Transfixed by the China hyper-growth story, global investors have spent more than $30 billion on mega-initial public offerings by mainland banks in 2006. However, former U.S. Federal Reserve chairman Paul Volcker struck a cautionary note in Beijing on Nov. 3 about the long-term credit quality of Chinese lenders and Beijing's commitment to cut off funding to struggling state-owned companies and discourage corporate corruption.
Volker suggested that despite much progress, some major government-owned companies were not "paragons of profitability and efficiency." He added: "The temptation is to keep them going by financing, but it's very important China be disciplined about credit policy" of its major banks. "That is probably the major challenge facing the Chinese financial system."
Widely respected in international financial circles for ending runaway U.S. inflation in the early 1980s, Volcker made his remarks during a wide-ranging interview with Business Week Editor-in-Chief Stephen J. Adler before global executives at the final day of the magazine's CEO Forum. Drawing on his high-profile role in investigating the scandal-ridden U.N. oil-for-food program in Iraq, Volcker also questioned the effectiveness of the international body and suggested that U.S. standing in the world had fallen due to its invasion of Iraq.
The former Fed chairman also weighed in on a running debate at the executive gathering about whether developing economies performed better with a free-wheeling democracy such as India's, or with China's more top-down authoritarian political system. "At some point, economic freedom ultimately clashes with a highly controlled political apparatus," he said of China. However, he thinks both countries could very well continue their high-speed growth rates, despite dramatically different styles of government.
Regarding the investor enthusiasm for Chinese bank stocks, Volcker reminded execs that mainland lenders have a mixed record in managing risk. Earlier this decade, China spent roughly $250 billion to inject capital into woefully undercapitalized banks and acquire nonperforming bank loans on preferential terms.
Since then, big mainland lenders such as China Construction Bank and Bank of China have raised massive sums from global investors in share offerings. These two and others have also raised billions by selling strategic equity stakes to Western financial players such as Bank of America (BAC), Goldman Sachs (GS) and American Express (AXP).
Investors in the U.S., Asia, and Europe stampeded to these offerings since some analysts contend that bank stocks represent a convenient "proxy play" investment to get broad exposure to China's high-speed economy, which has averaged nearly 11% growth rates through the first nine months of 2006. On Oct. 27 Industrial & Commercial Bank of China (ICBC) raised nearly $22 billion in a dual listing in Hong Kong and Shanghai that will go down as the biggest IPO in history (see BusinessWeek.com, 10/26/06, "The Great China IPO Haul").
Volcker also suggested the key to lowering China's swelling global trade surplus isn't rapid currency appreciation but the expansion of domestic consumption. China is now the world's No. 3 trading nation, exporting and importing about $1.4 trillion worth of goods and services a year. Its global trade surplus hit $102 billion in 2005, roughly triple year-before levels, and is on track to finish the year at more than $150 billion, most economists figure.
China's big 2005 bilateral trade surpluses with both the European Union ($127 billion) and the U.S. ($202 billion) continue to send trade hawks in the West into fits of outrage. Volcker said efforts by some U.S. lawmakers to impose punitive trade tariffs on China to prod it on currency reform were misguided. "It's hard to believe that is a constructive strategy," he said.
Cleaning the Tank
Despite China's financial reform challenges, Volcker does believe that its economic clout will grow mightily during the next two decades and that eventually the yuan will become a powerful international currency like the dollar and the euro. The Chinese currency "will become a kind of anchor currency for a group of countries" in Asia, the former Fed chairman predicted.
Volcker noted that Chinese President Hu Jintao's government has made serious efforts to clean up corporate corruption, though he thinks more work needs to be done. What's more, it is in China's long-term economic interest to do so. "The best fish go to the cleanest water," he quipped.