Investment Banking and Chinese Entrepreneurship

John D. Langlois, Jr.
Shorenstein Reports on Contemporary East Asia
Number 15
March 1997

The 1996-97 Shorenstein Seminars on Contemporary East Asia presented a public lecture on economic and financial trends in China and the role U. S. investors and Chinese entrepreneurs are likely to play in the coming years. The talk took place at The Faculty Club on Wednesday, March 12, 1997.

John Langlois is a Managing Director and Head of Investment Banking/Asian Clients in the United States for J. P. Morgan. Prior to his fifteen years with J. P. Morgan, Dr. Langlois served as chairman of the History Department at Bowdoin College in Maine.

Summary:

The real subject of the talk, Dr. Langlois began, is "how to look at China and how not to." The March/April 1997 edition of Foreign Affairs provides two examples of how not to look at China, he said, citing "The Coming Conflict with America" by Richard Bernstein and Ross H. Munro and "China's Troubled Workers," by Anita Chan and Robert A. Senser. In contrast with these views, Dr. Langlois presented what he sees in China, focusing on the entrepreneurial activities of government bodies and state-owned enterprises and how they intersect with Western investment banks.

As an investment banker, Dr. Langlois brings together those who need money and those who have it; he connects investors with producers and entrepreneurs. China's immense potential for growth, or "G" in the parlance of the financial world, has generated great interest in securities issued by Chinese firms through foreign intermediaries. While China's transition to a market economy remains incomplete, in general the trends in the business climate are positive. Dr. Langlois spelled out a number of such trends:

• The Chinese government has rearranged its fiscal structure, moving toward a system with a central revenue-collection agency.
• The Chinese government has unified the two exchange rates and begun to overhaul the banking system.
• State-owned enterprises are selling equity to domestic investors.
• The state now auctions domestic bonds, rather than compelling workers to buy them. Some bonds are linked to the inflation rate, which has dropped to just a little over six percent.
• People are filing lawsuits under newly passed laws.
• Money-losing state-owned enterprises are gradually being "euthanized," in part by putting a cap on the stipends laid-off workers receive. As inflation eats away at employees' incomes, they are forced to find other means of supporting themselves.
• Some 100 to 200 million people in China, mainly those living in coastal regions, today have reached nominal incomes of $3,000-$4,000.
• Western rating agencies like Standard and Poors and Moodys give investment-grade ratings to China. With high reserves, no history of default, and strong capacity to service foreign debt, China could have even better ratings if it were not for concerns about political stability.
• Gross domestic product has grown at 9 percent a year for the past thirteen years.
• Foreign direct investment has grown quickly since 1991, reaching $40 billion last year.
• Foreign exchange reserves are up to $100 billion, comparable to the holdings of Taiwan, Hong Kong, and Singapore. Aggregated, Chinese control reserves of $400 to 500 billion.
• Chinese investors can now buy many types of securities. China's stock exchanges are highly automated, and 500 companies with a total market capitalization of $120 billion are listed on them. China has made limited progress in securities regulation.
• China has wisely avoided "hot money syndrome," like that responsible for the peso collapse in Mexico, by keeping its currency only partially convertible.

At the same time, Dr. Langlois pointed out, there is another side to the economic story in China:

• China's counterpart to the Securities Exchange Commission does not exist to protect the investor; it has social and political goals as well and may list companies on the basis of connections or a political agenda. Also, disclosure remains poor.
• The central planning apparatus remains strong.
• Accounting standards still need much work.
• State-owned enterprises take up 60 percent of national investment and a third of the government budget; 75 percent of household savings go to support such enterprises through the banks. Rather than duplicate Russia's experience, the Chinese government is only slowly "pulling the plug" on state-owned enterprises.
• Frequent government policy changes, as well as scandals, trigger volatility in the markets.
• The Bank of China and other state-owned banks are trying to be a commercial banks but are weighed down by the legacy of bad loans to state-owned enterprises. If these were written down, there would be negative equity left in the banking system.
• Interest rates for many loans are set by government policy, rather than being weighted for risk. Banks often have no capital left to lend to credit-worthy firms like joint ventures.
• At the end of 1993 the government announced that twenty-one state companies were eligible to list offshore. The underwriters who won the right to do the underwriting for some of these companies, upon examining their books, found them unfit.
• Rather than privatize, state-owned enterprises are selling minority shares to investors. The Chinese government is still unable to countenance private control of a major sector of the economy. The word "privatization" may never be politically acceptable, but eventually China will pursue it under a politically palatable label. Still, the government is beginning to allow state-owned enterprises to go bankrupt. In 1996, Shanghai saw fifty-two cases of bankruptcy involving 60,000 employees. The authorities are gradually getting comfortable with the idea of closing down companies that aren't profitable.

Turning to the issue of entrepreneurship, Dr. Langlois asked Who are the entrepreneurs in China? Some of them are part of the army, which has 15,000-20,000 subsidiary companies. The army is involved in such diverse areas as pig farming, hospitals, airlines, coal mines, trucking, hotels, three pro basketball teams, textiles, pharmaceuticals, futures, counterfeit CDs, and real estate development. Rather than worry about China's growing defense budgets, people should think about how much of that budget is being diverted to commercial investments.

In fact, many branches of the government have companies associated with them; Dr. Langlois calls this "official entrepreneurship." For instance, the state administration for foreign exchange has a company selling information about foreign exchange rules. Even the Ministry of Finance has commercial subsidiaries.

Official entrepreneurship can be seen in the several kinds of Chinese securities on the market. A-shares and B-shares are listed in China; the former are for purchase by Chinese citizens, the latter by foreigners. H-shares are issued in Hong Kong by Chinese companies, and Red Chips are issued by Hong Kong companies whose assets are all in China. Red Chips often have a surprising array of holdings; for instance, China Poly Group, a branch of the army, owns among other things the new stock exchange building in Pudong. State-owned enterprises, too, are engaging in entrepreneurship of their own, recruiting foreign investment banks to help them sell shares outside China. Shares in a number of Chinese highways are currently on the market as well.

Nonstate entrepreneurs also have a place in China's economy, said Dr. Langlois. One day a man claiming to possess contracts giving him the right to collect tolls and fees on several highways, bridges, and waterworks in Guangdong walked into the J. P. Morgan office in Hong Kong.

Dr. Langlois was initially skeptical, but the contracts proved to be genuine and written carefully by lawyers; J. P. Morgan helped him raise capital. The man turned out to be a self-taught entrepreneur. There are many such people in China, Dr. Langlois said, and many opportunities for successful cooperation between investors and genuine business ventures.

China is a diverse place, not monolithic, Dr. Langlois concluded. "Based on our work there, we're seeing a very dynamic place, but at the same time a very difficult place. Sometimes the concepts are new, and like anywhere, there are a lot of people who aren't honest, so you have to be careful, and exercise a lot of due diligence. But if you do those things, you can find a lot of opportunities, and get that 'G'. The 'G' is still there."

Summarized by Benjamin Read.