Book review of Privatising China by Walter and Howie

Privatising China by Carl Walter and Fraser Howie: A review. This appeared in Business Standard on 31 January.

One of the many mysteries about China is the dichotomy between a booming economy and a malperforming stock market. Walter and Howie have written a fascinating book which helps us understand what is going on inside China's stock markets.

The first piece of the puzzle lies in the distinction between the Chinese economy and Chinese firms. China has done three key things right: they have good infrastructure, they have a proper national VAT and they have good labour law. Through this, China is an ideal destination for global corporations seeking to place factories. In China, this global economy is booming. This MNC activity has nothing to do with the Chinese stock market.

The second important distinction is between the onshore and offshore markets. The existence of Hong Kong has given China a quantum leap forward in the construction of a modern market economy. Hong Kong was immune to Chinese socialism, and governed by British law all along. To make an analogy, suppose Surat was ruled by the British after 1947. Through this, suppose Surat had escaped the ravages of socialism, had capital account convertibility, lacked a license-permit raj in finance, etc. Then Surat today would have been an international financial centre with top quality markets and knowledge. That is what China has in Hong Kong. China does not really need to create exchanges that trade the spot and derivatives markets because it already has them in Hong Kong. The entire story of Shanghai and Shenzen summarises to only one thing: that these exchanges do not hold a candle to Hong Kong.

If China has a world class financial centre in Hong Kong, then what is the problem with the Chinese stock market? The problem lies in the legal entity called "the corporation". Under socialism, there was no such thing as a firm; everything was a part of the State. To make an Indian analogy, recall the Department of Telecommunications. All Chinese production was organised like that. In India's case, when the time came to corporatise and privatise DOT, it was possible to shift the operations of DOT into the legal entities called limited liability corporations - MTNL, BSNL and VSNL. This was possible because India always had company law and now has centuries of experience with the idea of a firm. This idea is not yet clear in Chinese law.

What the Chinese have done is to carve up something like DOT into multiple sets of assets and liabilities. This has resulted in multiple classes of shares which trade separately. The legal rights of these distinct classes have not been adequately clarified, and they trade separately at very different prices. Because they are distinct legal rights, they are not fungible and these distinct prices cannot be arbitraged. It is not like Indian firms listed on NSE/BSE/NYSE where the securities are essentially identical.

In India, we also have problems associated with the notion of the firm. We have a good situation on the basic notion of equity; we have difficulties on corporate governance and we have a bad situation on the concept of debt. In China's case, the problems are much more acute and basic. The very foundation of a firm as a single financial unit does not exist.

The overall flavour of the Chinese equity market is one where the State has obtained some financing by doing a little disinvestment in a SOEs. Roughly 75% of the listed firms are such partly disinvested SOEs.

From the viewpoint of a foreign investor, the Chinese market is a forbidding one, with these deep problems afflicting the notion of a firm, difficulties with exchanges, trading and regulation, and a overbearing role of the State.

Walter and Howie have done an excellent job of painting a picture of what is going on in China. From an Indian perspective, it is a call to arms to focus on the core business of becoming a mature market economy: that of establishing sound legal and institutional frameworks. In the case of firms, the biggest piece lacking in India today is a bankruptcy code. What happens when a firm fails to repay a bond or a loan in a mature market economy? A swift procedure ensures full legal clarity on the next steps: the firm is taken over by a court-appointed receiver and auctioned off; using the proceeds, the bondholders are paid and finally if there is anything left over it goes to the shareholders. The whole thing ought to take less than six months. India has as much of a mess on this question as the Chinese have a mess on the notion of firm equity.