (Collateralized Debt Obligations: Structures and Analysis). Trans.

Shanghai Wincom Investment Management Co., Ltd. 上海永嘉投資管理有

限公司. Beijing: China Machine Press, 2005.

Gorton, Gary. “Guanyu ci ci quanqiu jinrong weiji de ba ge weishenme” 關於此

次全球金融危機的八個為什麼 (Questions and Answers about the Financial

Crisis). Trans. Wang Yu 王宇 . China Economic Times 中國經濟時報 , April 08, 2010.

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Chapter 15 Chinese materials: Cao Erjie 曹爾階 . “Guanyu gufenzhi he gupiao shichang de jige lilun renshi

wenti” 關於股份制和股票市場的幾個理論認識問題 (Several Theoretical

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———. “Ziben yunying: Women mianlin de xin keti” 資本運營:我們面臨的新課 題 (Capital Operation: A New Challenge for Us). Financial News 金融時報,

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Guo Tongxin 郭同欣. “Guanyu woguo fuwu ye tongji he zhanbi de youguan wenti”

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Huang Yiping 黃益平. “Renminbi li guoji huobi you duoyuan?” 人民幣離國際貨幣 有多遠？ (How Far Is Renminbi from an International Currency?). Century

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Li Keqiang 李克強. “Guanyu tiaozheng jingji jiegou cujin chixu fazhan de jige

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Liang Da 梁達. “Woguo fuwu ye fazhan jixu tisu” 我國服務業發展亟須提速 (China’s Service Industry Is in Desperate Need of Accelerated Development). Shanghai Securities News 上海證券報, April 11, 2011.

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Wang Xianzhi 王先知. “Wuliu ye bukan chongfu shoushui zhongfu, yingyeshui

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2003.

———. “Rang laodong zhe chengwei you chan zhe” 讓勞動者成為有產者 (To Turn Workers in Men of Property). International aviation News 國際航空報,

April 17, 2000.

Chen Guangjin 陳光金. “She ke yuan zhuanjia: Shehui shouru chaju kuoda, jinni

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Chen Xiaofeng 陳曉楓. “Yingxiang jumin caichan xing shouru zengzhang de

yinsu fenxi” 影響居民財產性收入增長的因素分析 (The Analysis of the Factors Affecting the Growth of Property Income). Economic Issues in China 中國經濟問題, (1) (2010).

Feng Liguo 馮立果. “Xian fu er yimin, Deng Xiaoping liao dao le ma” 先富而移 民，鄧小平料到了嗎 (Did Deng Xiaoping Expect Those Who Get Rich First

Emigrate Later?). Caijing.com.cn 財經網, November 04, 2011.

Han Zhiguo 韓志國. “Fuhao yimin huo zhi Zhongguo jingji bengkui” 富豪移 民或致中國經濟崩潰 (The Emigration of China’s Wealthy May Cause the

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2011.

Hu Jintao 胡錦濤. “Zai qingzhu Zhongguo gongchandang chengli 90 zhounian

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Li Xingwen 李興文, Li Song 李松, and Zhang Xingjun 張興軍. “Woguo gengdi

zongshu jiejin 18 yi mu hongxian, kongzhi mianji chao 1 yi mu” 我國耕地

總數接近18億畝紅線，空置面積超1億畝 (The Total Area of China’s Arable

Land Approaches the 1.8 Billion Mu Warning Line, and the Rural Vacant Land Exceeds 100 Million Mu). China Comment 半月談, (3) (2011).

Liang Da 梁達. “Ying dali tigao jumin caichan xing shouru bizhong” 應大力提 高居民財產性收入比重 (To Greatly Increase the Proportion of Property

Income in Residents Total Income). Shanghai Securities News 上海證券報, March 14, 2011.

Liu Di 劉迪. “Riben shi ruhe zaojiu zhongchan jieji de” 日本是如何造就中產階

級的 (How Did Japan Create the Middle Class?). Eastday.com 東方網,

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Lou Jiwei 樓繼偉. “Jixu shenhua gaige de jidian sikao” 繼續深化改革的幾點思考 (Some Thoughts on Continuously Deepening the Reform). Century Weekly 新世紀, (27) (2011).

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Qu Zhehan 曲哲涵, Xu Zhifeng 許志峰, and Tian Junrong 田俊榮. “Lengjing miandui ‘xin yimin chao’ ” 冷靜面對“新移民潮” (Remain Calm with the New Emigration Wave). People’s Daily 人民日報, May 24, 2011.

Ren Lixuan 任理軒. “Kexue renshi he jiejue shouru fenpei wenti” 科學認識和解決 收入分配問題 (To Understand and Solve the Income Distribution Problem

in a Scientific Way). People’s Daily 人民日報, July 22, 2011.

Song Xiaowu 宋曉梧. “Tiaozheng shouru fenpei jiegou, zhuanbian jingji

f a z h a n f a n g s h i ” 調整收入分配結構，轉變經濟發展方式 ( A d j u s t t h e

Income Distribution Pattern, and Transform the Economic Development

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———. “Zhongguo butong hangye shouru chaju kuoda zhi 15 bei, yueju shijie shouwei” 中國不同行業收入差距擴大至15倍躍居世界首位 (The Income Gap

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Sun Zifa 孫自法. “Zhongguo shouru chaju cheng jixu kuoda qushi” 中國收入差距呈繼

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Tao Dong 陶東 . “Touzi yinmin chao” 投資移民潮 (The Wave of Investment Immigration). Caijing.com.cn 財經網, November 10, 2011.

Wang Hongru 王紅茹. “Shouru fenpei gaige zai qibu” 收入分配改革再起步 (The

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“Wang Zhen fangwen Yingguo de gushi” 王震訪問英國的故事 (The Visit of China’s

Vice Premier Wang Zhen to the United Kingdom). Yanhuangchunqiu 炎黃春秋

(China Chronicle), (3) (2008).

Xin Lijian 信力建. “Ping shenme yao xianzhi furen yimin” 憑什麼要限制富人移民 (Why

Should the Chinese Government Restrict the Emigration of the Rich?). China

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Yang Yiyong 楊宜勇. “Dui kuoda zhongdeng shouru zhe bizhong de shidian renshi” 對

擴大中等收入者比重的十點認識 (Ten Points of Understanding Concerning the

Expansion of the Middle-Income Group). China Economic Times 中國經濟時報,

August 23, 2005.

Ye Tan 葉檀. “San da zhejia bichu yimin chao” 三大折價逼出移民潮 (Three Institutional Defects Impelled the Migration Wave). Nanfang City News 南方都市報, October

16, 2011.

Zhao Renwei 趙人偉. “ ‘Rang gengduo qunzhong yongyou caichan xing shouru’ de

zhenyi” “讓更多群眾擁有財產性收入”的真義 (The True Meaning of “Enabling

More Citizens to Have Property Income”). Beijing Daily 北京日報, November 07,

2007.

“Zhongguo chengshi fazhan baogao No.4 — Jujiao minsheng” 中國城市發展報告

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quanmian jianshe xiaokang shehui xin shengli er fengdou” 高舉中國特 色社會主義偉大旗幟，為奪取全面建設小康社會新勝利而奮鬥 (Hold High

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244

Index A-Share Market 83, 214 accounts, current 155, 160-1, 163, 165 acquisitions 51-3, 56-7, 66, 70, 86, 88-9, 93-4, 96-7, 151, 166 agglomeration, economies of 107, 130, 132-3 American International Group (AIG) 2-3 arbitrages 14-15, 22 areas, metropolitan 112, 124, 127-8, 132, 137-8, 172 asset-backed securities (ABSs) 4-6, 11-12, 15, 24 asset management 50, 148, 214 asset reorganizations 53-4, 82-3, 85, 88, 93 asset securitization 2-9, 11, 13-15, 17, 19, 21, 23-7, 145, 150-2 asset securitization market 6, 24 asset securitization products 6, 11, 14, 16, 23-4, 26 Bank of China (BOC) 49, 56, 77 Bank of Communications (BOCOM) 56-7, 77, 82 banking panics 18-19, 21 banks, merchant 50, 55-6 Beijing Enterprises Holdings Limited (BEHL) 73-4, 91-2 Beijing-Shanghai High-Speed R ailway 123-5 bond market 4, 13, 23, 60 inter-bank 23 business-government collusion 222-3 business mergers 50, 52, 56-7, 59, 62-3, 65, 93, 96, 151, 166 business tax (BT) 178-80

capital rights of 220-1, 224-5 social 66, 85, 88, 207 speculative 165-6, 172 capital adequacy ratio (CAR) 4 capital formation mechanism 4-5, 106, 108, 110, 115 capital market reform 215 capital operation 47, 49-51, 53-9, 61-7, 69-79, 81, 83, 85, 87, 89, 91-3, 95-7, 99, 148 Chicago Board of Trade (CBOT) 32, 36 Chicago Mercantile Exchange (CME) 302, 36 China Banking Regulatory Commission (CBRC) 14, 23, 60-1 China concepts stocks 73, 91 China Construction Bank (CCB) 23, 48-9, 55, 57-8, 77, 179 China Development Bank 23-4 China Financial Futures E xchange (CFFEX) 32, 39 C h i n a Hu a r o n g A s s e t M a n a g e m e n t Company 23 China Insurance Regulatory Commission (CIRC) 24 China Investment Consulting Company (CICOC) 55, 104 China Merchants Group (CMG) 68 China National Petroleum Corporation (CNPC) 82 China Securities Regulatory Commission (CSRC) 60, 217 China State Construction Engineering Corporation (CSCEC) 69 China Strategic Holdings Limited 70-2 China Telecom 75-6, 92 China Venture Capital 88-9 Chinese Academy of Social Sciences (CASS) 202-3

245

Index

Chinese high-net-worth individuals 222-3 Chinese People’s Political Consultative Conference (CPPCC) 177, 184 cities medium-sized 106, 118-19, 132, 211 small-sized 119, 128 city clusters 112, 120, 123-4, 126, 132, 136 collateralized debt obligation (CDOs) 2-3, 6-8, 11-13, 22, 25, 167 commercial mortgage-backed securities (CMBSs) 6 companies, shell 66, 68 comparative cost 132, 143, 157-8 consumer price index (CPI) 205, 213 consumer services 145-6 consumption, delayed 187, 195 contracted land 219 corporate control 71, 94-6 transfer of 94-6 credit assets 2, 5-6, 23, 167 credit default swap (CDS) 6-8, 11-13, 15, 22, 25-6, 167 credit system 45-6 debt-for-equity swap 58-9 default risk 8, 11 demographic dividend 130, 132-3 derivative products 25, 35, 98, 167 derivatives market 11-12, 32, 98-9, 148, 151-2, 157, 167 differential ground rents 130, 132-3 distribution, primary 203-4, 210-11 domestic demand 116, 122-4, 140, 171 economic financialization 150-4, 161, 166-8, 172 economic globalization 144, 149, 152-4, 156, 158, 160, 162, 165-6, 173 economies asset-dependent 158-9 real 12, 16, 36, 39, 144, 151-4, 167, 171-2

246

virtual 12, 16 emerging industries 127, 147 enterprise bonds 4, 39, 60 equity disputes 94, 96 equity financing 39, 43, 48, 67, 69, 89-90 Euro-dollar market 50-1, 151 excessive speculation 37-8, 43, 45, 52, 84, 88 exchange rates, floating 31, 140, 165 farmers income of 205, 210 per capita property income of 205 farmers-turned workers 116, 122, 130, 133, 135, 205 fictitious economy 3, 144-5, 149-53, 156-7, 159, 161, 167-8, 171-2 finance direct 53-4, 66, 151, 153, 167 indirect 24, 49, 53, 145, 153, 162 financial crisis 2, 13-14, 16-19, 76, 92, 97, 99, 115-16, 127, 163, 165-7, 170 financial interrelations ratio (FIR) 152-3 fixed exchange rate system 30-1 funds, mutual 3, 12, 14, 19-20, 35, 216-17 futures contracts 30-1, 33-4, 37, 42 f utures markets 29-33, 35-9, 41, 43, 45, 167 Gini coefficient 201-3 global currency 139-41, 143, 145, 147, 149, 151, 155, 157, 159, 161-5, 167, 169, 1713, 175, 177 global financial crisis 2, 8, 14-15, 17-19, 23, 117, 120, 122-3, 155, 162-3, 167-8, 170-1 government bonds 6, 37-8, 52, 129, 161, 171 g over n m ent i nter vent i o n 2 2 - 3 , 7 0 , 110, 173 government investment 116, 129, 181 Government National Mortgage Association (GNMA) 32

Index

gross national product (GNP) 152, 197 group, low-income 190, 204-5, 207-8, 213, 226 growth enterprise market (GEM) 77 growth rate, annual 9, 120-1, 137, 143, 181, 198, 200 hegemony, financial 162, 166-7, 171 high-speed railways 112, 123-6, 128, 130, 136-8 Hong Kong Futures Exchange (HKFE) 36 Hong Kong Securities Clearing Company (HKSCC) 36 Hong Kong Stock Exchange 36, 66-9 Hong Kong Telecom 96-7 housing system reform 188-90 human capital 94, 156, 187-8, 209-10 imbalance, international economic 154-6 immigrants, illegal 134-5 income annual household 102, 193, 197 disposable 158, 201, 213 income disparity 202-3 income distribution 188, 191-2, 194-5, 203-6, 210-11, 213, 220-1 income distribution ratio 204 income distribution system 194, 199 income gap 201-2, 205-6, 208 income inequality 203, 207 income tax individual 207 unitary 207 Industrial and Commercial Bank of China (ICBC) 23, 49, 77, 82 industrial capital 54, 110, 114-16, 131, 133, 144, 149, 156, 166, 168 industrial clusters 148 industrialization 51, 63, 106-7, 110, 117-18, 120-3, 130, 144-7, 173, 181, 202-3, 209

industries secondary 145, 147-8 tertiary 108, 126, 145-7, 173 Initial public offerings (IPOs) 39, 66, 68-9, 76, 78, 82-3, 89-90, 92 institutional investors 2, 5, 7, 11-12, 14, 17-18, 20, 22, 25, 27, 37, 79-83 insurance companies 12, 15, 50, 79, 177 intellectual services 51, 54, 62-3, 78-9, 81, 92-4, 96-7, 152 International Economic Association (IEA) 207 International Monetary Fund (IMF) 10, 154, 166 International Monetary Market (IMM) 31 investment banking 50, 52-3, 55-8, 150 mentality of 49, 56-61 investment banking industry 50-6, 96-8, 167, 179 investment banks 3, 5-7, 9-17, 19, 21-3, 25, 27, 47-59, 61-7, 69, 71, 73-9, 81-3, 89-93, 95-9 investment channels 39, 213-14 investment funds 3, 79-80, 216-17 investment immigration 222-3 investors, individual 30, 80, 216-17, 225 labor division of 75, 109, 146, 173, 178-9 materialized 195, 220 mental 185, 191 labor income 187, 195, 204, 211 land, capitalization of 219-20 land prices, a negative 114 land reform 190, 219 land transfer 205-6, 219 legal person shares 85, 94 liquidity crisis 2, 4-5 logistics industry 174-5, 180-1 Longgang Town 102-6 low-income earners 186, 209, 213, 226 management, financial 45, 49, 57, 169, 213

247

Index

manufacturing capital 149, 157, 159 cross-border transfer of 160, 171 market full-circulation 77, 83-4 parallel 84-5 market capitalization 67, 91, 154 market-oriented reform 37, 114, 144 mass migrations 222-3, 226 men of property 186, 188-90, 221, 225-6 middle-income earners 189-90, 192-3 middle-income group 190, 192-3, 203, 208-9, 211-12, 214, 221, 225 migrant workers 123, 130, 133-5, 199 modern service industry 108, 112, 145-8, 156, 173-4, 176, 179, 181 monopoly industries 205-6 mortgage-backed securities (MBSs) 2, 6, 10, 12-14, 32, 86, 94 mortgage loans 6, 8, 11

National Bureau of Statistics of China 200, 202 Na t i o n a l D e v e l o p m e n t a n d R e f o r m Commission (NDRC) 60-1, 175, 206 National People’s Congress (NPC) 86, 131, 177, 188, 202 negotiated transfer 59, 84-9 New Deal 196-7 non-tradable shares, negotiated transfer of 84, 86, 88-9 olive-shaped society 107, 193-4, 197, 199 overproduction 122 parallel banking system 15, 17, 19-20, 22, 27 per capita GDP 181, 193 planned economy 38, 55, 57, 64, 71, 169, 199, 225

248

Plaza Accord 140-1, 143 price difference 42-3, 79, 83-4, 86 price elasticity 36 primary market 43, 50, 78-81, 90, 93 principle of comparative cost 132, 143, 157-8 private capital 46, 88, 95-6, 104, 113, 173, 189, 219, 221, 224-5 producer services 146-8, 179 profit maximization 64, 94-5, 114-15, 151 property income 158-9, 186, 199-201, 204-5, 211-19, 221 property rights regime 223 real estate investment trust (REIT) 6 real estate market 8, 12, 38-9, 159, 217 Reform and Opening Up 16, 49, 56-7, 59, 66, 69, 71, 102, 113, 118, 121, 126, 131, 153, 169-70 repo market 17-18, 20-2, 27 revolution financial 2, 140, 144-5 urban 109, 112-13 rural migrant workers 121-3, 127, 133-5, 198 scale, economies of 93, 109, 119, 130, 132-3, 176 scandal, 327 bond futures 36-8 secondary market 2, 24, 43, 50, 75, 78-81, 85, 88, 93, 189 securities, asset-backed 2, 4, 20, 23, 152 securities markets 15, 33, 41, 43-6, 72, 80, 93, 151, 167, 216 securitization 4-5, 19-20, 22-3, 25, 63, 145, 151, 153 securitized products 5-6 service industry 119, 145-7, 150, 156, 169, 171-3, 176-9, 181, 206 Shanghai Industrial Holding Limited (SIHL) 72-4, 91-2

Index

Sino-foreign China International Capital Corporation Limited (CICC) 53, 55-6, 58, 76, 92 socialism builders of 190-1, 224 primary stage of 192-6, 224-5 socialist market economy 25, 38, 55, 64, 71, 121, 169, 186, 203, 211 socialization 53, 145-8, 156, 173, 179, 192 special purpose vehicles (SPVs) 6 speculation 13, 40-6, 75, 78, 81-2, 85, 88, 184 state-owned enterprise reform 65, 71-2 state-owned enterprises 49, 58-9, 65, 71-2, 74, 80-3, 85, 88-9, 95, 173, 189, 206-7, 224 state-owned shares 83-9, 94-6 negotiated transfer of 85-6 state shares circulation 87 Stock Exchange of Hong Kong (SEHK) 36 stock index futures 32, 34-5, 38-9, 42 stocks, red chip 69-70, 73-5, 91 Structured investment vehicle (SIV) 15 subprime mortgage loans 8-10, 12, 14, 19, 26, 96 subprime mortgage market 9-10 subprime mortgages 8-12, 19, 97, 155, 163, 167 supply chain management 174-5, 177 surplus capital 2, 5, 54, 150 surplus labor income 195, 203-4 synergy effect 93-4

Treasury bonds 4, 11, 18, 37 unfair capital operation 60, 78, 83-9 urban agglomerations 112, 120, 125, 127-8, 136-8 urban economy 101, 103, 105-10, 113-17, 119, 121, 123, 125, 127-9, 131-5, 137 urban infrastructure capital 108, 110, 113-16 urbanization 106-7, 109-10, 112, 117, 119-24, 126, 128, 130, 133, 135-8, 171, 181, 202, 205, 211 urbanization bonus 130-1, 133-5 urbanization rate 117-18, 120-2, 137 value-added tax (VAT) 113-14, 178-9 value discovery 37, 57, 59, 78, 86, 151-2 VAT reform 179 World Bank 55-6, 58, 132, 163, 166, 175, 201

time-space compression 101, 103, 105, 107, 109-13, 115, 117, 119, 121, 123-5, 127-9, 131-3, 135, 137 trade deficit 155, 157, 161 trade surplus 140, 150, 155, 160-1 transfer-operate-transfer (TOT) 72, 115 transformation, economic str uctural 123-4, 128 Treasury bond futures 37-9

249