The authors contributing to this issue of China Currents in one way or another touch on this decades old but intensely current question. Has China finally reached a tipping point where Beijing must fundamentally reform its political structure or face an end to what ranks as one of the most stunning examples of economic emergence in world history? Andrew Wedeman explains how corruption on a massive scale has become an integral part of the China economic model, but that it now threatens forward momentum. Yawei Liu, in his analysis of the recently held Party Congress, argues that the tipping point is indeed near. Vijaya Subrahmanyam makes a case for the benefits to Chinese companies and investors of permitting foreign companies greater market access — just the kinds of policies that would be more likely in a pluralistic political system.

Opinion piece writers Penelope Prime, John Garver, and William Foster also make arguments that relate to the question of political reform in China. Prime and Garver point out how China became a bogeyman in the recently concluded U.S. presidential election campaign. A democratic China would be far less likely to be framed in such a way, making needed bi-lateral cooperation much easier. Foster argues that the Chinese multinational Huawei has been unfairly made a scapegoat in U.S. efforts to focus attention on Chinese hacking and industrial espionage. Huawei, Foster argues, has technology the U.S. needs and is independent and powerful enough to withstand demands from China’s security apparatus. It is an argument that would be a much easier sell if China were to make a turn toward democracy.

The pictures used in this issue of China Currents are courtesy of David Hoyt.

The post Editor’s Note appeared first on China Research Center.

Stunning though the spread of corruption after the adoption of economic reforms may be, it is only half the story. At the same time corruption was increasing, China’s economy also grew rapidly. Between 1980 and 2010, Gross Domestic Product (GDP) per capita increased thirteen- fold, according to the International Monetary Fund. China, in fact, had the second-largest gain in per capita GDP globally during this period, two times more than the next-best performer (South Korea) and almost eight times more than the United States, where per capita GDP increased only 65% in these three decades. Equatorial Guinea, which was the only country to outperform China, grew not as a result of sustained economic expansion, but because it struck oil and went almost overnight from abject poverty to vast wealth – wealth that was being swiftly stripped away by a government far more corrupt than China’s. China thus not only experienced rising corruption as it moved from a command economy toward a market economy, it also experienced rapid growth, a combination that economists suggest is unlikely, if not impossible.

The worsening of corruption during the reform period thus confronts students of contemporary China’s political economy with a series of questions. First, why did corruption worsen? Second, what forms did this new corruption take? Third, why has worsening corruption not slowed or even retarded China’s economic growth?

In the pages that follow, I will address these questions to explain why China was able to experience concurrent rising corruption and rapid economic growth.

Rising Corruption

After seizing power in 1949, the CCP cracked down on corruption in a series of major campaigns. In late 1951, the party launched the Three Antis Campaign against corruption, waste, and bureaucratism. In January 1952, the Five Antis Campaign targeted bribery, tax evasion, theft of state property, bid rigging, and the theft of state economic information. The following year, the New Five Antis Campaign struck at bureacratism, commandism, and other violations of law and disciplinary regulations by state officials and party cadres. Subsequent campaigns, including the Socialist Education Movement (1963-66) and the One Strike, Three Antis Campaign (1970-72) attacked other forms of official malfeasance. By the late Maoist period, these repeated attacks on corruption and the political environment ushered in by the Cultural Revolution had largely eradicated most visible manifestations of corruption.

Corruption was, however, far from eliminated. On the contrary, during the 1960s and 1970s a new culture emerged in which individuals sought to cultivate personal relationships (guanxi) that would allow them to slip “through the backdoor” (zou huomen) to obtain scare commodities, get admission to schools, find work, and seek favors from bureaucrats and officials. At the time, money was of secondary importance because it alone could not buy rationed goods or access. More often, people seeking to build relationships and get favors relied on “gifts” of cigarettes, liquor, meat, and other hard-to-find commodities. Officials often peddled equally mundane goods – ration cards or a “chop” on a document. There were, of course, more egregious cases of corruption, including that of Wang Shouxin, a mid-level official whose position as head of a local coal supply unit enabled her to spin a web of illegal deals that netted her and her confederates the then-princely sum of Y500,000 (US$320,000).

In the early and mid-1980s, petty corruption flourished. Many goods remained in short supply and would-be buyers found that they still had to present officials with a carton of cigarettes and a couple of bottles of Chinese liquor (baijiu) to obtain ration cards. Would-be entrepreneurs and private businessmen seeking to establish new enterprises also found the only way to navigate the thickets of red tape was to use personal connections and, increasingly, cash. In the mid-1980s, the party decided to put off comprehensive price reform in favor of a hybrid system wherein commodity prices were fixed by the state based on whether they were being sold within the state-planned economy or in emerging markets. Because ongoing scarcity ensured that market prices were generally much higher than in-plan prices, officials found they could earn quick profits by diverting goods out of the planned sector and onto the market. Arbitraging between the two sectors created by the so-called “two track” price system, and fueled a wave of “official profiteering” (guandao) during the late 1980s. By the later 1980s, official profiteering had become so widespread and visible that the perception that corruption was enabling officials reap the lion’s share of \ gains from reform became a major factor intensifying support for the anti-government demonstrations that swept China in the spring of 1989.

Faced with rising corruption and evidence that corruption was undermining its legitimacy, the CCP cracked down, first in 1982, then again in 1986, and a third time in July 1989. In each campaign, the government announced it had substantially increased the number of officials charged with corruption, made a show of putting the “big tigers” it had caught on trial, and, in some cases, publicly executing corrupt officials. Despite these repeated crackdowns, the best available evidence suggests that corruption increased substantially during the 1980s. The Procuratorate “filed” 9,000 corruption-related cases in 1980, the 1989 anti-corruption campaign yielded some 77,400 cases. Thereafter, the average number of cases hovered around 60,000 from 1991 to 1997. Revision of the criminal code in 1997 resulted in the decriminalization of a range of lesser offenses, and dropped the average number of cases filed to approximately 32,000.

In the early 1990s, after a second round of reforms, corruption intensified. By the mid-’90s more senior-level officials had become corrupt; they were now “auctioning off” control rights for enterprises and real estate and receiving much larger illicit payoffs in return. In 1995, for example, the Party Secretary of Beijing, Chen Xitong, who was also a member of the party’s core leadership, was caught raking in millions of dollars in “commissions” from real estate developers. The number of cases involving senior officials (defined in Chinese law as those holding leadership positions at or above the county level) shot up from a dozen a year in the mid-1980s to an annual average of 2,500. The amount of money reportedly recovered per case jumped from Y4,000 (US$1,700) in 1984 to Y42,000 (US$4,900) a decade later. Four years later in 1998, the amount exceed Y121,000 (US$14,600), and in 2007 the Procuratorate reported it recovered funds averaging more than Y273,000 (US$35,800). Meanwhile, the party’s Discipline Inspection Commission, which has responsibility for maintain intra-party discipline, was sanctioning around 150,000 party members a year, one-third of them for corruption-related infractions.

As corruption got worse, the party fought back. But the effectiveness of China’s anti-corruption effort has been questioned. Official statistics, however, show that about 10,000 officials are sent to prison each year on corruption charges and an additional 20,000 receive lesser punishments. Among those sentenced to prison, roughly 5,000 received sentences ranging from five years to life. Almost 400 individuals are known to have been sentenced to death; an additional 240 got “suspended death sentences.” To date, there is no hard or convincing evidence the war on corruption has had a significant effect. Some evidence, however, suggests that corruption actually has worsened over the past decade. So it would appear the war on corruption has succeeded in the sense that it has brought corruption under control.

Assessments by outside experts also suggest some degree of improvement. According to Transparency International’s index (using a scale of 1 to 10, with 10 as the most corrupt), corruption in China dropped from a high of 7.57 in 1995 to either 6.4 or 6.5 between 2007 and 2011. In 2011 China ranked overall a middling 75th out of 182. A recent poll of Chinese citizens found that only 9% reported having had either firsthand experience with corruption or had known somebody who had paid a bribe in the preceding year. At that level, direct experience with corruption in China was actually the same as reported by citizens of Singapore, which was one of the five least corrupt countries, according to TI. More surprisingly perhaps, 5% of Americans surveyed reported that they had paid a bribe.

In sum, it is clear that China experienced a significant surge in the incidence of corruption during the 1980s and that in qualitative terms corruption “intensified” in the 1990s. Since then, evidence suggests that corruption has remained at about the same levels and hence has been brought under control in the sense that China’s “war on corruption” has prevented it from spiraling further out of control. Rising corruption, however, failed to retard economic growth. On the contrary, according to the IMF, GDP per capita grew at an average rate of almost 8% between 1980 and 1991, then shot up to an average of 12% between 1992 and 1995, and falling to a still torrid 8% between 1996 and 2004. Thereafter average growth rates jumped back up to greater than 11% during 2005-07 before settling back to 9% after the advent of the global recession in the summer of 2008. Since then, growth has slowed, but at 7.5% remains strong by global standards. Growth rates have thus remained robust even after corruption worsened and intensified.

Corruption with Chinese Characteristics

If worsening and intensifying corruption didn’t inhibit China’s economic boom, is there something “special” about corruption in China? In the 1970s, a number of scholars argued that given gross inefficiency in the allocation of resources by the state, bribery might allow would-be entrepreneurs to “buy” these resources and use them more efficiently. Others argued that bribes were often given to poorly paid government officials with the goal of getting them to cut through red tape. “Speed money,” some claimed, might not only lubricate the creaky machinery of government, but also might even give bureaucrats a profit-based motive to perform their duties more efficiently. Some have argued that corruption in China differed from that found elsewhere because it often involved “profit-sharing.” Businessmen cut officials in on their profits when officials helped them earn money. In some areas, local governments were said to have transformed themselves into entrepreneurial “local developmental states” by entering into partnerships with businesses and facilitating their operations in return for ad hoc taxes and other forms of illicit profit-sharing.

Although it does not appear that corruption in post-Mao China was qualitatively different, the nature of China’s economic reform did create conditions in which some corruption (not all) was compatible with rapid growth. In abstract terms, economic reform involved large-scale transfers of potential value from the state to the market. In the early stages of reform, for instance, the de-collectivization of the agricultural sector transferred control over production to individual households. Because they stood to reap substantial windfall profits from land transfers, farmers had incentives to pay bribes to secure particularly productive plots and control rights for “sideline” production. Local cadres were also often in a position to leverage “considerations” in return for providing farmers with access to state subsidized inputs such as fertilizer, pesticides, and diesel fuel.

As reform deepened in the 1990s and the state began to lease out land for industrial, commercial, and real estate development, would-be industrialists, businessmen, and developers stood to earn quick windfall profits. A plot of unused land attached to a state-owned factory, for example, could generate a very substantial windfall if it were redeveloped into high-priced condominiums, shopping malls, or luxury hotels. Quick profits could, in fact, be made by simply flipping a piece of land leased cheaply from the state and then selling the lease rights to others.

Rapid growth also created a high demand for capital. Because China lacked a developed capital market when the economy moved into high gear, government agencies were often important sources of investment loans. Most government agencies either controlled stocks of capital or had accumulated substantial slush funds (known in Chinese as xiao jinku – literally small golden treasuries) \ they could use to make under-the-table loans with interest rates above those for regular bank loans. Even if they lacked their own capital, government agencies and state-owned enterprises enjoyed better access to the state-controlled banking system and could profit from arbitrage borrowing and re-lending to private entrepreneurs who could not obtain bank loans. The windfall profits generated by reform and the demand for capital thus created a series of new opportunities for officials to cash in.

The reform period also witnessed a major expansion in infrastructure. Since the 1980s, the Chinese government has spent vast sums – upward of Y6 trillion (US$874 billion) from the state budget alone as of 2009 – building new highways, railroads, airports, ports, and urban infrastructure. Public works contracting is a notorious source of corruption worldwide and China has been no exception. The development of China’s much-touted high-speed rail system, on which the government will have reportedly spent Y3.5 trillion (US$532 billion) by 2015, has resulted in unprecedented cases of corruption. China’s Minister of Railways Liu Zhijun allegedly conspired with middlemen and major state-owned companies to skim about Y800 million (US$122 million) (BBC 2011). Zhang Shuguang, the deputy chief engineer for the project, was said to have stashed Y18 billion (US$2.8 billion) in overseas bank accounts.

China’s surge in corruption can be attributed to other factors as well. During the Cultural Revolution, China’s law enforcement institutions had been “pulverized.” Branded as bastions of “revisionism” and “counter-revolution,” the Procuratorate and the party’s Control Commission ceased to function or were taken over by the military. In 1979, these institutions were only in the early stages of reconstitution, and it was not until that year that China’s first criminal code was enacted. On a very fundamental level, therefore, China entered the reform era with a very rudimentary institutional capability to fight corruption.

The lack of a functioning judicial system staffed by trained investigators, prosecutors, and judges was a major impediment to fighting corruption because, unlike a street mugging in which you have an obvious victim, corruption is a hidden and “victimless” crime to which the actual victim – the public – is not a direct party. Corruption most often involves two offenders – an official who accepts bribes and a private party who pays them – both of whom stand to profit from their transaction. More critically, “properly” done, corruption is a subtle “art,” a careful “dance” wherein the parties never directly discuss exchanges of favors for bribes, use multiple subterfuges to hide payments, and conduct all transactions in cash to leave the most minimal trail. Corrupt relationships are best framed not in terms of quid pro quo “deals,” but rather as exchanges involving “diffuse reciprocity” wherein financial “considerations” are repaid indirectly and seemingly in the “normal course” of business. For example, an official might discuss a contract with a building contractor who might then engage the official’s son as a “consultant” for other “unrelated” matters or donate money to an “educational foundation,” which just happens to be funding the official’s daughter’s doctoral studies at an American university. High-level corruption of the sort that became increasingly common in the mid-1990s is, moreover, apt to be much harder to detect than street-level corruption. Street-level corruption is apt to take place in open view and create aggrieved victims willing to report unjust demands. But high-level corruption is more likely to take place behind closed doors and be mutually profitable for both parties, neither of whom are apt to report their illegal deals to the authorities. In addition, powerful officials can take advantage of their authority to create conspiratorial “protective umbrellas” that enable them to stonewall and even suborn investigators.

China’s emerging business culture also has contributed to China’s surge in corruption. All of the business fortunes in contemporary China were built in a rough and tumble environment in which new businesses frequently rested on questionable foundations, by bending the rules, very often by paying bribes, providing kickbacks, giving lavish gifts, and participating in a culture of “banqueting” involving not only expensive dishes and fine liquors but often the provision of prostitutes and other “favors.” In this environment, corruption only becomes a problem for those willing to pay when officials bought with bribes fail to “stay” bought or cannot deliver the benefits supposedly secured with under-the-table money. Otherwise, bribes can become nothing more than a quick means to obtain inflated profits and remove unwanted government impediments. And as corruption spread, many officials came to view it as “normal” and essentially an official perk enjoyed by “everybody.” A “culture of corruption” thus emerged in which embezzlement and bribery were not deemed sins, per se, but more of a fact of life.

Anti-corruption work in China thus faced considerable challenges from the beginning. In fact, what is perhaps most surprising is that corruption did not reach even greater levels and come to the point at which so many officials were engaged in corruption that the state’s emerging anti-corruption capabilities were simply overwhelmed.

Rising Corruption and Rapid Growth

If China experienced a significant worsening of corruption and corruption is negatively correlated with growth, why did the Chinese economy to manage grow so rapidly, even as corruption was worsening? Three factors help explain why this was possible. First, corruption was not a serious barrier to the initial acceleration of growth. Second, the most intense period of corruption coincided with large-scale transfers of value from the state to the emerging market economy. Third, despite a somewhat halting start and less than decisive results, China’s anti-corruption efforts managed to bring corruption under control by the early 2000s, albeit without significantly affecting its overall severity. The first two factors combined to create a situation wherein corruption fed off growth rather than stifled it. Even though corruption became much worse than it had been in the pre-reform period, it was kept at levels that are not necessarily extraordinary for a developing economy.

At an abstract level, corruption can be broken down into two major forms: “plunder” and “transactive” corruption. In the case of plunder, officials prey on the state, stealing tax monies, looting the treasury, privately selling off state property, and so on. Officials engaged in plunder often target the private sector, expropriating profitable businesses and real estate, extorting money from wealthy individuals, or even demanding cash at the point of a gun. Transactive corruption, on the other hand, involves exchanges of money and favors. Neither form of corruption is benign. Transactive corruption may, in fact, involve extortionary bribery that borders on plunder. Nevertheless, plunder is apt to have a much more debilitating effect than transactive corruption because while transactive corruption often involves exchanges that are mutually beneficial to those directly involved, plunder attacks the economy’s vitals by rendering property rights insecure and encouraging capital flight. Plunder wreaks economic destruction in much the same way that roving bandits destroy rural communities by driving off farmers’ cattle, destroying their crops, stealing their goods and savings, and burning their homes. In its most extreme form, anarchic plunder by official “bandits” can morph into “kleptocracy.” Best defined as a form of political system in which the state becomes an instrument for the extraction of plunder by the kleptocrat-in-chief and his inner circle of henchmen and cronies, kleptocracy generally results in a wholesale assault on an economy’s core structures and the systematic destruction of the formal economy.

As noted earlier, during the Maoist era, petty bribery predominated. Officials and workers in state-owned enterprises also pilfered state property, stealing goods either for their own consumption or sale on underground black markets. Large-scale bribery was uncommon because so long as the state monopolized the economy, there were few private parties in a position to use illicit means to influence officials. Reform fundamentally changed the dynamics of corruption by creating a set of actors, including not only private businessmen but also the managers of state- owned enterprises, who could leverage financial advantage by bribing officials. As the economy took off, this “demand side” for corruption grew quickly. Not only did the incidence of bribery increase, but it also began to displace plunder as the modal form of corruption. A growing economy and thus increasing profits and incomes caused the size of bribes to grow as the “returns” from bribery grew.

When the state began letting out many more valuable assets, including land, the amounts paid in bribes increased exponentially. More senior officials became involved because they, not street-level bureaucrats, were in a position to “auction off” assets that would yield entrepreneurs and developers large windfall profits in the form of sizable gaps between the state’s nominal valuation of assets and their actual market value. Rising corruption was an endogenous byproduct of economic reform; it was this reform, and the rapid economic growth it created, that fed rising corruption. Much of the “new corruption” that emerged during the mid-1990s can thus be linked to transactions involving the transfer of value-bearing assets from the state to the market. Because these transfers also spurred rapid growth, the result was a concurrent worsening of corruption and an acceleration of growth. This is not to say that corruption had a positive effect on growth. Instead, rising corruption imposed real costs. Inefficiency and misallocation, however, were what economists call “marginal costs” because they siphoned off a share of the total gains that might have been realized from investment.

The regime’s much-maligned anti-corruption campaign also played a role. As noted earlier, corruption becomes most destructive when it morphs into kleptocracy and state institutions are converted into instruments for corrupt gain. The fact that the regime fought back and brought to justice at least some of those who turned corrupt prevented such a transformation of the Chinese state. Thus, even though individual officials and agencies may have succumbed to the “silver bullets” of corruption, the state as a whole did not degenerate into a kleptocracy. This is not to deny that some localities became “mafia states” where corrupt officials freely and even openly connived with unscrupulous businessmen and even criminals. Nor is it to say that very senior officials, their wives, children, relatives, and cronies were not deeply involved in corruption. The result was a dynamic wherein corruption was “controlled” in the sense that the regime’s anti-corruption efforts were minimally sufficient to keep the aggregated level of corruption below the vaguely defined boundary that separates serious corruption and outright kleptocracy.

Conclusion

To some, economic reform in China is a miracle. To others, reform is a tale of ever-worsening corruption. There is no question that the latter version is true. Each new major corruption scandal seems to make those that came before pale in comparison. What was a “shocking” amount in the early 1980s was nothing compared to the corrupt monies being reported in the 1990s, and chump change by today’s standards. Today, a case such as that of the Wang Shouxin ring and its Y500,000 (US$320,000) take would hardly raise the eyebrow of a public that has witnessed the 1999 Yuanhua case wherein a ring of smugglers colluded with local, provincial, and central officials to run an estimated Y53 billion (US$6.4 billion) worth of goods through the port of Xiamen in Fujian province in broad daylight, or read reports on the wealth of Premier Wen Jiabao’s family, or heard to tales of corruption and murder involving Chongqing Party Secretary Bo Xilai and his wife Gu Kailai.

China’s experience with rising corruption and rapid growth does not necessarily contradict the existing economic orthodoxy that corruption is negatively correlated with growth and hence rising corruption causes growth rates to fall. As argued herein, rising corruption in China was actually the result of rapid growth. If China stands out, it is not because it is exceptionally corrupt, but rather because its growth rate has been exceptionally high. There is also nothing about corruption in China that somehow distinguishes it from corruption elsewhere. If anything, “corruption with Chinese characteristics” more closely resembles the sorts of corruption found in much of the developing world than the “structural corruption” found in nations such as Japan, South Korea, and Taiwan.

That China has managed to maintain high growth rates despite rising corruption also does not mean that corruption might not cause greater economic damage in the future. As argued herein, rising corruption was a function of the transition from the planned to market economy. Completing that transition and consolidating a functioning market economy requires that the Chinese government begin to make substantial gains in its fight against corruption. Ultimately, the regime has to implement administrative and political reforms that would increase transparency and accountability. Before now, progress on these fronts has been limited, and even though the regime seems to understand that corruption has the potential to kill the economy, many within the party and leadership seem to fear that fighting corruption will certainly kill the party. As a result, many within the party have resisted the sorts of structural reforms needed to deal with the root problem – the party’s monopoly on power and the resulting extensive discretionary power wielded by officials – rather than its overt manifestations. Nevertheless, the partial measures, such as mandatory disclosure of officials assets, documentation of the employment of their spouses and children, and requirement that officials account for the origins of property and assets or face prosecution under a new “unexplained assets” law may prove sufficient to keep corruption from getting substantially worse, and thereby may help ensure that the current combination of high levels of corruption and rapid growth continues for some time to come.

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Read a Short History of the Party Congresses

The Congress clarified at least some things. First, in a year of the shockingly public airing of the Communist Party’s dirty laundry in the form of the Bo Xilai and other scandals, the top positions were handed to the men who were long touted to receive them: Xi Jinping and Li Keqiang. Beyond that, the conservative Jiang Zemin faction dominated, and Hu Jintao’s power was circumscribed. It is clear that the Xi-Li administration will not waver from the economic reform opened by Deng Xiaoping three decades ago. But there is no roadmap to political reform, despite a great deal of talk about the need to deal with corruption and bureaucracy.

Prelude to the Congress

To understand the political changes unveiled at the Congress, some background is necessary. In the years leading up to the event, China’s economy surpassed that of Japan to become the second largest in the world. Beijing awed the world with its successful 2008 Summer Olympic Games. The celebration of the 60th anniversary of the founding of the People’s Republic in 2009 also was a smash. The relationship with Taiwan, due to the KMT’s success at the polls and Hu Jintao’s open-mindedness, was calm and productive. At the same time, social disturbances continued to grow, escalating according to some scholars to about 180,000 in 2010. The expanding gap between the rich and the poor became a rallying cry for the new left, which openly praised Mao Zedong and tried to turn nostalgia into policies.

Hu Jintao signaled that the CCP would promote political reform, but there was no follow through. On July 23, Hu declared in a speech at the Central Party School that the CCP would introduce political reform. Hu said reform must be conducted within the framework of three pillars: the supremacy of the CCP leadership, people being masters of their own destinies, and rule of law. At the time, many observers indicated this speech would establish the tone of political reform in the upcoming political report to be delivered by Hu at the Congress. Judging from the speech, nothing new would be produced at the Congress. Indeed, there was no breakthrough announcement about how the CCP would introduce political reform or what shape it might take. Neither an action plan nor timetable was offered. Hu’s political swan song, like all his policy speeches, was boring, listless, and utterly devoid of an implementable plan.

Bo Xilai makes his move

Bo Xilai, a Politburo member who was sent to Chongqing as Party Secretary, executed populist programs in a masterful fashion, at least for a time. Playing on leftist sentiments, he unleashed a populist campaign that inspired many in China who were concerned about the growing gap between the rich and the poor. The campaign also planted fear among many who despised his overbearing leadership style, manipulation of the media, and neglect of the rule of law.

Bo deeply resented his assignment to the southwestern metropolis of more than 30 million people, and his populist initiatives were part of his strategy to get back to Beijing with the goal of being named to the Standing Committee of the Politburo at the 18th Congress. He believed he was qualified to be vice premier, and many top leaders, including Xi Jinping, went to Chongqing to praise his achievements. During a meeting with a few foreign NGO representatives, a top advisor for Bo Xilai boasted that his boss would move into the Standing Committee. The only uncertainties were when and which portfolio Bo would take. The possibilities were the premiership, the propaganda portfolio, or the job overseeing the Party’s law enforcement arm.

Bo was playing on neo-Maoism as a solution to corruption, which had become a cancer spreading wide and deep at a time when the leadership seemed stalled. Hu Jintao and Wen Jiabao continued to govern without vision, imagination, and bold measures despite popular sentiment in favor of political reform. At the top, a split seemed apparent. While Wen Jiabao kept talking about China needing political reform and embracing universal values, other top leaders ignored him. When Tunisia, Egypt and Libya were engulfed by the Arab Spring, the top leadership strengthened media controls and the gigantic stability maintenance apparatus was revved into high gear against any sign of a Color Revolution in China. In March 2011, Wu Bangguo, the number two man of the nine-member Standing Committee, declared in his opening speech to the annual session of the National People’s Congress that China would adhere to “Five Nos,” namely, 1) no multiple party system, 2) no diversity in ideology, 3) no checks and balances and bicameral parliament, 5) no federal system, and 6) no privatization. In July, at the celebration of the 90th anniversary of CCP’s founding, Jiang Zemin did not appear, leading to speculation that he had already died. When he did attend the October 10 meeting to commemorate the centennial of the Republican Revolution, Jiang appeared to be frail and weak, creating more uncertainty about behind-the-curtain power arrangements. Meanwhile, the economy was slowing down, the relationship with the United States was on a downward slide because of Washington’s pivot to Asia, and decision-making at all levels of the party-state began to slow down in anticipation of the power transition that would take place in the fall of 2012.

At this time of gathering challenges, the CCP needed a smooth 18th Congress to maintain its leadership, political stability, and unity. The usual controls on the official media were in place, and, as usual, the Chinese people themselves had no say in who would be named to leadership posts. But two other things had changed. The international press focus on the upcoming leadership changes would be more intense than ever, and social media inside China had become a new, more potent vehicle for politically helpless citizens to make comments and spread “secrets” about China’s byzantine politics. Still, at the beginning of 2012, there was no sign that the power transfer could suffer a meltdown that was unprecedented in the history of CCP.

A series of events changed all that:

• On February 6, Wang Lijun, the deputy mayor of Chongqing who had just lost his position as police chief of the city, walked into the U.S. Consulate General in Chengdu and requested political asylum. This shocking incident eventually led to Bo Xilai’s dismissal from all leadership positions, his expulsion from the CCP, and his wife’s conviction of murdering a British businessman.
• On March 18, a Ferrari crashed near the North Fourth Ring Road in Beijing with the driver killed on the spot and two half-naked women severely injured. The driver turned out to be the son of Ling Jihua, who was Hu Jintao’s chief of staff and widely expected to be elevated to the Politburo at the 18th Congress. Despite his efforts at cover-up, the facts were “leaked” and shocked Party officials. A few retired Party leaders led by Jiang Zemin intervened, and Ling was transferred to the United Front Work Department.
• On June 29, New York-based Bloomberg news service stepped into unchartered political waters in China by reporting on the family wealth of Xi Jinping. According to public documents compiled by Bloomberg, as Xi climbed the Communist Party ranks, his extended family expanded their business interests to include minerals, real estate and mobile phone equipment. Those interests involved investments in companies with total assets of $376 million. They included an 18% indirect stake in a rare earths company with $1.73 billion in assets and a $20.2 million holding in a publicly traded technology company. The report said, “The figures don’t account for liabilities, and thus don’t reflect the family’s net worth.”

All eyes were on Xi Jinping and there was speculation that this “foreign intervention” might derail his ascension to the top. But Xi continued to appear in public and behaved like a man ready to take the reins in October. Then in early September, Xi suddenly disappeared. His scheduled meeting with United States Secretary of State Hillary Clinton on September 3 was canceled, and a Chinese Foreign Ministry official told upset American officials that Xi had sustained shoulder injuries. Xi also missed the scheduled meeting with the Danish prime minister on September 10, and no official explanation was given. This set off furious speculation on the Internet that either the physical or political health of the 59-year-old Xi was failing. A Chinese language website hosted in North America even put out an unverified report that there was an assassination attempt on Xi, and that He Guoqiang, a fellow member of the Politburo Standing Committee, also was wounded in a separate incident. The Chinese government kept silent until Xi resurfaced without prior announcement on September 20 when he visited China Agricultural University.

Another bombshell dropped on October 30, 10 days before the 18th Congress was to open in Beijing. The New York Times reported that many relatives of Wen Jiabao, including his mother, son, daughter, younger brother, and brother-in-law, had become extraordinarily wealthy during his tenure in office. A review of corporate and regulatory records indicated that the prime minister’s relatives — some of whom, including his wife, had a knack for aggressive deal-making — controlled assets worth at least $2.7 billion. Both the English and Chinese versions of the Times website were shut down in China hours after the report came out. The Chinese Foreign Ministry spokesperson declared that the report was false. Two U.S.-trained lawyers threatened to sue the paper. Overseas Chinese websites began to publish accounts that Wen’s family was clean. However, there was no official rebuttal from Wen himself.

The CCP nevertheless muddled through, and the 18th Congress opened and closed without any glitches. On November 15, the new members of the 18th Central Committee met and “elected” the Politburo and Standing Committee. To the surprise of many, neither Li Yuanchao, former Minister of Organization, nor Wang Yang, Party Secretary of Guangdong Province, was placed in the Standing Committee. Both are known to be reform-oriented, and their failure to move into the top tier is indicative of the conservative nature of the new leadership. With the exception of Xi Jinping and Li Keqiang, the other five members of the Standing Committee — Zhang Dejiang (NPC), Yu Zhensheng (Chinese Political Consultative Conference), Liu Yunshan (Secretariat), Wang Qishan (Central Discipline Commission) and Zhang Gaoli (State Council) — all appeared to be handpicked by Jiang Zemin or his allies. A bigger surprise of the first plenary session of the 18th Congress was that Hu Jintao relinquished his chairmanship of the Central Military Commission, and then Xi was “elected” to succeed him. Both Hu Chunhua (who will replace Wang Yang in Guangdong) and Sun Zhengcai (who already became the Party secretary of Chongqing) moved to the Politburo. Barring any unforeseen developments, in a decade, Hu and Sun will become China’s top two leaders.

Political writings on the wall

Looking back at the rocky road to the 18th Party Congress, we offer some tentative observations on CCP politics in action. It is worth noting that this is just the second time in CCP history that a power transfer was peaceful and predictable. Despite fierce power struggle and factional rivalry, no attempt was made to challenge the pre-agreed setup that involved Xi becoming CCP general secretary and Li Keqiang being named premier. The next generation of the top leaders is also in the pipeline. It is unclear whether this so-called method of top leader chosen by the retiring leaders once removed (i.e. Hu Jintao chosen by Deng Xiaoping, Xi Jingping by Jiang Zemin, and Hu Chunhua by Hu Jintao) can be sustained. The best that can be said is that without real intra-Party competition for the top leadership, the current arrangement is a step-forward.

It also is worth nothing that the unseemly convention of geriatric politics continues inside the CCP. Jiang Zemin demonstrated great influence in determining who was elevated to the Standing Committee. Li Peng was probably instrumental in eliminating reformer Li Yuanchao from the race to the top. Other retired leaders might have played roles in removing Ling Jihua, whose son was killed in the Ferrari crash, from contention for the Politburo. Li Changchun could have been the crucial factor in getting Liu Yunshan into the Standing Committee.

That said, the era of political domination by elderly, retired leaders may slowly be coming to an end. Hu Jintao’s inability to hang onto the Military Commission chairmanship signaled a repudiation of Jiang Zemin’s ability to exercise power once the Congress had finished its work. Just a day after Xi Jinping replaced Jiang as the chairman of the military commission, he praised Hu Jintao as a person of high integrity and moral standards. This is tantamount to criticizing Jiang in a very serious manner because he insisted on retaining the military commission chairmanship when he stepped aside as president and Party general secretary. Despite Hu’s inactivity on the political reform front, many hailed his last act — stepping down from the military commission — as the most memorable of his entire political career.

The jockeying for power at the top in the months before the Congress highlights the reality that the CCP is rife with factional disputes and conflicts of interests. The fact that five of seven members of the Standing Committee will have to retire in 2017 is evidence that the final lineup was the result of compromise and concession. Just like any other political party, the CCP has to face the reality of political dissent and allow intra-party competition. Power-sharing and consensus-building through negotiation is the first step toward intra-Party democracy. It is safe to say that the day may come when factional fights within the CCP become a zero-sum game and can no longer be contained, resulting in a break into two or more political parties. Democracy could come to China, not through social movements but by by virtue of top-down politics.

The days of non-interference in Chinese politics by foreign countries are gone now. The size of China’s economy and its international influence do not permit non-intervention. Second, the increasing tendency by CCP factions to leak sensitive information to further their quests for power and to undercut their rivals has enabled both mainstream Western media outlets and online Chinese-language entities to publish reports that are not available inside China. As a result, Western media and think tanks have fully engaged the Chinese political process, despite the utter opacity and secrecy of the inner workings of the Party. Western reporting and analyses play a role in the final outcome of Chinese politics. I n addition, the growing popularity of weibo in China has magnified the impact of these information channels. On the one hand, the dynamics of Chinese politics has changed because of rapid and omnipotent distribution of information that has put secret holders on the defense. On the other hand, it has created new ways for Chinese citizens to engage in Party politics in a way that was never available to them before.

Popular indifference inside China to official propaganda about the Congress coupled with intense interest in elections abroad also could be impetuses for political change in China. Organized efforts by the CCP to promote the spirit of the 18th Party Congress through publicity tours nationwide have remained a Party affair outside the life of ordinary Chinese citizens. In contrast, many Chinese people, including media outlets, spent a good deal of time reading, watching and thinking about power transfer through elections in countries such as Mexico, France, and the United States. These elections were fascinating and reminded the Chinese people what was lacking in their homeland.

The future of political reform

The need for movement on political reform is clear. For the CCP not to chart a new course in the wake of the Arab Spring, the Bo Xilai and Ling Jihua scandals, and the revelations of obscene amounts of wealth accumulated by the families of the top leader would be shocking to many reform-oriented scholars and political observers. Hu Wei, dean of the School of International Affairs and Public Administration, Shanghai Jiaotong University said China is facing a “three-D” crisis: social decay, social disorder and social divide. Only one “D”— democracy — could overcome the three-D corrosion. Historian Zhang Lifan wrote, if we do not see reform in five years we will see collapse in ten years. Sun Liping, professor of sociology at the Tsinghua University, recently told a gathering of both Chinese and foreign financial workers, “A silent revolution is taking place in China. The biggest force against reform in China is those who do not want to go back nor desire to move forward but to maintain the status quo. Reform and China will be like Taiwan. Without reform, China will be like the Qing dynasty.” Li Weidong, former publisher of the China Reform Magazine, said in a “Tweet” that the entire nation is daydreaming now and one of the new dreams is the so-called “three self-confidences.” (In his political report, Hu Jintao talked of the CCP’s unswerving endeavor to build socialism with Chinese characteristics and urged the Party to have self-confidence in roads chosen, theories adopted, and institutions established.) Li declared, “Not only is this a pipe dream, it may soon engulf China in a nightmare.” The most popular weibo nowadays is this: “Introducing reform means seeking death and not introducing reform means waiting to die.”

Where does Xi Jinping stand amid hope and frustration, expectation and anger? During his November 15 press appearance, Xi delivered a powerful pledge. He focused his messages on the nation, the people, and the Party. He spoke of the collective but not the individual; he advocated responsibilities but not rights; he called the Party to serve the people and change its work style, but there was little about institutionalizing accountability and transparency. He identified four cardinal problems the Party is facing: corruption, condescending, formalism, and bureaucracy. He said that unless the Party overcomes these challenges, it will not be able to lead the nation in building socialism with Chinese characteristics.

In 2002, shortly after the 16th Party Congress, Hu Jintao took all members of the Standing Committee of the Politburo to Xibaipo in Hebei Province, where Mao and his comrades lived and worked before marching to Beijing and establishing the People’s Republic. Hu vowed that the new leadership would call on all Party members to overcome arrogance, maintain integrity, and serve the people well. On November 29, Xi took “the magnificent seven” to the National Museum to see “The Road to Rejuvenation,” a Party history exhibition. He repeated everything he mentioned or alluded to in his November 15 speech. He talked about the destiny of the nation and the China Dream. He used three lines from the poems of Mao Zedong and ancient poet Li Bai to highlight China’s humiliating past, its glorious opening up and reform, and its bright future. Again, the focus was on a mysterious and historical Chinese collective.

To follow up his two speeches, on December 4, Xi convened a Politburo meeting that adopted a resolution to improve the work style and deepen the ties between the CCP and broad masses. Included were measures to cut Party circulars; reduce domestic inspection trips and foreign visits; prevent the blocking of roads when top leaders travel; eliminate profuse media reports; cut national meetings to only those absolutely necessary; stop publication of speeches; end the practice of traveling the country and writing inscriptions that become memorialized; and stop unnecessary meetings, ceremonies, and groundbreakings. Also in December, Xi made a trip to Guangdong. In Shenzhen, he placed a wreath in front of Deng Xiaoping’s statue and vowed not to deviate from the road of reform and opening up, a policy that was put in place by Deng Xiaoping in late 1978.

Xi’s performance in the wake of the Congress is impressive, and has made it very clear to both the Chinese people and the outside world that he has no intention to deviate from the road chosen by Deng Xiaoping and his cohorts 34 years ago. What is a bit disappointing is that he has not delineated a clear vision on the issue of political reform. In his political report to the Congress, Hu Jintao solemnly declared that China will not take the old road of xenophobia and lack of innovation, nor will it take the deviant road of implementing any reform that weakens the Party’s supremacy. There is no sign at this point that Xi Jinping will break away from this pledge.

However, people still remember what Xi Jinping said in a speech at the Central Party School in 2010: “The Marxist view of power can be summarized in two sentences: ‘power comes from the people’ and ‘power has to be used for the people.’ The first sentence highlights the source and foundation of power, and the second informs us of the essence and destiny of the power. The sole mission of the CCP is to serve the people heart and soul. This is the difference between the Marxist view of power and capitalist view of power.” The interpretation of this statement is that Xi may move forward with political reform, installing procedures through which the governed will offer their consent to the governing party. Even though Xi has great power because he is fully in charge of the Party and the military, he has not made any reference to his earlier statement that has inspired many in China.

Some suggest waiting for the Third Plenary Session of the 18th Party Congress to see whether the Xi-Li Administration is serious about introducing meaningful political reform. It was during the Third Plenary Session of the 11th Party Congress in December 1978 when Deng Xiaoping finally was able to marshal his political capital and move the Party from the narrow road of rigid ideology to the highway of pragmatic economic growth.

China’s growth dividends will expire soon. When they do, the CCP’s legitimacy will face daunting challenges and fierce questioning. The extent of corruption, the loss of trust, the increasing unemployment of the young and educated, and the opacity of decision-making may all become the trigger of a Chinese Spring. Will China muddle through and sustain its economic growth without making significant social and political changes? If it does, the model touted in Beijing of sustained economic development and authoritarianism will get a boost and pose a serious challenge to the conventional wisdom that political accountability is necessary for long-term, economic prosperity and social harmony. If not, the entire world will watch as turmoil engulfs China and very possibly shakes up the global power balance and ushers in a period of instability.

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After Mao’s fighters dismounted from their horses in 1949, they took up positions behind desks in a corner of the Forbidden City called Zhongnanhai. But Mao saw himself as a new emperor, and failed to establish a regular pattern for Party congresses. The 8th Congress was not held until September 1955. By this time the Party had grown to more than 10 million in members. The 9th Congress was not held until 1969, a full 14 years after the previous gathering. Liu Shaoqi, one-time anointed successor to Mao, was expelled from the Party at the 12th Plenary Session of the 8th Congress, and died shortly before the 9th Party Congress was convened, which established Lin Biao as Mao’s successor.

The 10th Congress was held in August 1973 with 1,249 delegates representing 28 million members. Only four years elapsed between the 9th Congress and the 10th, but many tumultuous events happened in-between. Moscow and Beijing clashed along their countries’ border, and Soviet leader Leonid Brezhnev even considered using nuclear weapons against China. Lin Biao died in a fiery crash in Mongolia in 1971. President Nixon visited China in 1972. Mao’s health was deteriorating. The Gang of Four, led by Mao’s wife, Jiang Qing, was leading the nation into a ditch of economic stagnation, ideological rigidity, and revolutionary fervor. The country was inching toward collapse.

Mao died in September 1976. Barely a month later, the Gang of Four was arrested and the new leader, Hua Guofeng, selected by Mao shortly before he died, vowed to follow Mao’s policies and dismissed Deng Xiaoping, who was also brought back by Mao to restore order. Mao’s comrades did not like Hua and they maneuvered to bring Deng back. Hua continued as the nominal leader, but decision-making was now in the hands of Deng.

The 11th Congress was held in August 1977. A five-year interval between CCP congresses was finally institutionalized. But transitions of power were yet to be institutionalized. Between December 18 and December 22, the 3rd Plenary Session of 11th Congress met in Beijing. Momentous decisions were made to abandon Mao’s legacy. The policy of reform and opening up was introduced. Three days before the meeting, Beijing and Washington decided to normalize relations. China was finally able to climb out of anger and isolation.

Ten years later, in October 1987, the 13th Congress was held. With support from Deng Xiaoping, General Secretary Zhao Ziyang formally announced that the Party would move forward with political reform. On April 15, 1989, Hu Yaobang – Deng Xiaoping’s first choice of Party Secretary, who was forced resign by the old guard of the Party – died. Popular mourning for him led to the tragic crackdown on June 4, 1989. Zhao Ziyang was dismissed from the position of General Secretary of the Party and Jiang Zemin, an obscure Party secretary in Shanghai, was abruptly brought in to be the new leader. Zhao was never allowed to appear again publicly, and he died in 2005.

In 2002, Jiang Zemin, who served as the CCP’s General Secretary for 13 years, finally stepped down. Hu Jintao, who was chosen by Deng Xiaoping as the fourth general leader and became a member of the Standing Committee of the Politburo in 1992, finally became the General Secretary. He assumed the presidency of the republic in March 2003, but Jiang Zemin did not relinquish his chairmanship of the Central Military Commission. He wanted to “babysit” Hu for a while. Wen Jiabao -who was Zhao Ziyang’s chief of staff and accompanied Zhao to Tiananmen Square where he bid farewell to the world – was now in charge of the State Council. Initially, there was euphoria about the new leadership. The Hu-Wen administration’s response to the case of Sun Zhigang and its efforts to inject accountability in the wake of the SARS outbreak convinced many in China that they were witnessing a New Deal. Hu and Wen’s emphasis on the welfare of the people rather than GDP growth alone also caught the imagination of the reform community. However, the signs of a can-do administration quickly dissipated. Even after Hu assumed the chairmanship of the Central Military Commission in 2005, there was no significant attempt to introduce political reform, despite Wen Jiabao’s repeated statements to foreign visitors that the Hu-Wen administration planned to do so.

In October 2007, the 17th Congress was held. Before the meeting, there was a lot of speculation about who would be named to the Standing Committee of the Politburo, and more important, who would be groomed to become top leaders of the fifth CCP generation. It was quite a surprise when Xi Jinping, who was only a member of the Central Committee, catapulted into the Standing Committee and was slated to be the next Party leader. Li Keqiang, who was Hu’s protégé and favorite to succeed him as president, was chosen instead to replace Wen Jiabao as premier in 2013. While details of the back room dealings of the personnel arrangement of the 17th Congress are yet to emerge, it is clear that Jiang Zemin was the chief engineer of the sudden shakeup at the top.

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Chinese policymakers are considering reforms to open China’s equity markets to foreign capital. A proposed International Board would allow both foreign firms and China’s domestic private firms to list on the new Shanghai exchange. With China’s increasing role in the global economy, it appears logical for China to open its markets further to foreign capital. However, this proposal has yet to be implemented, indicating there are both potential benefits and possible hidden costs, at least to some of the players involved. This article analyzes the pros and cons of launching an International Board in China, both for China’s economy and for Chinese and foreign firms. The conclusion is that having an International Board is an essential step in the development of China’s financial markets.

China’s stock market development

China began to reform its economy in 1978 when Deng Xiaoping rose to power. Notwithstanding such reforms, firms continued to be largely owned and operated as state-owned enterprises (SOEs), and their lackluster performance implied the necessity of the discipline of a stock market. The government believed that adopting a Western market model, with its diversified ownership and strong regulations, would lead SOEs to become more efficient and competitive in the global marketplace. The Shanghai Stock Exchange was established in 1990. A large amount of investment in technology and infrastructure followed, to develop the exchange. However, while the investment in modern technology was intended to bring the Chinese equity markets up to par with the Western world, the resemblance was minimal at best. In part, this may be a result of trying to fit a U.S.-style stock market into a Chinese-type command-economy, wherein much of the equity market is run and owned by SOEs which, in turn, also regulate the markets. To correct these deficiencies, China has made efforts to be more financially inclusive, and China’s regulatory body, the China Securities Regulation Commission (CSRC), is playing a critical role in changing the composition of market participants.

Chinese firms typically are classified by ownership type as state-owned enterprises, domestic privately-owned enterprises or foreign-funded enterprises. SOEs are either wholly owned by the government or have majority shares belonging to the government (state-holding enterprises). Privately-owned firms by definition are not state-owned but are private limited liability corporations and private sole and partnership enterprises. Foreign-funded enterprises include firms that are registered as joint ventures, cooperatives, sole-proprietorships or LLCs that are funded with foreign funds, including funds from Hong Kong, Macao or Taiwan.¹

The government increasingly has been making provisions to attract foreign firms and their investments. Given these efforts, the Chinese stock markets have grown substantially, in both wholesale and retail investment sectors. Financial markets in China offer different types of shares. The most prominent are A-shares and B-shares, which are issued by companies incorporated in mainland China. The main difference between A-shares and B-shares is who is allowed to trade them. A-shares, the largest class of shares in China, are renminbi (RMB) denominated shares, which can be traded only by Chinese nationals and foreign institutional investors classified and authorized as Qualified Foreign Institutional Investors (QFII). B-shares are denominated in foreign currency, USD or HKD. They were originally designed solely for foreign investors, but since March 2001, they also include domestic retail investors with access to foreign currency.²

In 2002, institutional investors made inroads into China’s markets. By 2011 they accounted for only two percent of the total stock market value, but their depth and impact on the Chinese markets was substantial, because of the composition of the participants in the program. Eighty percent of the 192 QFIIs approved since 2002 are long-term investors, including asset management companies, insurers and pension funds. Further, in April of 2012, the CSRC raised the investment ceiling for QFIIs to $80 billion from $30 billion, and in July China eased its investment controls on QFIIS allowing them to enter the interbank bond market. These moves will increase the importance of QFII investors in China. On the flip side, China also has begun to allow domestic institutional investors to invest abroad via the Qualified Domestic Investors (QDII) program, allowing them to diversify risk and reduce excess liquidity.

China’s equity markets also have witnessed innovations. For example, ChiNext in Shenzhen lists companies in high growth sectors, and there is now a futures stock exchange. Mini-QFII recently was introduced, which allows qualified Hong Kong subsidiaries of China’s securities and fund management companies to channel RMB deposits in Hong Kong into the mainland financial markets via investment products. With a high savings rate, and few investment options because of limited product offerings, when the government and regulators offer new financial products, the market in China responds quickly.

The Chinese markets have grown tremendously, and in June 2012, based on domestic equity market capitalization, both Shanghai and Shenzhen exchanges in mainland China were listed among the top 10 largest exchanges in the world with market capitalizations of 2,411 billion and 1,149 billion USD respectively.³ By the end of fiscal year 2012, the Shanghai exchange had 944 companies listed with A-shares and 54 with B-shares.

The latest development is the expected rollout of the Shanghai Stock Exchange’s International Board allowing foreign companies access to the Chinese markets and domestic investors to share in the returns achieved by international companies. While in theory this seems like a logical next step, market analysts in China have not been completely on board with the idea. Many argue that while the International Board may successfully put China on the global financial map, the ride may be very bumpy because of possible effects on the existing system. The recent global economic downturn has increased funding pressures in the A-shares market, and some market experts voice concerns about the proposed International Board creating pressure to sell existing shares to raise cash to buy stocks on the new exchange. Further, the financial crisis largely has halted the B-shares market, and analysts argue that the introduction of the International Board may result in redundancy with B-shares. Market experts also have pointed out potential problems in share price evaluation, erratic capital flow and supervisory issues that remain unresolved.

Before launching the International Board, China’s regulators need to spell out listing requirements, reporting regulations and disclosures. So far, information has gotten out through news reports. These indicate that the Board will require a company seeking a listing to have a market capitalization of more than 30 billion yuan ($5.5 billion) and a combined three-year net income of more than 3 billion yuan.⁴ In addition, proceeds of an initial public offering may only be used abroad.⁵ These are reasonable stipulations by international standards. However, there are concerns around financial disclosures including issues surrounding the use of Chinese accounting standards for non-Chinese companies trading in China, and the type of reconciliation approaches that may be required. Details, if any, are very nebulous on how Chinese regulators would enforce the International Financial Reporting Standards, or the role of auditing and disclosure requirements for non-Chinese firms who list on the International Board. Criteria for non-Chinese accounting firms to audit non-Chinese firms listing in mainland China need clarity, and so far there seems to be little documentation regarding this issue. Critics strongly urge postponing the launch of the Board until some or all the aforementioned issues have been addressed. Hence, while the Chinese government expressed the possibility launching the International Board to allow foreign firms and domestic private firms to list back in 2009, this has not yet materialized.

Benefits to Chinese firms

Research suggests that the fundamental reason for countries to have a stock market is to provide financing and liquidity for corporations.⁶ Because of the political environment within China that favors state-owned firms and investments, private firms in particular have an uphill battle finding financing for projects or expansion abroad. A large number of foreign firms and private domestic firms have expressed interest in the development of an equity market to be able to gain access to available liquidity. Additionally, since the 1980s, as part of the reform process, China has implemented a policy of zhengqi fenkai, which translates as “separating government functions from business operations.” In the process, China’s SOEs were increasingly privatized. However, this trend has exposed the weaknesses of many of these state-owned companies laden with legacy assets, including obsolete equipment and technology, and expensive social policies that include health care and worker pensions. The potential spillover effect of know-how from foreign firms that may list in the Chinese market is thus considered as a benefit to firms in China. Hence skepticism regarding the opening of the International Board may be only temporary.

While China disallowed non-state-owned companies from the stock markets if they listed elsewhere, it also increasingly made SOEs “public” by issuing shares while continuing to hold majority control. The IPO (initial public offering) process in China is largely mythical since it often is funded by loans from a state-controlled bank and not outside investors. For instance, the Agricultural Bank IPO in 2010 was largely funded by other SOEs. In addition, only a small number of Chinese companies that are not state-owned can trade in the Shanghai markets. The more practical issue is that this leaves no room for non-state companies to raise outside capital, and for listed firms to be correctly valued via trading. Opening the markets to foreign firms should help create liquidity, visibility, depth and better market pricing for firms. To truly reform the Chinese markets, however, the state must exit the equity markets.

As the line between state-owned and privately and/or publicly owned firms blurs, the challenges that confront them would not be dissimilar. Chinese multinationals have sought growth, requiring additional capital and visibility (branding) that the larger markets abroad more easily offer. Many of these multinational firms have listed abroad because the CSRC does not allow them to list on the Shanghai or Shenzhen exchanges once they incorporate outside of the PRC. As Chinese companies move from an export orientation to an outward FDI strategy, many companies find themselves ill-prepared to compete in the global markets. The lack of qualified manpower and adequate technology, and limited experience and knowledge of strategy and business processes, puts both private- and public-sector firms equally at a disadvantage in the global arena. Liquidity needs and expansion of products and markets are significant factors regardless of ownership type.

In order to gain ground in the global markets, these companies go abroad to seek talent, tap new markets, search for raw materials and acquire new technologies. China’s direct outward investment was only around $20 billion in 2006, but reached around $365 billion by 2011. In addition, while expanding geographically, concentrating largely on developing nations, resource-rich Australia and Canada, since the early 2000s investors have moved more toward Europe and North America.⁷ While expanding Chinese companies have had to learn to be apolitical and deal with regulatory policies with regards to governance, disclosures, financial reporting and intellectual property rights, thus forcing them to face a steep learning curve upon expansion.

Further, with capital controls still imposed by the State, large firms that list and trade abroad currently are unable to repatriate profits. If foreign firms are allowed to list in Shanghai, they will be able to more easily retain profits within China, which will create greater liquidity in the domestic markets. Thus, by trading both domestically and in foreign markets where they are listed, they could create more depth in the Shanghai market, and their fundamentals would more accurately reflect their true value. In addition, Cavoli, McIver and Nowland’s (2011) study of a sample of Asian markets suggests that higher trade openness, higher output growth and lower inflation may be associated with a greater proportion of foreign listings. They note that the extent of foreign listings on domestic stock exchanges (cross-listings) may serve as one measure of financial and economic integration among nations.

The Chinese investor would then have a potpourri of investment options, including both blue chips and red chips, thus integrating China into the global equity markets. If capital controls were relaxed concurrently with the launching of the International Board, Beijing could allow for cross-border transactions in yuan, thus letting its value be determined in the financial markets via trading. With increasing discussions in the country of making RMB an international currency, this would be an important step toward that goal.

More recently, some Chinese companies have been permitted to settle trade transactions in yuan via Hong Kong banks, and the yuan is being used more frequently in trade conducted between China and its trading partners. In a mere three years, the share of China’s international trade settled in yuan increased from zero to eight percent in 2011. Increasingly, yuan-denominated securities are available for investors, such as the “dim sum” bonds traded in Hong Kong. As China’s economic might continues to grow, the influence of its currency will inevitably increase with it. Consistent with this internationalization, and with plans to make Shanghai a global financial hub, the new Board will list shares by foreign companies denominated in yuan.⁸

Benefits to firms listing in China

Two reasons largely predominate with regard to why foreign firms list in China. One is to seek capital and the other is to diversify risk. With China’s high growth and savings rate, foreign firms can gain access to new sources of capital and expand their investor base to include those who previously had limited investment options. Reese and Weisbach (2002), Karolyi (2006), Hail and Luez (2009) and others have noted financial benefits for firms that cross-list including increased opportunities to raise capital, higher liquidity, greater visibility, and lowered costs of capital.

With growing consumer sophistication in China, there is a large untapped market for foreign firms to sell their goods and services. For well-positioned foreign firms, the opening of Chinese financial markets may create an investment boom, especially in this post-financial crisis period in the U.S. and Europe. Chinese buyers are likely to be a great market for diversifying products and services offered by these firms. In addition, if Chinese multinationals aim at growing via acquisitions of firms in the developed nations, foreign firms may be able to divest of assets/divisions more easily and it may be a win-win for both. In addition, firms in U.S. and Europe in post-crisis mode may welcome joint ventures and partnership alliances in China to diversify their risks as well as gain new revenues. As China is closely connected to the East Asian Tigers and Japan through fairly well-developed production networks (Prime, Subrahmanyam and Lin, 2012), access to those markets may be available via a listing in China, thus making it more attractive for the long run.

The scarcity of resources and human capital, caused by Chinese multinationals also vying for the same resources and workforce as the foreign multinationals, could be a hindrance. On the other hand, because employment opportunities are being limited in Europe and the U.S. for trained professionals in the post-crisis era, Chinese firms or foreign firms in China may offer employment opportunities, thus positively impacting global unemployment. Hence there are numerous positive outcomes that could result from establishing an International Board in China.

Many Chinese companies have been successful and today appear in the Fortune 500. However, restrictions are still imposed by Chinese regulations on domestic firms listing on the Shanghai exchange if they have listed abroad. As the Chinese government contemplates the introduction of the International Board, transparency of information, corporate governance, price discovery and economic development are all necessary for efficient functioning of a public stock market. These are areas in which the Chinese government needs to invest time and effort so China can compete internationally to attract domestic and foreign firms to list in China. This would also greatly benefit Chinese firms, as they would learn to respond to policy structures and changes domestically before expanding globally.

While it is not clear as to when the Chinese government will launch the International Board, for China to be a major player in the global markets, this is a necessary step. China’s financial markets have witnessed a major transformation in the past couple of decades, but the global financial crisis of 2008 seems to have dampened that process somewhat. Recent media reports indicate, however, that the government in China is focusing on the technical details with regard to listing, leadership of the Board, and related policies, and may have more definite plans concerning the opening of the Board possibly in the coming year. Reports indicate that more than 300 international companies have contacted the CSRC expressing interest in listing with the Board.⁹ For the country’s growth and development to continue, the Chinese government should launch the International Board allowing foreign firms and all private domestic firms to list in the Shanghai markets. The focus going forward should be on creating and sustaining an efficient, diversified, liquid and stable financial market.

References

Cavoli, T, R, McIver and J. Nowland, “Cross-listings and Financial Integration in Asia,” ASEAN Economic Bulletin, Vol 28 (2), 2011, pp 241-56.
Hail, L. and C. Leuz, “Cost of capital effects and changes in growth expectations around U.S. cross-listings.” Journal of Financial Economics, 93, 2009, pp 428-54.
Karolyi, G.A., “The world of cross-listings and cross-listings of the world: challenging conventional wisdom,” Review of Finance, 10, 2006, pp 99-152.
Prime, P. B., V. Subrahmanyam and C.M. Lin, “Competitiveness in India and China: the FDI Puzzle,” Asia Pacific Business Review, Vol 18, No. 3, July 2012, pp. 303-333.
Reese, W. and M. Weisbach, “Protection of minority shareholder interests, cross-listings in the United States and subsequent equity offerings,” Journal of Financial Economics, 66, 2002, pp. 65-104.

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