Outward dissimilarities aside, China, South Korea, and Japan are exemplars of the East Asian “developmental state.” Allowing for case-specific variations, we posit that the developmental state has three structural components. First, it requires a stable policy environment to insulate government bureaucrats from political demands that might derail state-led guidance of a market-driven economy (Johnson 1982, 315-6). Japan’s Ministry of International Trade and Industry (MITI, the organizational predecessor of today’s Ministry of Economy Trade and Industry), South Korea’s Economic Planning Board, and China’s National Development and Reform Commission played the part of pilot planning agencies in their respective economies. Second, the economic bureaucracy must be “embedded” in a set of ties that bind the state to society and open channels for ongoing negotiation and renegotiation of goals and policies (Evans 1995, 12). And, third, the long-term success of the developmental state requires a relatively equitable distribution of national wealth to ensure the social quiescence needed to endure the rigors of forced-march industrialization (Johnson 1995, 29). Japan industrialized while simultaneously narrowing the gap between rich and poor, and South Korea did so without expanding that gap. China’s increasing income inequality – which, in theory, allows a “few to get rich first” – is rationalized as a temporary expedient to achieve the socialist ideal of income equality (Prime 2012, 693).

Similarities in institutional responses at comparable levels of advancement suggest that the East Asian developmental state evolves through discernible stages. To test this premise, we explore the state of affairs in post-1978 China by focusing on a key subset of the broad set of consequences produced by the obsessive pursuit of profit and improved productivity. Specifically, we focus on the institutional responses of Chinese state actors to pressure to address environmental degradation, which is an inevitable social cost of the developmental state’s business-first growth strategy. In this way, the institutional response of Chinese state actors to environmental protest represents a crucial case study of the sorts of forces that punctuate the development of the East Asian developmental state into discernible stages of growth.

Environmental Challenges and Stages of Growth

The developmental state is constructed of institutions, which we define as humanly devised constraints that structure behavior and carry power-distributional consequences (North 1990, 3; Mahoney and Thelen 2010, 7, 14). Viewing institutional choices in this way draws attention to their “social costs,” which, in the case of the developmental state, includes all of the losses imposed on domestic and foreign interests as a result of a business-first economic strategy. For example, under China’s developmental state, “producers have been favored over consumers, state companies … over private firms, and production of export goods … over provision of household services” (Prime 2012, 688). In other words, the developmental state’s institutional arrangements give favored interests an implicit license to pollute, and, in so doing, create potential change agents among those who must suffer in a degraded environment.

While the East Asian developmental state is the focal point in a contentious debate, little effort has been made to explain how and why its institutional arrangements change over time. We argue that the developmental state progresses through a process that, to paraphrase W.W. Rostow, can be understood as a “sequence of stages rather than merely a continuum” (1959: 2; italics added).¹ During Stage 1, the primary task is to erect the institutional scaffolding to nurture strategic industries and sectors. In Stage 2, export-led growth brings industrialization along with predictable consequences, including a badly degraded environment and friction with trading partners. As a result, during Stage 3, state actors must decelerate the high-growth machine and liberalize some of its mercantilist components. If and when a developmental state arrives at the frontier of technological and economic advancement – and, in so doing, enters Stage 4 – state actors will be pressed to address the challenges of globalization and sustainable development. To be clear, there is considerable room for case-specific variation within these broad stages (e.g., the relatively greater powers of local Chinese authorities), and consequently, there is no reason to assume an exact convergence of developmental processes or outcomes.

We argue that Japan and South Korea have progressed to the fourth hypothesized stage, while China is just now crossing the threshold of the penultimate stage. In the analysis that follows, we explore China’s progression through these stages of growth, focusing intensively on the response of political leaders to pressure from domestic and international interests negatively impacted by a polluted environment.

Stage 1: “Crossing the River by Feeling the Stones,” 1978-1992

China’s developmental state began to emerge in December 1978 at the Third Plenum of the Eleventh Central Committee of the Chinese Communist Party (CCP). With annual per capita income at around $155, trade volume at a mere trickle, and China’s lagging development brought into sharp relief by the normalization of relations with the United States and Japan, CCP leaders were incentivized to experiment with institutions to guide in the gradual transition to socialist modernization. In his famous “Emancipate the Mind, Seek Truth from Facts, and Unite as One in Looking to the Future” speech, Deng Xiaoping made the case for pragmatic change. Not surprisingly, leftist critics lambasted Deng’s reform program, arguing – correctly, as it turned out – that it would transform China “from a planned economy to a semi-market one” (Prime 2012, 694). While questions were voiced about the suitability of Maoist institutions for the tasks at hand, when properly modified these institutions provided political leaders with “an impressive array of policy instruments and political capacity” (Oi 1995, 1133).

Reforms were enacted to increase agricultural production, nurture the growth of township and village enterprises (TVEs), and expand foreign trade. The first clear sign of change appeared Anhui Province, where peasants reaped a bumper crop after taking the liberty of decollectivizing farmland. In 1982, after initial misgivings, central authorities established the “household responsibility system” to permit decollectivization nationwide (Oi 1995, 137). Subsequent reforms targeted the fiscal system and nurtured TVEs, whose contribution to GDP leaped from six percent in 1978 to 26 percent by 1996 (Naughton 2007, 271). By allowing firms to compete in markets while continuing to fulfill obligations under central planning, gradual market liberalization spurred growth in the non-agricultural sector.

In 1979, Shenzhen, Zhuhai, Shantou, and Xiamen were designated “Special Economic Zones” (SEZ), and, by 1985, an additional 14 coastal cities and three delta regions had been added to the list. While these SEZs were becoming growth engines, many state-owned enterprises (SOEs) floundered. Officials began looking to Japan – a potentially attractive reference model because of its interventionist state and a hegemonic ruling party – for solutions to China’s problems (Heilmann and Shih 2013, 6). In 1988, an “industrial policy” (chanye zhengce) division was established under the State Planning Council, and the transportation, coal, oil, and steel industries were singled out for developmental nurturing. However, these early industrial policy experiments produced mixed results.

China’s full-speed-ahead growth strategy produced badly sullied air and waterways, just as had been the case in Japan and South Korea. Although China established its first national-level organ for environmental protection in 1973, a half dozen years would pass before a nationwide environmental law was promulgated and another decade would elapse before the law was fully implemented (Jing 2010, 198). In 1982, the authorities established an Environmental Protection Commission under the Ministry of Urban and Rural Construction and Environmental Protection. Political leaders set a target year of 2000 to harmonize environmental protection and socioeconomic development, and had, by 1993, almost a dozen laws relating to environmental and natural resource protection were on the books (China 1994, 7). However, local governments and SOE managers were incentivized to grow the economy and not curb pollution, which translated into lax enforcement. Fearful of an authoritarian state and with no environmental NGOs to turn to, Chinese citizens were left with few channels through which to voice their complaints.

Stage 2: “Blind Pursuit of GDP Growth”: 1993-2007

Deng attempted to respond to critics who claimed that his reforms displayed “disregard of the difference between socialism and capitalism,” but the People’s Daily refused to publish the op-ed (Peng and Chen 2008, 375). So, in the spring of 1992, the 87-year-old retiree ventured to southern China to visit the reform “laboratories” that “lit the fire for further market opening and faster growth” (Vogel 2011, 664). In a series of speeches, Deng called for a “socialist market economy,” and warned that “leftist” elements posed the greatest impediment to progress. Afterward, Jiang Zemin and Zhu Rongji – Deng’s handpicked successors – took the baton and pressed a broad reform package that included price liberalization. While the reforms granted local governments greater leeway in steering economic policy, a centralized Leninist regime continued to function.

In November 1993, at the Third Plenum of 14th Party Congress, the CCP embraced Deng’s vision, and proceeded to institute tax and financial system reforms. The 1994 Outline of Industrial Policy proposed measures to grow the electronics, machinery, construction, automobile, and petrochemical industries. Other industries were subsequently added to the list, while central authorities invited the inflow of FDI that would transform China into the “world’s factory.” Although the non-state sector was confined to only a few industries, its total factor productivity expanded twice as fast as the state sector, which, between 1995 and 2002, shed 38 million workers as a result of restructuring (gaizhi) and layoffs (xiagang) (Brandt et al 2008, 687). Although China was now deeply enmeshed in the world economy, the accumulation of large reserves of foreign currency enabled the country to avoid the worst effects of the 1997 Asian Financial Crisis.

In December 2001, after 15 years of lobbying, China finally became a member of the World Trade Organization. Henceforth, state actors would have to respond to accusations of “unfair” trade practices from foreign governments whose markets were now awash in Chinese exports (Prime 2012, 695). By reducing tariffs that restricted Chinese exports and opening the door to the increased inflow of FDI, WTO membership accelerated the pace of growth, and the world took note of a Chinese economic machine that displayed characteristics of the East Asian developmental state.

The reforms pressed by Deng and his successors produced a system of decentralized authoritarianism that employed concrete measures of growth in GDP and foreign direct investment as yardsticks for assessing the effectiveness of local officials (Oi 1995, 1136). Officials whose metrics were positive stood to gain promotions and their localities might be upgraded in administrative status, say, from county to city level. Meanwhile, poor performing officials could expect demotions or less desirable postings (Xu 2011; Knight 2012, 8). By inducing a sort of “best practices” competition among local authorities, China’s reformist leaders created a gigantic “laboratory, with different economic experiments taking place all over the land” (Coase and Wang 2012, 149).

China got its pilot planning agency in 1998 when the State Development Planning Commission (SDPC) replaced the State Planning Commission. Five years later, the SDPC morphed into the National Development and Reform Commission (NDRC), which became a superagency with responsibility for formulating and implementing policies affecting all aspects of socioeconomic development. Nicknamed the “mini State Council” because as many as four members of the CCP’s powerful Central Committee were recruited from its ranks (as opposed to the solitary representatives from most other ministries and departments), the NDRC became the cockpit for national-level economic planning, price setting, and industrial policy coordination. While its formal powers rivaled those of Japan’s MITI or South Korea’s Economic Planning Board at comparable levels of development, in practice the NDRC was obliged to share power with local authorities in China’s decentralized authoritarian system. Like their counterparts at MITI and the EPB, however, many NDRC officials – as well as senior CCP leaders – were alumni of prestigious educational institutions such as Tsinghua University and Beijing University.

The double-digit growth rates of the 1990s reshaped China’s industrial structure into one founded upon consolidating the commanding heights sectors of iron, steel, energy, chemical and heavy machinery, while encouraging an emerging high technology sector led by telecom. Still, much of the growth was driven by labor-intensive exports, which, between 1992 and 2002, expanded from 19 percent to 25 percent of GDP, elevating China to fifth place among trading nations. As economic growth picked up, more and more motor vehicles appeared on roadways, especially in large cities such as Beijing, where the number of cars quadrupled between 1990 and 2002 (Tang 2004). In the Seventh Five-Year Plan (2001-2005), central authorities aimed to produce a Chinese family car that would encourage mass ownership. The rapid increase in auto ownership contributed to heightened levels of airborne pollutants and CO2 emissions, which had already jumped from 2.7 million kt (thousand metric tons) to 3.7 million kt in the decade that began in the early 1990s (World Bank 2013). China now found itself numbered among the major culprits in the global campaign to combat climate change.

As had been the case in South Korea and Japan, Chinese state actors did almost nothing to prevent environmental pollution, even as favored firms reaped windfall profits. For the most part, those actions taken – e.g., the 1998 decision to grant the National Environmental Protection Agency vice-ministerial status – were not accompanied by a corresponding expansion of enforcement authority. It is not coincidental, therefore, that the first troubling reports of hundreds of so-called “cancer villages” (aizheng cun) appeared at this juncture (The Guardian, June 4, 2013). Meanwhile, local Environmental Protection Bureaus (EPBs) were hamstrung in their enforcement efforts by local governments committed to economic growth (Economy 2005, 92). Although Friends of Nature – China’s first environmental non-governmental organization – was established in 1994, it and similar groups mainly advocated for protection of endangered species and nature preservation. Citizens voiced their discontent over environmental issues by submitting letters and petitions, filing civil lawsuits, and staging demonstrations. In 2006, authorities received 600,000 protest letters, a six-fold increase from the 1997 figure, and, beginning in the early 1990s, an average of 80,000 citizens submitted petitions each year (Jing 2010, 197). While protests took place in localities, fear of harsh treatment by an authoritarian state kept a nationwide protest movement from congealing, in contrast to the large-scale protests that erupted in late 1960s Japan and in South Korea two decades later (Economy 2007, 47-8; Broadbent et al 2006).

Stage 3: Deceleration and Structural Change, 2007 to present

As China’s experiment with the developmental state model enters its fourth decade, central authorities retain control of capital investment and labor mobility. After peaking at a rate of 14.2 percent in 2007, the Chinese economic juggernaut began to decelerate, leading to predictions of five to seven percent growth over the forthcoming two decades. Some observers believe that Premier Li Keqiang’s 7.5 percent growth target for 2014 is overly optimistic (Bloomberg BusinessWeek, April 3, 2014). Despite an expanding private sector, SOEs continue to dominate the economy. Ninety-five of the world’s 500 largest companies are Chinese, and most of them are SOEs in “pillar industries” (zhizhu chanye) such as petrochemicals, steel, telecommunications, and banking. With their strong ties to state actors, the SOEs are positioned to exploit rent-seeking opportunities (Nee et al 2007, 43; Xia 2000). Although South Korea and Japan realized economic miracles in spite of – or, perhaps, because of – “structural corruption,” rent-seeking poses a grave threat to the legitimacy of the CCP’s claim to be the “people’s party” (Wedeman 2012, 9).

The “cost side” of the Chinese economic miracle includes a dangerously damaged environment, and state actors must find a way to decouple economic growth and pollution control. Today, China is home to 16 of the world’s 20 most polluted cities, and energy inefficiency is a major cause of the problem. To produce goods worth $10,000, it is estimated that China has to consume seven times the energy needed by Japan, six times more than the U.S., and three times the requirement for India (Economy 2007, 40). In 2006, 36 percent of China’s sulfur dioxide pollution was the result of export production, more than one-fifth of which found its way to U.S. markets. Ironically, the outsourcing of “dirty manufacturing” to China improved air quality in America’s eastern states, but pollution from Chinese factories now pollutes the air in western states (Lin et al, 2014). In response to international and domestic outcry, the CCP pledged in its Eleventh Five-Year Plan (2006-2010) to improve monitoring, enforcement, and assessment of environmental protection regulations. China’s first-ever comprehensive air pollution prevention and control strategy was proposed in the current Twelfth Five-Year Plan (2011-2015).

Despite some reforms and much oratory, economic growth continues to trump environmental protection. Local officials and company managers are rewarded for promoting economic growth, not for rigorously enforcing environmental regulations. In 2007, central authorities launched a study of China’s “Green GDP,” but scrapped the project upon discovering that the costs of pollution negated more than 3 percent of 2004’s GDP. In 2008, the State Environmental Protection Administration (SEPA) became the Ministry of Environmental Protection (MEP), but the new ministry remains relatively weak in the State Council. That same year, the central government began experimenting with “environmental courts” in the hope of keeping protests from mushrooming out of control (Jing 2010, 197). Local EPBs continue to lack enforcement power, and are obliged to compromise with local authorities obsessed with growing GDP and expanded tax revenues (Chow 2013, 6; Ma and Schmitt 2008, 99). This message was conveyed to an EBP director by a high-ranking local government official who made it clear that: “If you don’t change your mind, we will change your place” (personal communication, May 24, 2013). Some local EPBs are said to view the trivial fines paid by local businesses caught violating environmental protection regulations as an important revenue stream.

In recent years, large-scale environmental protests broke out in major Chinese cities (Xie 2011, 210; Zaobao 2013). To address the problem, the SEPA (MEP’s predecessor) issued a 2006 report entitled “Tentative Measures for Public Participation in Environmental Impact Assessments,” which advocates roles for ordinary citizens, developers, and NGOs in environmental impact assessment. In addition, Chinese authorities are being pressured to take action by media reporting and foreign governments. In 2011, the U.S. Embassy began publishing hourly air quality monitoring data for Beijing using an index based upon particulate matter with aerodynamic diameter smaller than 2.5 micrometers (Wall Street Journal, February 1, 2013). Prior to this, the Beijing Municipal Government had assured citizens that “fine particulate matter” poses no harm. Consequently, in June 2012, central authorities ordered foreign embassies to stop their reporting on domestic air quality (CNN, June 6, 2012). On September 12, 2013, the State Council announced 10 broad measures to curb pollution, including a 30 percent pollution reduction in heavy polluting industries by 2017 and greater accountability for local governments (Xinhua, September 12, 2013). Meanwhile, protests are becoming larger and more frequent, and surveys show that a majority of Chinese people favor environmental cleanup over economic growth (The Guardian, May 16, 2013).

Stage 4: China’s Road Ahead?

When the East Asian developmental state arrives at the frontier of technological and economic advancement – the threshold of Stage 4 – policymakers must address the challenges of globalization and sustainable growth. Currently, Japanese and South Korean state actors have put these issues at the forefront of policy, and, although China has yet to embark upon this stage, its leaders are under pressure to curb emissions while sustaining growth. Combating climate change was not the policy agenda when Japan decoupled pollution control and economic growth, and it was only on the distant horizon when South Korea tackled the challenge. Japan accomplished the objective by enacting a raft of laws that created incentives (e.g., low-interest loans, tax breaks, mandatory appointment of an “energy manager” in factories and workplaces, etc.) to encourage energy efficiency, establishing a cabinet-level Environment Agency (later given ministerial status), and expanding reliance on nuclear power and renewable energy (Woodall 2013, 154-7). Yet the challenge is even more daunting for Chinese leaders, who must reduce pollution while pondering policies to cut greenhouse gas emissions.

China’s leaders must orchestrate environmental cleanup efforts in a context in which globalization and advances in information technology make it difficult to muzzle demands for reform from an increasingly affluent citizenry, as well as from the international community. Authorities succeeded in making Beijing’s air somewhat more breathable in advance of the 2008 Olympics, although, in truth, many heavy polluters merely shifted operations outside the capital. Meanwhile, although state authorities are able to shut down groups that fail to do as they are told, the emergence of environmental NGOs and anti-pollution protests in major cities seems to indicate that China’s store of “social capital” is growing (Ma and Schmitt 2008, 102; Economy 2007, 54). Nevertheless, by the time the CCP embraced sustainable development in its Tenth Five-Year Plan (2001 – 2005), China had already overtaken the U.S. to become the world’s largest CO² emitter (Economy 2007, 45). Only time will tell whether Prime Minister Li Keqiang’s declaration of “war against pollution” is a signal of genuine governmental resolve (New York Times, March 25, 2014).

In the final analysis, the East Asian developmental state model can be adapted to settings as dissimilar as those presented by China, South Korea, and Japan. Many unique aspects of China’s institutional arrangements are the product of path dependence and situational imperatives, including the fact that the country is more akin to an empire than to a typical nation-state. Going forward, the stability of China’s developmental state will depend on how well its leaders respond to the challenges of decoupling economic growth and environmental cleanup, curbing corruption while resisting the temptation to prop up politically potent but inefficient firms, and narrowing the gap between rich and poor. The well-being of the world economy hinges on the success of the Chinese leaders in addressing these critical challenges. Although China has ascended a developmental staircase broadly comparable to that trodden by Japan and South Korea, there is no reason to assume that development cannot beget decay or that the road ahead inexorably leads to a common terminus. Indeed, the institutional framework of China’s developmental state remains fragile, and concrete steps must be taken if it is to survive and prosper in an uncertain future.

Selected References

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Fortunately, occasions when front-page headlines support the analysis in a due diligence report remain rare. On this occasion, the bankruptcy of Pioneer Iron and Steel leading to transfers of company assets from the trading company to other entities owned by the Pioneer Metals Group fulfilled the worst-case risk scenario in a due diligence report I’d given to a client a few years before. The largest risk, depending on what business the client planned to do with Pioneer, was that the corporate structure allowed for undocumented asset transfers. I never expected to see the exact risk we’d documented on the front page of a newspaper.

I noticed the client’s name was not on the list of creditors, so it was likely they had put measures in place to protect their company from the financial losses and potential reputation issues that headlines about deals gone bad can bring.

For most companies, due diligence focuses on protecting a company’s reputation and finances through understanding business partners better. To highlight the importance of due diligence on investment partners or supply chain partners in China, let me provide examples of successes and failures companies have experienced in their China business and show how robust — or superficial — due diligence affected the outcome.

Deals go bad all over the world and in one’s own backyard. Yet, it is often the lure of China, the promise of increasing revenues, the exciting focus on guanxi (networking and relationships), and the mystique of the potential in this huge market that make executives overlook risks they might not ignore in a domestic market or one without as much perceived upside potential. I’ve been involved in numerous situations in which executives with the stars of market potential in their eyes ignored the necessity of deep due diligence on a pre-transaction project. The dealmakers stuck to a fig leaf compliance approach, wanting to cover up the full picture of a risky investment. They would check a compliance box to satisfy a board prior to pushing through a lightly vetted deal. The investment team may have received their bonuses that year, but down the road the fig leaf would fall and companies would often suffer financial and reputation losses. Those types of clients are the best for consultants, public relations firms, and lawyers because we know that these types of deals will probably result in lucrative investigations once the deal goes bad.

A basic principle of any partnership is understanding the identity and experience of a partner. Most people wouldn’t get married without knowing their future spouse’s background, but companies regularly don’t take the time to learn about the companies and executives they do business with, paying them millions of dollars and often losing millions.

The first step of any due diligence is to verify the company’s registration details with China’s Administration for Industry and Commerce (AIC) or Hong Kong’s company registrar. In this case, the AIC records showed the Steel Princess set up a network of companies, ultimately owned by her and her mother, through which she held shares in iron and steel producers in China. The parent company also had holdings and links to Hong Kong companies that in turn had interests in entities in the British Virgin Islands, providing an easy route for transferring money out of China or Hong Kong and causing large risks to investors.

Either the Steel Princess or her mother were the legal representatives of each of the companies in the Pioneer Group. In China, the AIC registration file shows the name of the company’s legal representative, the person responsible for any of the company’s legal obligations such as paying bills or transferring funds. The legal representative is the ultimate controller of the company. The legal representative must sign any contract a company in China enters into. The Steel Princess set up her companies well. She was clearly the boss. By contrast, we often come across scenarios where clients are negotiating with people who are not the company’s legal representatives. Deals are not valid until the legal representative signs off.

The CEO of Pioneer Metals, called by China’s press the Steel Princess because her grandfather was the Minister of Metallurgy in the 1970s, did have connections in the metals industry in the country as a princeling, a child or grandchild of government or party official in China. However, during our research for the client’s due diligence report, we interviewed industry insiders and did not find any history of the Steel Princess having worked in government steel producers or in the Ministry of Metallurgy. The structure of her company and cash infusions appeared to be her main contribution to the industry.

Another risk I pointed out to the client was that the CEO’s grandfather was a policymaker more than 30 years ago. As such, it was unlikely she or her family had any influence with current policymakers. For the client, the risk could be that they were paying a person for a pedigree without any evidence the person had practical skills to get the job done. If the client wanted her to lobby for or against regulations or gain connections in the current government, they might find her connections dated and irrelevant. If they were looking for practical industry knowledge, they might consider someone with different experience.

Restrictions in the metals industry required multinationals to deal with domestic Chinese companies, and Pioneer Metals had a high profile. The CEO was one of the richest women in China, according to various annually published lists. The Forbes or Hurun “rich lists” often attract investors or business partners for those on the lists on the assumption that connections with perceived money and power will help them do business in China. But in our experience, a spot on the rich list is often short-lived. Many former rich list stars have experienced meteor-like falls from grace as a result of high-profile investigations by China’s Economic Crime Bureau. By 2010, China’s richest man in 2006, Huang Guangyu, CEO of Gome Electrical Appliances, was serving a 14-year prison sentence on a fraud and corruption conviction. Another 2006 rich list rising star, Wu Ying of Bense Group, later received a commuted death sentence for the allegedly fraudulent activity that got her onto the rich list.

A quick Internet search will identify high-profile individuals such as the Steel Princess or Huang Guangyu, but a few times, clients provided only the English name of a Chinese person they saw as the key to success of their China business based on a dinner or business meeting. That’s how one due diligence report started on a Shanghai-based gentleman applying for a high net worth account with a multinational bank in New York. The client sent us the individual’s English name and China bank account number. First, like most countries, privacy laws protect bank accounts in China. Second, a Chinese bank account must be registered with the individual’s Chinese name as it appears on his or her Chinese identity card or passport. Obviously, the English name could have been made up. We asked the client for better identifying information, such as a Chinese name and copy of a passport. Fortunately, they sent a business card and passport copy the next day, so we had a proper Chinese name and a company name and address.

The AIC records showed that the gentleman in question was indeed the legal representative of the investment firm he claimed to own, but a visit to the offices in Shanghai’s Pudong district found an office with a locked door. The management of the high-end office building was not familiar with the company or the legal representative, but confirmed the company did rent the office space and pay its bills. Media searches found no record of the investment firm or the firm’s CEO. Industry contacts had never heard of the firm, which according to the client had about US$300 million in assets.

With most companies or individuals in China, it is possible to research and find information on track records within an industry and trace a CEO’s “first bucket of gold,”as many rags to riches stories of Chinese entrepreneurs are documented in profiles of executives for business magazines, known by industry insiders or by current and former employers. But the assets and seed money of our client’s potential client were untraceable. It was as if he had created the money out of thin air.

We had to issue a report stating that we couldn’t find the source of funds or any business profile for the executive and concluded that any transaction with him would be high risk. Fortunately, anti-money laundering regulations require banks to prove the source of their clients’ funds. A few months later, the executive’s name was all over China’s front pages, but not connected to our client. The executive and his investment firm reportedly were the cover for a corrupt government official attempting to siphon off millions of dollars from the Shanghai municipal pension fund and hide the money abroad.

Another scenario where due diligence plays an important role involves compliance with laws in the client’s home country. The U.S. and U.K. both have anti-corruption statutes that apply to multinationals in their home markets as well as international markets. In the U.S., they are the Foreign Corrupt Practices Act and Sarbanes-Oxley acts. In the U.K., it is the Anti-Bribery Act. Companies must have transparent programs in place to show they understand the identities of their suppliers, vendors, and distributors.

Consider cases in which companies applied a fig leaf compliance approach, determining only whether the company is registered with the AIC, for example, rather than verifying any government connections or reputation issues:

• By 2010, Siemens AG paid more than US$ 1 billion in fines to U.S. and German government agencies for overlooking the fact that subsidiaries in foreign countries, including China, used consultants or marketing firms to pay bribes to government officials to obtain contracts. Most of the consulting firms were owned by friends and relatives of government officials. (See https://www.sec.gov/news/press/2008/2008-294.htm for a full article.)
• Also in 2010, telecommunications company Alcatel-Lucent paid US$135 million to the Securities and Exchange Commission for similar payments to government officials made via consultants acting as agents for telecommunications bids. (See www.sec.gov for plenty of examples of similar cases).
• And British pharmaceutical giant GlaxoSmithKline has been involved for the past year in a corruption scandal that began in China where sales and marketing vendors are said to have paid bribes in the forms of airplane tickets, vacations, and cash to doctors to get the company’s drugs in Chinese hospitals, which are state-owned and thus government entities for purposes of the U.K. Anti-Bribery Act and U.S. Foreign Corrupt Practices Act. It should be noted that while fines have not been set, a number of GlaxoSmithKline executives and business partners in China have been imprisoned as the case came about through investigation by China’s Ministry of Public Security. (For a thorough article on this case see: http://www.nytimes.com/2013/07/16/business/global/glaxo-used-travel-firms-in-bribery-china-says.html.)

For industries such as telecommunications, pharmaceuticals, and real estate, government restrictions on participation by foreign companies, project bidding, and a high level of government ownership in domestic China assets creates risk for many forms of corruption in the downstream supply chain.

One telecommunications multinational wanted to get ahead of the game and start a due diligence program for its existing sales and marketing vendors. These vendors were assigned to participate in bids for government projects, and their task was to understand the technical requirements, outline technical specifications for the client, and manage the bid process. They thought that by keeping this kind of arm’s-length approach, they would protect themselves from any situations in which their staff would be in a position to bribe government officials during the bid.

We were assigned to conduct due diligence on hundreds of these agents. The client maintained a few agents in every province in China. The main objective was to determine whether any of the agents were linked to government officials.

We initially identified a few agents either linked to government officials or entities, or linked to the client’s own employees. Unfortunately, the client put its employees in a difficult position requiring sales staff to find the agents, brief them, and sign contracts with them. They had no front-end due diligence process in place to check agents prior to signing contracts. In other words, they had no substantial controls in place. The sales team was, of course, under pressure to win bids and make money. Without any initial controls, the sales team found whomever they thought could win the bid, which included companies with close government connections.

The client also had a substantial base of agents with a track record for working on telecommunications bids and no obvious government connections, so they were not in danger of losing too many of their agents.

The vice president of sales in charge of our project, who reported findings to corporate legal counsel, came to me one day with a report that raised red flags about an agent. The AIC records showed the agent’s company had a connection to an employee and a government official as a minor shareholder. He said, “Are you sure about the findings on this company?”I explained to him that the AIC records were very clear. “But this is my top agent and my top salesperson here. What am I going to do?”

The vice president of sales did not flinch when it came to cutting out a few of the initial agents with unwanted connections, but he balked in this instance. Taking action against this agent could hit sales figures. Shortly thereafter, the system I had set up to compare agent company AIC filings to sales staff names and known government official names was taken back for the sales and marketing team to handle.

It is not uncommon for companies like this one to find themselves a few years down the road caught between over-reliance on guanxi and the vagaries of fig leaf compliance. Executives are often fearful of dropping the fig leaf because of what might be revealed.

From a slightly different perspective, the real estate industry in China has been the source of the most exciting and scandalous due diligence reports and fraud investigations I’ve been involved in. The combination of government ownership of land and skyrocketing land and housing prices over the last 15 years has created interesting bedfellows and motivations.

A U.S. based multinational investment bank requested a due diligence report on a Chinese-owned real estate development company that approached them for funding of a five-star hotel in a prime location of a major Chinese city.

The client felt comfortable with the Chinese real estate company through the CEO, a man born in China who had immigrated to a European country in his 20s after making his first “bucket of gold.” A few years after returning from abroad, the CEO had a thriving real estate development company and planned to list it on the Hong Kong stock exchange. It was not surprising when the investment bankers and the legal counsel requested a conference call to discuss the findings of our report.

With many companies and people involved in the hot real estate market, industry insiders were easy to track down. They led us to other industry insiders and even family members of the CEO. We discovered that the CEO made his first “bucket of gold”through working with the Triads (Chinese mafia) in southern China, and sometimes still used them to threaten business partners. Additionally, the CEO had close connections with the Communist Party secretary of the city involved in granting the land use rights for the hotel, and in the past the developer had received some deals that simply could not have happened without under-the-table government support.

On the phone, the client said, “I just can’t believe these findings. This sounds like a mafia organization, but when we go to their office everyone speaks fluent English. They’re very professional. I mean, the staff are all wearing khakis and Polo shirts.”

To which his colleague (the legal counsel, I presume) replied, “The 9/11 terrorists were also wearing khakis.”

I explained to the investment team that the findings were definitely unusual, and because of that we made sure that we corroborated the most serious allegations with three or more sources that included former and current employees, business partners and even a family member. The client did not go through with the deal, but the developer found other investors. When I’m in China, I go to the bar of the luxury hotel the developer built and wonder whether the story will ever hit the headlines.

For me, China is still one of the most interesting markets for due diligence because of the competition between a market potentially teeming with deals and profits and a very opaque business and legal environment. In that context, many companies have gotten burned financially or their reputations have taken a beating merely due to not taking the time or spending the money to understand their business partners.

The post In Due Time: China’s business environment makes the case for due diligence appeared first on China Research Center.

Introduction

As China’s economy moves ever closer to surpassing the U.S. in terms of purchasing power GDP, China’s currency system seems incompatible with its global economic status. China’s new leadership led by President Xi Jinping is pushing to modernize and marketize the currency system along with necessary concurrent reforms. The 2008 financial crisis was a wake-up call for many countries, demonstrating the heavy dependence of the global economy on the U.S. dollar. The vulnerability of the U.S. economy became everyone’s challenge. Reform of the Renminbi (RMB) became a priority in order to establish the Chinese currency as a global player and lessen China’s reliance on the U.S. dollar. Aside from the fallout from the financial crisis, the sheer size of China’s cross-border trade is creating demand for far more depth and flexibility in the currency markets.

On April 28, 2014, China Research Center Director Penelope Prime talked with Henry Yu, Managing Director of Fifth Third Bank in Atlanta, Georgia, via telephone about China’s current currency reforms. This commentary is based largely on that conversation.

Based on his observations of China’s most recent moves towards currency reform and from talking with bank officials and other experts in China about the on-going policy discussions, Henry Yu expects major changes to occur within three to five years, with the lifting of all capital restrictions a few years later.

Yu believes that the process of establishing the RMB as an international currency will involve merging offshore and onshore currency markets. This merger will require deepening the sophistication and depth of China’s financial institutions in order to integrate China’s system with global markets. If China’s currency is to become a major player, whether as a managed or a free floating currency, many steps need to be taken throughout the economy. Multinational corporations today manage cash on a global basis, and the RMB is acting as a constraint in this process. As has been the norm in China during the reform era, China’s leaders are taking measured steps, one baby step at a time, to achieve these goals, but Yu sees definite movement forward.

Historical Context

In the early days of economic reform and opening, China established Foreign Exchange Certificates as a parallel currency to the domestic Renminbi, or “people’s currency.” Yu remembers this as an awkward system, especially as cross-border trade increased, but it served the purpose of controlling access to foreign currency by domestic business and consumers to shield the economy from global markets. This was a political imperative at the time.

By the early 1990s, the Chinese National Yuan (CNY) was introduced as part of comprehensive banking and financial reform, and Foreign Exchange Certificates were retired. Soon after this the Asian financial crisis revealed that freeing capital flows without a sophisticated financial system could lead to serious trouble. One could surmise that China’s leaders took this lesson to heart and decided to delay more currency reform until after successful banking reform. The next decade saw measures to lower China’s banks’ bad debt, to create and strengthen the supervision of the banking, securities and insurance sectors, and to prepare for and successfully carry out initial public offerings of the four major state banks in the global market place.

Yu emphasizes the importance of Hong Kong in China’s currency reform process. From the beginning of China’s reforms, Hong Kong played a major role in both the shift of manufacturing from the territory to southern China and the financial logistics and support behind it. By the early 2000s, Beijing tapped Hong Kong to play a key role in the next steps of currency reform. Hong Kong was designated as a test location where banks could facilitate individuals’ retail conversion of Hong Kong Dollars to RMB with a small daily conversion limit imposed, but companies were not yet allowed to do so. This was the first offshore currency trading in RMB, and was distinguished from onshore RMB (or CNY) as CNH.

As Yu put it, “The way I look at it, the leadership is creating a new currency outside of China using Hong Kong as a window.”

The Yuan Offshore Market

The movement of onshore and offshore RMB became possible as part of China’s cross-border trade transactions rules. Over the last decade the yuan offshore currency market has steadily developed, propelled by China’s entry into the World Trade Organization in 2001. The currency has been freely convertible for trading purposes since 2009, and growing offshore access facilitates these transactions. The currency is not deliverable outside of China except in offshore centers, which now include Singapore, London, and Taipei. At this time the offshore circulation is quite small, estimated at less than 1 percent of the onshore circulation. However, about 15 percent of China’s cross-border trade is settled in domestic currency, which means that many traders have access to RMB either onshore or off. As a result, then, there is a rising demand to hold RMB outside of China, creating an even greater need for offshore markets.

China’s Vice Premier Li Keqiang visited Hong Kong on August 19, 2011 to reaffirm China’s Central Government’s commitment to develop the territory as the offshore RMB Center. The People’s Bank of China designated the Bank of China as the clearing institution for CNH in Hong Kong. An offshore link to China’s domestic national advance payments system (CNAPS) is needed for the free flow of fund, Yu says. Ideally there would be a one-to-one correspondence between the value of the CNH and CNY. This is evolving, with CNH commanding a premium for now.

With an estimated $140 billion worth of RMB now in Hong Kong, a balance of RMB assets and liabilities and broader investment options are needed for offshore RMB to expand its reach, value, liquidity, and acceptance to investors and traders, Yu says. Right now, RMB can be held in Bank of China accounts, with some options to buy bonds (known as Dim Sum bonds) or derivatives offered by Hong Kong banks tied to the stock exchange. The latest option is lending offshore CNH back to onshore Chinese or foreign companies. This is being tried on a very limited basis with large companies in special zones such as the Qianhai zone in the West Shenzhen (announced in 2012) district and the new Shanghai Free Trade Zone (announced in September of 2013). Both the Qianhai Free Trade Area and Shanghai Pilot FTZ broadened the usage of RMB and for the first time allowed companies within the zone to borrow offshore RMB for operating needs on a limited basis, as well as pooling of onshore and offshore RMB. One of the major benefits is that companies can borrow at lower costs offshore, which will also eventually lower the onshore interest rates. In addition, the new practices create a limited testing ground for free movements of onshore and offshore RMB.

According to Yu, on the official level, China has negotiated bilateral currency swaps worth over $400 billion with 20-plus countries, with approximately half of these countries in the Asia-Pacific region. These have two purposes. One is that in the case of distress, the two countries can have access to each others’ currency. Second, it opens a currency channel between the two central banks, allowing liquidity to be shared.

The Capital Account Opens

A key aspect of moving the RMB toward serving as an international currency is the continued loosening of restrictions on inward and outward flows of capital. New moves are expected with respect to allowing Chinese tourists to convert more RMB into foreign currency, allowing some investors to begin buying foreign equities and eventually increasing the amount of capital that can be used outside of China for investment purposes (Davies 2014). Ultimately private outflows of capital would lessen the need for official purchases of government bonds, assuming China continues to experience trade surpluses. Outward flows would also serve as a counter-balance to the inward flows aimed at capturing an ever rising value of the RMB.

What to Expect Next

The strategy of “taking baby and calculated steps” is expected to continue, Yu says. Chinese policymakers will not want to introduce currency value volatility or encourage “hot money” flows, especially when they still need time to create currency instruments, extend banking sector experience, and improve the debt and equity markets to handle the new stage of financial deepening. But eventually, according to Yu, there will be few if any restrictions on offshore RMB flowing back into China. The ultimate goal is to increase the circulation of offshore RMB and eventually merge the offshore and onshore markets into one currency system with one value. Yu feels strongly that the new leadership team of President Xi and Premier Li is serious about increased market reforms, and financial reform in particular, to allow the market to be the force in driving the economy and to further reduce government intervention. Yu cites as one example an official at the People’s Bank of China indicated that if a transaction can be done in dollars it should also be able to be done in RMB.

As China’s economy grows and with cross-border trade expected to surpass $10 trillion by 2020, the sheer quantity of currency transactions will require more options and flexibility. All indications are that China’s policy makers are responding to this growing global demand for RMB.

References:

Davies, Gavyn (2014). “China’s changing exchange rate policy,” The Wall Street Journal, May 4^th. http:/blogs.ft.com/gavyndavies. Accessed May 6, 2014.

The post China’s Currency Reforms from a Banker’s Perspective appeared first on China Research Center.

These interests may explain why China has decided to call in a $3 billion loan to Ukraine in late February¹. If China stands by this demand for Ukrainian repayment of this loan as Kiev faces mounting Russian pressure and economic difficulties, this would represent substantial, if low-keyed Chinese support for Moscow in this crisis.

On the other hand, Beijing has long-standing and strongly felt taboos against foreign interference in the internal affairs of sovereign states and secession of territories within sovereign states on the basis of popular elections. Since the end of the Cold War, China has emerged as a staunch defender of strong state sovereignty norms, opposing attempts by one state to bring about political changes within another. This preference for strong state sovereignty norms is rooted in Beijing’s apprehensions regarding Taiwan, Tibet, and Xinjiang and fears that “the West led by the United States”² might attempt to detach one or all of those regions from the PRC, using the pretext of popular will and elections. From Beijing’s perspective, this was what “the West led by the United States” did first with the Baltic republics of the declining USSR, and then with ex-Communist Yugoslavia. Thus, if Beijing openly endorsed Putin’s seizure of the Crimea, it would open China to charges of hypocrisy. Such charges could be influential with Western public opinion, which is the main target of China’s defense of state sovereignty norms.

In line with these interests, Beijing abstained in the U.N. Security Council when Britain, France, and the United States proposed a resolution condemning the Russian-organized referendum on Crimean secession from Ukraine and entry into the Russian Federation. President Barack Obama telephoned President Xi Jinping before the Security Council vote on March 16 to lobby for China to vote “yes” on the Western-backed proposal.³ Instead China merely abstained, allowing Russia’s veto alone to kill the condemnatory proposal. This was a marked departure from the close cooperation of Moscow and Beijing on a score of issues before the Security Council since the mid-1990s. It also allowed Western powers to claim that Russia was isolated. More important for Beijing, it allowed China to evade endorsement of foreign intervention in another state’s internal affairs and succession of territories on the basis of popular will and elections. In terms of formal declared position, Beijing has called for resolution of differences through peaceful discussion and dialogue, and for respect for Ukrainian sovereignty. Chinese Foreign Ministry Spokesman Qin Gang said on March 4:

“We uphold the principle of non-interference in others’ internal affairs and respect international law and widely recognized norms governing international relations. Meanwhile we take into account the historical facts and realistic complexity of the Ukrainian issue”⁴

When pressed to explain what he meant by relevant “historical facts,” Qin invited his audience to “please review or refer to the history of Ukraine and this region.” That “history” might refer to “the eastward expansion of NATO” condemned routinely by Beijing and Moscow during the 1990s, and/or to the long and close association between Russia and the Ukraine. Or it might not. That is left to one’s imagination. When the issue was debated again in the General Assembly (in which no country has veto power), China joined 57 other countries in abstaining from a resolution condemning Russian actions and calling on states to “desist and refrain” from actions recognizing changes in Ukraine’s borders achieved through threat or use of force. On this occasion Ambassador Liu Jieyi stated that a General Assembly vote “would only complicate the picture,” and he called on all parties to “examine proposals for a political settlement.”⁵

At a more fundamental level, it is fortunate for China that the U.S. has been pulled, once again, into a crisis in a region of the world far from the Western Pacific where the U.S. and the PRC are working out a new balance. Beijing recognized the 9/11 attacks as a strategic windfall for China, keeping the United States from fixing on China as its next rival after the demise of the Soviet Union. Beijing views Obama’s desire to conclude U.S. involvement in the Iraq and Afghanistan wars as the counterpart of his “pivot to Asia,” which it deems to be a type of crypto-containment of China. The Ukrainian crisis, combined with deep cuts in U.S. defense spending, will hinder Washington’s ability to give substance to this new crypto-containment effort.

Against those hard realities Beijing weighs the specter of a world dominated by the will of the stronger in which armed seizure of territory becomes common. Some in Beijing certainly understand that that would lead to greater global instability that could undermine both China’s economic growth and national security. On the other hand, cooperation with a seemingly declining U.S. to uphold international order may be a step too far for China’s realist-minded leaders.

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