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The Enduring Allure of China
October 26, 2006 By Peter Zeihan The Industrial and Commercial Bank of China (ICBC) is expected to raise nearly $22 billion in an initial public offering (IPO) — the largest in history — after shares are made available to retail investors Oct. 27. The ICBC offering is the latest in a series of IPOs involving Chinese banks, into which Western investment firms have poured billions since 2005. What is surprising about the expectations for the offering is not only the tremendous amount of cash likely to be raised, but the fact that it comes only months after a number of major global accounting firms began taking note of serious structural weaknesses in China’s financial system. Recall that, in early summer, a series of reports were issued by Ernst & Young, PricewaterhouseCoopers, McKinsey Global Institute and Fitch concerning the problem of nonperforming loans (NPLs) and questioning the long-term stability of the Chinese market. These reports, we noted, aligned with a long-standing STRATFOR forecast as well; the structural weaknesses have been apparent and widely discussed in the Chinese press for years. What is curious, then, is not why mainstream accounting firms and consultancies suddenly began to question the prospects of China’s economy, but rather why foreign investors are continuing to pile into the state’s banking industry regardless. The simple answer, of course, is “irrational exuberance.” The shine of a market that services 1.3 billion people — and a chance to carve out a piece of that market for oneself — is difficult to ignore. But there is more to be considered: China has gone to considerable lengths to generate the impression that the systemic weaknesses are being addressed and to make its banks (and other state industries) appear attractive to foreign investors. It is no accident that a spate of banking IPOs — Bank of Communications ($1.6 billion raised), China Construction Bank ($8 billion), Bank of China ($11.2 billion), China Merchants Bank ($2.6 billion) — have been announced since June 2005. It also is no accident that ICBC, one of China’s “Big Four,” is going public at this time — as the transition period for full World Trade Organization membership is drawing to a close. Beijing, which long has been aware of the economic weaknesses (not to mention the political and social implications stemming from them), has been pursuing a brilliant strategy that bears some consideration. A Structural Dilemma China long has had a pressing need to address its NPL problem — and limited means of doing so. The core issue, as has been noted many times, rests in the attitude toward loans and state-driven industries — with lending practices that differ sharply from those common in the West. For Western lenders, money is viewed as a scarce commodity, and loans are allocated with rates of return and profits in mind. In the Chinese system, capital has been viewed as a political asset, allocated to achieve social aims. Controls over what kinds of collateral could be used, credit histories and sources of income have not been critical considerations. Given such values, citizens have little choice but to funnel their savings into state-owned banks (remember that legendary Asian savings rate?). Historically, those banks then have parceled out the cash — at below-market rates — to projects that contribute to the social good of mass employment. From Beijing’s perspective, it does not matter if these projects (which typically have been state-owned) turn profits or even break even financially. A bum project that runs to the red, but keeps many Chinese employed, was considered a success — and besides, it could always be buoyed up by more loans. Ultimately, projects became mired in massive debt, and the banks were saddled with masses of NPLs. Clearly, this system would lead to instability even in a perfect world — and China is far from perfect. Because of wealthy coastal magnates, local leaders now dabbling in business and the ever-present availability of easy loans, the Communist Party, and the Chinese system in general, is massively shot through with corruption. Former President Jiang Zemin in 1998 attempted to start closing down some of these dud projects — particularly the redundant and wasteful commercial projects at the local level — but met with massive backlash from local officials who had no desire either to face hordes of local unemployed or to give up suckling on the mother’s milk provided by state banks. As we noted in May 2005, a destabilizing shock appeared to be all but unavoidable by December 2006, when the transition period for China’s WTO accession ends. At that point, foreign banks — which, unlike their Chinese counterparts, actually charge interest for their loans and pay out interest on deposits — will be allowed to set up shop throughout China. Odds are that the average depositor would move his money out of the state banks, denying them the resources they need to keep the system running and leading to financial chaos and collapse. Chinese policymakers also could see this problem approaching, and they have no intention of letting the financial system be the state’s downfall. Thus, they embarked on a creative strategy. The Cleanup Strategy Again, the U.S. or Western model of cleaning up the system — a painful purge of corruption and implementation of stringent financial policies — does not apply. For the Chinese, there is simply too much at stake: As recently as three years ago, the central government, which has a vested interest in lowballing these figures, pegged the total stock of bad loans at 35 percent of gross domestic product. The Chinese could not apply the model used in the United States during the savings and loan crisis of the 1980s. At that time, independent auditors went through the books of suffering S&Ls and chopped up their loan portfolios, ranking the pieces in terms of the chances that debtors ever could pay them off. Those loans were then packaged together, ranked and sold to other — healthy — banks. Some of the S&Ls were closed; others faced massive personnel and policy overhauls. Some of the S&L corporate clients went out of business. Some S&L officers went to jail. China, rather than going down such a capital-centered route, has come up with a two-pronged strategy designed to fit its own social needs. First, the Chinese cleaned the banks’ books. The government simultaneously has pumped out cash from its now trillion-dollar foreign currency reserve to recapitalize the banks, and transferred the bulk of the NPLs to “asset management corporations.” These asset management entities are ostensibly responsible for collecting on the bad loans — though, because these remain government-owned, Beijing has no intention of forcing compliance on that issue. The asset management firms issue bonds to the banks for the full face value of the loans, making the banks’ balance sheets look sparklingly clean indeed. Second, the banks — drawing on the full authority of the Chinese state — seek out foreign investors, either through IPOs or strategic capital allocations from foreign corporations. This is a critical step, for four reasons:
This is the strategy that several Chinese banks already have followed: Bank of Communications drew capital from HSBC; China Construction Bank found an investor in Bank of America; and ICBC, which opened its IPO to institutional investors Oct. 16, lured Goldman Sachs. Conclusion Given the upcoming share sale to retail investors, ICBC’s history of action is, of course, particularly worthy of study. Since 2004, it has transferred about $85 billion in bad loans, through asset management company Huarong. Then, in 2005, it received a $15 billion cash injection from Central Huijin Co., the Chinese recapitalization body. Finally, earlier this year, ICBC sold a 5.8 percent stake to a consortium led by Goldman Sachs for $3.7 billion. As a result, the bank, which had an NPL ratio of more than 21 percent at the end of 2004, had (by its own, and therefore questionable, assessment) reduced that number to 4.1 percent as of June. Intriguingly, foreign investors seem not to have noticed how ICBC got from Point A to Point B. Some concerns about the bank’s lending practices have been voiced — most recently, following news in September that ICBC had funded a company, Fuxi Investment, that has been linked to the widening pension funds scandal. However, seemingly no attention has been given to the fact that China has been transferring NPLs from, and providing capital infusions for, state banks — including ICBC — for years, without overhauling their corporate decision-making processes or management. Not to mention the short-lived impact of all of those global accounting firm reports in May. But the anomaly in all of this — the lure of China to Western investors — remains. Digging up information about the problems in the Chinese system is not difficult; every bit of it is regularly reported in the state-run press. Government statistics are frequently optimistic, but even Beijing’s own estimates clearly point to significant structural problems. The Chinese, obviously, have been paying attention and communicating. What is puzzling is why the message does not seem to be getting through.
An Inflection Point In China's Banking Problem June 7, 2006 By George Friedman The month of May witnessed an interesting phenomenon: a spate of reports on China’s nonperforming-loan problem. What is most intriguing is that these reports did not come from organizations like STRATFOR — minor outfits that have been talking about this for a couple of years. It came from real, solid, serious mainstream organizations that were, and continue to be in some cases, quite positive about China on the whole. What is important here is not that China has a serious problem with bad loans in its banking system. That’s old news. What is important is that mainstream analysts in the West now are taking official notice of it. The wide divergence between the Western perception of Chinese economic health and the realities of China’s economy is beginning to close. There will be consequences to that. The first report came from Ernst & Young, which released a study saying that China had a substantial problem with nonperforming loans (NPLs). We have to confess to not having seen that report, because the accounting firm withdrew it a few days later. The Chinese government blasted the report, using words like “ridiculous” and “distorted.” Ernst & Young, which has a substantial practice in China, denied having retracted the report because of pressure from the government. Whatever their reasons for doing so, we wish we had been faster in asking for a copy. No matter, because May also brought studies on the same subject from PricewaterhouseCoopers (PWC), McKinsey Global Institute, and Fitch. Each said the same basic thing: that Chinese banks have enormous NPL numbers on their books. The PWC report was issued by a group within the company that specializes in making markets in NPLs. Their news was that the water in China was fine and everyone should come in. McKinsey focused on inefficiencies in the Chinese banking system that should be cleared up, so that NPLs could decline and the Chinese gross domestic product could surge. Fitch was the harshest of the three, but that firm also argued that the Chinese had the tools in place to handle the problem. The bottom line was that all three acknowledged that NPLs were a big issue for China, but they took different approaches in trying to put the problem in perspective. In other words, they gave a warning without yelling “Fire!” Some of the reports were criticized by the Chinese, but none were blasted. Meanwhile, Moody’s Investors Service has told us that they will be releasing a report in a couple of weeks. It will be interesting to see what their take is. Let’s begin this analysis by looking at a couple of quotes from these reports. McKinsey, for example, writes: “Underlying these reforms, however, is capital misallocation by the system. Nonperforming loans are the most conspicuous outcome of this misallocation, but our research shows that the much larger volume of loans to underperforming ventures that don’t go bad but yield only negligible returns are potentially more costly to China’s economy.” Fitch’s report states: “Summing all of these figures, we come up with total official nonperforming loans of US$206 bn and other estimated problem loans of over US$270 bn in the banking system. We would reiterate, however, that a large portion of this latter figure is comprised of estimated Special Mention loans or loans that currently are not classified as nonperforming [emphasis Fitch’s]. At the same time, there is an additional US$197 bn in NPL carveouts still remaining on the balance sheets of China’s asset management companies, which no longer represent direct losses for banks but are a future liability for the government.” Fitch also states: “Beyond this, estimating a rate of flow of new nonperforming loans is not an easy exercise given Chinese banks’ extremely weak historical data and ongoing deficiencies in accounting and disclosure. Few banks report data on NPL flows, and those that do show recent flow rates in the extremely low single digits. We believe these numbers understate the likely level of ultimate credit losses, given what we know to be the slow evolution of a strong credit culture and risk management practices and our suspicion that China’s over-reliance on investment-led growth comes at a cost to bank credit quality.” Fitch is estimating China’s bad-loan situation (our term, lumping all these categories together) at $673 billion, but it warns that — given Chinese accounting and reporting, and the fact that what reporting exists is not credible — $673 billion is a low number. That’s important. If $673 billion was the final number, then measures that are put in place could limit the ultimate losses to a level below that figure. If, however, the total number of bad loans is substantially higher than $673 billion — which is our view of the situation — then the system would be lucky to have to write off only this amount. There are numerous ways to measure the magnitude of the problem, but one of the simplest is this. China is said to hold nearly $819 billion in foreign reserves. Fitch’s conservative estimate of the bad loan situation comes close to matching that number, and a more liberal calculation would swallow those reserves up and then some. Put very simply, the Chinese banking system is in deep trouble — and with it, so is the Chinese economy. It has become an article of faith that China’s economy is booming. The economy certainly is growing rapidly. But growth and size alone don’t tell you how healthy an economic entity is. During the Great Depression, the U.S. economy was enormous, but it was crippled. Japan’s economy was growing at a phenomenal rate in the 1980s, all the while heading for its disaster. Size and growth are but two measures of an economy — or of a business. They do not tell you how well it is doing. The basic problem of the Chinese economy, as in many Asian nations, is that the banks have not made loans with business considerations in mind. They made loans for political reasons and to maintain social stability. In many cases, loans were seen as being more like grants. As a result, they were invested in enterprises that did not make enough money to repay (or even attempt to repay) the loans. Frequently, rather than bankrupting the business or writing off the loan, the banks lent more money to the business — so that it could repay old debts, and there was an appearance that the loans were viable. Loans went into land speculation or to investments in areas that were already overbuilt. (And this does not attempt to take into account ancillary problems, such as corruption and embezzlement, which also have been significant issues for the Chinese government.) In the first part of 2006, there has been a huge surge in lending in China. With the economy already growing at rates of more than 9 percent, it would seem structurally impossible to grow it any faster. Shortages in skilled workers, management, buildings — all these limit the rate of growth. The truth is that a substantial portion of the loans that went out were issued to keep bad loans floating, like using one credit card to pay the monthly payment on another. You can do that for a while, but you can’t do it forever. What keeps the Chinese system alive is not domestic consumption, which is not rising in tandem with overall growth. What keeps China afloat is exports — exports in ever greater numbers, and with ever-smaller profit margins. Surging exports are critical to China, as they were to Japan before it. They generate the cash that allows the financial system to continue operating. This is also the Achilles’ heel of the Chinese economy, as Fitch points out: “Given the weaknesses already discussed, we believe Chinese banks remain acutely vulnerable to an economic slowdown, although the analysis above recognizes that much work has been done to tackle these weaknesses and at a minimum suggests that Chinese banks and the government are more equipped today than in the past to deal with problems that may arise.” Here is the problem. The official policy of the Chinese government is to cool off the economy. In fact, the Chinese are attempting to cool growth only in certain sectors, where they perceive particularly dangerous bubbles starting to form. For the most part, however, they are doing everything they can to keep the economy hot, in order to try to manage the financial problem. Now, Fitch argues in its report that the Chinese banks are better equipped than in the past to deal with their problems. We agree with that assessment; they were completely unprepared in the past and now are abysmally prepared. You cannot prepare to deal with a loan situation as bad as that in China. You simply keep cycling as fast as possible and hope that something turns up. In our view, this spate of reports on China’s financial situation marks a turning point. One of the things that has kept the Chinese economy booming was cheap exports. But another was the perception in the West that, underneath it all, China was sound. This perception induced foreign banks to invest in Chinese banks. There have, of course, been studies detailing the Chinese debt problem for some time: Standard & Poor’s, for example, estimated the bad debt in 2002 at $600 million. That part isn’t new. However, when “irrational exuberance” (to quote Alan Greenspan) is at its peak, it is hard to break through the noise. Markets continue to rise, even as bad news comes out. Last week, for example, we saw the Bank of China make its initial public offering and shares soar, just as these financial reports were emerging. That doesn’t mean these reports are wrong or that the Chinese have things under control. It simply means the market is ignoring news and rising on its own giddiness. Nevertheless, a turning point has been reached that will be difficult to ignore. Reports from STRATFOR are, of course, one thing. Reports from a single credit agency are another. But when a series of reports from highly respected, mainstream analysts all come out within a few days of each other — with each, in their own way, telling the same basic story, it becomes hard for the system to dismiss that. Western companies moving into China have CEOs and CFOs who must exercise due diligence. There are now too many reports out there to be simply ignored. All of them are caveated. None of them write China off. But a critical mass is forming that will cut through the froth in due course. Obviously, this does not mean that China will implode, disappear or anything like that. It will remain an enormous economy and an important one. But this does mean that the dynamics of the Chinese economy are shifting. The debt issue represents a deep structural problem that China will either deal with — as South Korea did — or not, as Japan did not. (Japan reaped more than a decade of economic stagnation as a consequence. It is significant that China lacks the degree of insulation that Japan built up; the economy has more external exposures and would not weather a similar crisis as well.) The point is that, ultimately, the books have to balance everywhere. That means that the huge structural imbalance of China, which these debts represent, must be rectified. And that process, as in all such matters, will be painful. It is not clear how much pain Chinese society can withstand before it fractures. This is clearly a concern for Beijing as it tries, simultaneously, to reform the economy and to crack down on dissent. The Chinese, like anyone in this fix, try to put the best possible face on the situation. Which is why they exploded at Ernst & Young. But even the government in Beijing couldn’t shout down the ensuing tidal wave of financial reports; instead, they grumbled and pointed to the passages that said it could all be managed. Perhaps it can. But if it can, it won’t be easy — and we doubt that it is possible. We have been writing about this problem for several years now, and people keep asking when the crisis will come. Our answer is simple: If this isn’t a crisis, what would a crisis look like? The Chinese financial system is sinking under nonperforming and underperforming loans. Mainstream Western analysts are all writing about the problem and calling for reforms that the Chinese cannot possibly implement in time to make a difference. At some point, the weight of evidence will shift the behavior of the Western financial community, and that will be that. In the meantime, let the exports flow — for they surely will, and in breathtaking quantities.
China: Crisis and Implications June 21, 2006 By George Friedman The Chinese government is continuing efforts to cope with its runaway economy. The People’s Bank of China has raised interest rates. Banks have been told to curb lending. The government has said that it will implement procedures to rein in foreign acquisitions at low prices — or, in other words, to block fire-sales of Chinese companies. As a recent headline in the Japan Times put it, “China’s Monetary Surge Dooms Its Boom.” A lot of things have gone into dooming China’s boom, and the money surge is one of the more immediate problems. However, as we have argued (and this article should be read in the context of past analyses), the end of the Chinese boom was inevitable. The issue now is how all of this will play out in China and in the world. What must be understood is that China now is moving from an economic problem to a socio-political one. The financial problem is a symptom; the fundamental problem is that tremendous irrationality has been built into the Chinese economy. Enterprises that are not economically viable continue to function through infusions of cash. Some of the cash comes from borrowing, some by exporting at economically unsustainable prices. The result is a squandering of resources. The reasons that this continues have nothing to do with economic rationalism and everything to do with political and social reality. If interest rates were to rise and lending were to become disciplined, many of China’s enterprises would fail. This would bring several consequences. First, and most important, it would result in a massive increase in unemployment. At this point, the irrationality has been going on for years. It is not only state-owned enterprises that are economically unsustainable; many newer enterprises, including those in which Western companies have invested, are not succeeding. When we look at the figures for nonperforming and troubled loans, they amount to nearly half of China’s gross domestic product. That represents a lot of irrationality, a lot of financial failures and a lot of unemployment. And unemployment is a political and social problem. The question is whether China politically can afford the economic solution. Second, lending has become a system for maintaining the political solidarity of China’s elite. Loans have been made not only to avoid the problem of unemployment; they also were made as part of political arrangements that allowed the Chinese Communist Party and regional party organizations to avoid conflict and divisions. As long as the pie was growing, everyone could have a piece. But if the pie starts contracting, there will be losers and winners. The question of who will go bankrupt and who will not will become a highly divisive and potentially destabilizing political crisis. Again, the economic solution — austerity — and political reality may run counter to each other. Obviously, China has massive cash reserves. These may not be massive enough to cover the financial crisis, but they are sufficient to allow the government to put off addressing the problem for a while. China also has the ability to promulgate rules and regulations that allow bankrupt entities to continue functioning. However, it always must be remembered that on the other side of a bad loan is a damaged creditor. A loan that can be deferred by fiat is an asset that can no longer be used. When you avoid economic disaster for the debtor, you transfer the pain — and potentially the disaster — to the creditor. And since the creditor is normally the economically healthier entity, you postpone the death of the weak by weakening the strong. The more you do this, the worse it becomes. Thus, whether the Chinese use cash reserves to postpone the problem or use regulation to do so, the net result will be buying time at the cost of increased pain. China’s Likely Path Asia has been here before. Japan encountered this problem around 1990, and East and Southeast Asia encountered it in 1997. Roughly three models for dealing with the problem exist:
Japan was able to do what it did because it is a highly disciplined, cohesive society, in which shared pain is viewed as preferable to social dislocation. South Korea was able to do what it did because the magnitude of its crisis was relatively less than Japan’s, and because the state had the means for suppressing unhappiness. Indonesia failed to do what it needed to do because it lacked resources and political power. Other countries have fallen somewhere along this continuum. China will make its own path. However, it should be pointed out that China is not socially similar to either Japan or South Korea. Like Indonesia, China is a diverse and divided nation. The Communist Party lost its moral standing in the 1970s. As with Suharto’s government, its legitimacy now derives from the fact that it has created prosperity. When prosperity slows down or stops, the Party cannot fall back on inherent legitimacy, as was the case with the system in Japan. And the wildly diverse levels of economic development make a single, integrated solution, as was used in South Korea, unlikely. The most likely direction for China, therefore, is massive social and political instability. Now, the Communist Party may lack moral authority, but it does wield tremendous power. The People’s Liberation Army and the various security forces are an enormous presence in China. Indeed, the government already is using its security forces aggressively, cracking down on dissent and against at least some business leaders, in anticipation of coming troubles. The ability to suppress unrest is not trivial. Therefore, the most likely path for China in a post-boom environment is to increase suppression and reimpose systematic dictatorship. This is not an absolute given. There are many in the Party who now are arguing that China has abandoned its Communist principles and its social base. In other words, they want to reach out to the peasants in the interior, who have benefited little from the boom and who resent the prosperity of the coastal regions. The idea is to use these peasants in a process of renationalization — or, at least, a process in which the free market is dramatically limited and at least some of the wealth is redistributed. This goal makes little economic sense, but what China needs economically is unsupportable socially and politically. Imposing a crushing austerity for five to ten years would solve the economic problem, but it is unlikely that the political center could hold. Indeed, if the Chinese were to follow this course, they could do it only with massive political suppression at the same time. The Party’s Tangled Web Therefore, one likely path is the reimposition of dictatorship, followed by whatever economic solutions the leadership might want to make. But there is a problem here: The interests of Party and People’s Liberation Army leaders in Shanghai diverge from those of the central government. These leaders are deeply involved in the financial process of the coastal area, in bringing in foreign investment, in taking advantage of the nonmarket access to capital. They have no inclination to stop. Indeed, their wish is to see the irrational boom continue as long as possible. There are splits in the interests of regional Party leaders, as well as a split between the regions and Beijing. The interests of coastal leaders lie not with Beijing so much as with Tokyo, New York and London. They have integrated themselves in the international financial system, and they are busy making plans for sustaining their regional enterprises in the event of a crisis. Meanwhile, Party leaders from the interior are demanding that these actions be stopped and that investment flow to their regions instead. Beijing is riding two horses that are running in very different directions. Beijing well might fall off the horses. China has a history of cycling between a dictatorial system that closes it off from the world (a poor, but equal and stable China) and a system in which China is open to the world but torn apart from the inside out. Consider: Mao marched into the interior, raised a peasant army, came back and liquidated the internationalist bourgeoisie in 1948. He closed off the country and united it, throwing out the foreigners. Under the other model, preceding Mao, the country was open to foreigners, who tore it apart in regional conflicts while the interior starved. The end result of China’s economic crisis, therefore, will be a deep-seated political crisis. Only ever-increasing amounts of money have allowed China to maintain the current political alignment. Without that, it has two options. The first is a return to some sort of dictatorship from Beijing, under which economic problems would be dealt with inefficiently but unambiguously. The other is to accept a split between the coastal regions and the interior, the weakening of Beijing’s authority and a period of instability and intense regionalism. It all depends on the political moves Beijing is making now, but our bet would be on the latter course. The instruments of power that Beijing has are too complicit in the financial crisis, and have too many diverging interests, to make the first option likely. Geopolitics and Ripple Effects Two possible geopolitical models emerge from this. Under one — in its extreme form — China returns to some sort of geopolitical Maoism. It encloses itself from the world, becomes increasingly bellicose but is limited by its own geography in what it can do. Under the other model, China slowly fragments and becomes a cockpit for the ambitions of foreign economic interests — backed up by political and military power, with regional Chinese officials collaborating with foreigners to continue economic development. Oddly, the latter model would be more destabilizing to the world than the former, inasmuch as everyone will want to maintain their investments in China and expand them. In this scenario, China would again be a magnet for problems. Mind you, these are not absolutes, but represent extremes on a continuum. There is surely a model under which Beijing would muddle through, as have the Japanese or Indonesians. No coherent strategy would emerge; it would all be tactical. It is difficult for us to see how this would not lead to regional destabilization, but then, China might be able to live with that. How it handles the unemployment and displaced peasant issue, however, is yet another question. This is a possible midpoint on the spectrum, but not in itself likely, it would seem. As for the effects on the international economy, there has been a great deal of discussion about China’s ownership of U.S. Treasury instruments and the consequences if that money were withdrawn in a crisis. In fact, this is the last thing that is going to happen. If China has a massive financial crisis, no one — including the Chinese government — is going to shift money from a safe haven into an uncertain cauldron. In crisis, the tendency would be a flight to safety. That means that rather than being pulled out, money would surge into the U.S. market — legally and illegally, from the Chinese standpoint. It is interesting to correlate the massive U.S. market surges that began in 1991, after the recession, and intensified dramatically in 1997 and 1998, with trends in Asia. In both cases, these surges followed major economic crises in rapidly expanding Asian economies. The events were, in our opinion, linked. The crisis in Japan in 1990 and 1991 led to major capital flight and helped to fuel the U.S. market rise. Similarly, the impending and expected East Asian meltdown in 1997 produced massive capital flight from Taiwan, South Korea and elsewhere to safer havens. A massive withdrawal from the U.S. market is the last thing to be expected. What are in danger, of course, are foreign investments in China. There is the obvious financial issue: Many of these investments were not economically viable to begin with. But there is a political problem as well. The Party is going to have to blame someone for China’s troubles, and it will not be the leadership. The obvious culprits will be corrupt officials and their paymasters in the international banking system. The truth or falsehood of the charge will matter little; corrupt officials and bankers already are being arrested, in the early stages of the crisis. As the situation intensifies, we would not be surprised to see foreigners investigated for corrupt practices as well. But the bottom line is this: China has a history of nationalization and expropriation, and the party that enacted those measures is still in power. No one would have believed that the Party of Mao possibly could have become what it is today, but one should not assume that the evolution of the Chinese Communist Party is complete. Leaders could find that they have reason to re-enact some of Mao’s own economic policies. We would be surprised to see a complete return to Maoism. We would not, however, be surprised to see the Party deliberately reverse some transactions that are no longer in its interests or (as and if things get more intense) take even more radical steps. It is still a Communist Party, it might be useful to recall. Ultimately, the choice that China is now making is how quickly it will allow the consequences of its economic irrationality to unfold. The economic answer to the problem is to let shaky enterprises fall — but the political cost of doing so will be too great, and a solution has already been long delayed. The longer an economic solution is delayed, the less one becomes possible and the more intense becomes Beijing’s need to address the problem with political and security solutions. The more dependent the Chinese become on such measures, the more catastrophic will be the consequences if these solutions don’t work. China is long past the point of being able to solve the problem easily. The question is simply whether to buy time and pay in intensity, or force the crisis now. At some point, there no longer will be a choice. But the single most important thing to understand is that China does not really have an economic crisis any longer. The time for that has come and gone. There is now a political crisis at hand.
China: Deferring a Banking Crisis September 5, 2006 Summary Chinese Minister of Commerce Bo Xilai said at a Sept. 4 event marking China’s five years in the World Trade Organization (WTO) that all Chinese sectors, including telecommunications and banking, will be open by Dec. 11, thus fulfilling Beijing’s WTO commitments. Opening China’s banking sector was a major concern for Chinese officials since the onslaught of competition could have stripped major Chinese banks of their deposits — thereby undermining Beijing’s ability to maintain the flow of money to the nation’s ailing state-owned enterprises. In the five years since China’s WTO accession, however, Beijing has taken several steps to minimize the potential banking crisis. Analysis Speaking at a ceremony marking China’s five years in the World Trade Organization (WTO), Chinese Minister of Commerce Bo Xilai said Beijing will meet all its WTO obligations, including opening sensitive markets, on time. Bo added that China is “actively promoting market opening,” promising that “China will fully open all markets, especially banking and telecommunications, before the deadline.” The deadline in question is Dec. 11, the fifth anniversary of China’s WTO accession. Beijing is waiting until the last minute to open its banking sector to substantial foreign competition. China’s political elite and economic planners have long viewed the opening with trepidation, as China’s major banks have been the lifeline of loans to the state-owned enterprises (SOEs), which in turn serve as engines of employment for China’s massive population. We have warned that foreign competition in China’s banking sector could trigger a chain reaction, removing capital from the government coffers vital to keeping the ailing SOEs afloat and to keeping unemployment at a manageable level. Over the past half decade, Beijing has sought ways to mitigate the impact of the looming Dec. 11, 2006, banking sector opening, and as the date nears, it appears these efforts will be largely successful. One of China’s first steps was to begin strengthening its own major state banks. Officials were removed, replaced and reshuffled. Bad loans were pawned off to newly formed asset management companies (AMCs) for disposal without significantly damaging the banks’ balance sheets. (The AMCs simply wrote off many of these bad loans.) The banks were then opened slowly and carefully to increased foreign ownership and management. The initial public offerings of major Chinese banks, underwritten by Western financial houses, served as a way to increase the capital-adequacy ratio in the banks, decrease the percentage of bad loans, and more important, give foreign banks a stake in the survival and growth of the major Chinese banks. After more than a year of indecision, China created the China Banking Regulatory Commission (CBRC) in 2003 to supervise and control Chinese financial institutions and create and enact banking regulations. One of the guiding realities for the CBRC has been China’s Dec. 11, 2001, WTO requirement that China in five years “lift all geographic and customer restrictions on foreign banks and eliminate any nonprudential measures that restrict ownership, operation and operational form of foreign-invested banks.” The CBRC has sought to follow the letter of that requirement while studiously avoiding its spirit. The CBRC has been in no hurry to issue its new regulations that will govern foreign banks after the Dec. 11, 2006, deadline. In August, the CBRC finally sent a draft of its proposed new rules to foreign banks, providing the first concrete insight into China’s planned banking regulation. Several points in the draft have caused concern among foreign bankers.
All told, these regulations could make establishing foreign banks in China possible, but they will not make it cheap. The $125 million capital requirement for each local bank operation combined with the repetitive legal and tax fees needed for each incorporation would impede foreign banks’ ability to establish extensive local networks. Also, in a country where the average income per capita is about $1,290, a $125,000 minimum investment for individuals would severely limit banks’ pool of possible depositors. This regulation threatens to keep vast pools of personal savings out of the reach of foreign banks — money that could be used for loans, earning interest for the banks. Though the foreign banks might complain, many have already come up with functional strategies to enter and remain in the Chinese market: Buy stakes in Chinese banks. This allows relatively easy access to Chinese markets with the added protection of the Chinese government in case the banks make errors in lending or investment judgment. Interestingly, some foreign banks with localized branches are finding it preferable to focus on joint operations rather than try to compete with the Chinese majors. One example is Bank of America (BOA). BOA recently sold its retail holdings in Hong Kong and Macau to China Construction Bank, in which it already owns a 9 percent share with an option maturing in 2010 to purchase 19.9 percent. BOA cited its lack of market share, but most likely it was better business to operate under the China Construction Bank banner. China appears to have come up with a winning strategy: Give foreign banks a greater interest in becoming partners and strategic investors in Chinese banks as opposed to trying to enter the market as competitors. For those still wanting to enter alone, make the requirements for entry high and relatively constricting. Then, if Beijing wants to make a special dispensation — for example, to encourage banks to move into the poorer central or western provinces rather than along the coast — it has plenty of incentives with which to do so. It appears that, at least as far as the December opening is concerned, Beijing has averted another potential trigger for a domestic economic crisis. But this is a crisis delayed rather than a crisis deflected. The Chinese economy remains in a precarious position. Unemployment is high; surplus rural labor continues to seek out employment in the cities, stressing the services and job markets; and most significantly, corruption in government and business relations still runs rampant despite Beijing’s frequent anti-corruption campaigns. This undermines whatever plans Beijing makes to bring the economy back into line. In the end, it also will produce a clash among the political and economic elite playing off the ire of the masses — ultimately causing economic instability.
Global Market Brief: Cleaning House in Shanghai September 28, 2006 Summary Chinese President Hu Jintao “struck hard” at corruption with the sacking of Shanghai Communist Party Secretary Chen Liangyu. But in a nation where economic relations are based more on personal connections than legal frameworks, the shake up in Shanghai is just one of several steps Hu is taking. These steps ultimately will require foreign and domestic businesses to readjust their personal connections — not with the local Party and government leadership, but with the central leadership in Beijing. Analysis Chinese president Hu Jintao “struck hard” at corruption with the sacking of Shanghai Communist Party Secretary Chen Liangyu. Chen also lost his position as a member of the Politburo of the Central Committee of the Communist Party of China, the upper echelon of Communist Party leadership. Chen’s removal was more than a blow against corruption, however; it was one of Hu’s most significant steps fully to consolidate his power ahead of the 2007 Party Congress. But in a nation where economic relations are based more on personal connections than legal frameworks, the shake up in Shanghai, the power base of former President Jiang Zemin, is just one of several steps Hu is taking. These steps ultimately will require foreign and domestic businesses to readjust their personal connections — not with the local Party and government leadership, but with the central leadership in Beijing. Shanghai, long the shining star of Chinese economic growth and prosperity, has seen its light dimming in recent years. Rising labor costs and increased competition from neighboring provinces have slowed the growth of manufacturing. At the same time, Shanghai has been unable to grab the top spot of Chinese finance, with Beijing playing host to the lion’s share of banking and insurance companies. (In 2005, some 44 percent of China’s financial assets were in Beijing, compared to just 10 percent in Shanghai.) Shanghai is no longer in the list of the top 10 fastest growing Chinese areas (gross domestic product growth fell from 15.1 percent in the first half of 2005 to 12.6 percent in the first half of 2006), and gross domestic product for the first half of the year amounted to less than half of that for Guangdong, Shandong or Jiangsu. While no longer in the lead, Shanghai remains a powerful draw for foreign investment, finance and industry (playing host to more Chinese headquarters of foreign companies than any other Chinese city aside from Hong Kong). And for two decades, Shanghai was the entry port for foreign capital — and for building business connections with influential Chinese politicians. Former Chinese President Jiang Zemin and his premier, Zhu Rongji, both hailed from Shanghai, and their influence in the city continued after their move to Beijing through the so-called “Shanghai gang.” Establishing good relations, or “guangxi,” with these local officials was a sure way to win favor with the central leadership — or at least to avoid the vagaries of Chinese economic policies and regulatory interpretations. Shanghai’s political power took its first hit in 2002, when Hu became general secretary of the Communist Party of China (CPC). Hu became president in 2003, and in 2004, Jiang stepped down from his last major position, chairman of the Central Military Commission (CMC), handing the post over to Hu. The leadership transition between Jiang and Hu, representing the third and fourth generation leadership respectively, was remarkably smooth, facilitated in part by the preoccupation of the United States with the wars in Afghanistan and Iraq — something that gave China time to look internally rather than try to shift the power structure while dealing with concerns of U.S. interference in the form of political and economic pressure. Immediately after Jiang’s transfer of the CMC leadership, Hu revealed his focus for the next several years: fighting corruption within the ranks of the Party. Chinese anti-corruption campaigns predate the CPC, and the Central Committee of the CPC under Hu’s guidance released a damning report criticizing Party cadres. The report said many of them “lack ideological and theoretical attainments, the ability to govern according to law and the competence to deal with complicated problems” and warned that, absent change, the Party’s rule “will not remain forever.” Less than a month later, Hu struck, knocking out five ranking officials in northeastern China’s Heilongjiang province. Rising social unrest throughout 2004 and 2005 reminded Hu and his allies of the serious need to purge the Party (corruption and graft being a primary cause of the increasingly bold and violent but localized uprisings), but at the same time emphasized the fragile nature of Party rule. Hu shifted to a more theoretical and rhetorical attack on corruption, cleaning out the banking system and select officials and giving local and provincial officials time to adjust their actions to the new government priorities. Hu began calling for the transfer of funds, investment and manufacturing from the prosperous coastal regions to the interior in an attempt to redistribute wealth. He simultaneously embarked on a program designed to re-centralize economic coordination and control. This dual strategy was aimed at undermining the economic incentives that made local officials rich and greedy and led China down the path of unequal and redundant economic growth and development. As the Oct. 8-11 CPC Central Committee plenary session approaches, Hu has intensified his anti-corruption campaign, going for the heart of the Jiang networks. (The plenary session will lay the groundwork for the leadership shuffle at the Party Congress in 2007 and shape China’s economic path.) On Aug. 11, Zhu Junyi, then-director of the Shanghai Municipal Labor and Social Security Bureau, was dismissed for lending some $400 million (a third of the Shanghai pension fund) to Fuxi Investment Holdings, which used the money to invest in a private toll road. Within days, Zhang Rongkun, China’s 16th wealthiest man, was also detained for questioning. Zhang was chairman of Fuxi and vice chairman and non-executive director of Shanghai Electric. Next to fall were Wang Chengming, chairman and party secretary of Shanghai Electric, and Han Guozhang, executive director of Shanghai Electric. One week after Zhu Junyi was dismissed, then-Shanghai Communist Party Secretary Chen Liangyu, thought to be on the fast track to succeed Jiang Zemin and Zhu Rongji in the climb from Shanghai to central leadership in Beijing, gave a speech calling on government officials to combat corruption and perform their duty with honesty. Five days later, on Aug. 23, Huang Ju, vice premier and a member of the Politburo, gave a very similar speech. Huang is a close ally of Jiang Zemin who rose from Shanghai to central leadership, but his younger brother is linked to Fuxi. Huang had apparently already faced pressure from Hu, and might have struck a deal. He was out of the public spotlight from February through June due to an illness, a common face-saving way of having one’s power reduced. While Huang has survived thus far, the bloodletting in Shanghai continued, with Qin Yu, governor of the city’s Baoshan district and previously secretary to Chen Liangyu, axed. Next in line was Wu Minglie, head of the Shanghai government-linked New Huangpu Group real estate company, who was dismissed Sept. 5. With the noose tightening around Chen Liangyu, foreign and domestic observers expected a face-saving out for the Shanghai Party Secretary, given his close connections to Jiang and to the Shanghai business community. But contrary to expectations, Chen was not allowed either to claim illness or simply be reshuffled off to another post. Rather, Hu simply had him removed from office, with Gan Yisheng, secretary-general of the CPC Central Commission for Discipline Inspection making an example of Chen and warning, “Anyone who violates Party rules or national laws will be severely punished regardless of who they are and what position they hold.” While Chen’s dismissal was unexpected, some form of punishment was anticipated, and reactions were muted. The general impressions in China and Hong Kong were that corruption needed dealing with, but that this was primarily about politicking (even if Chen was corrupt). The Shanghai stock index fell as much as 1.3 percent on news of Chen’s sacking, but recovered some lost ground. Real estate stocks took the worst hit, however, as the scandal centered on real estate deals, and there was word Beijing was demanding that all those who obtained loans based on the pension fund would have to repay the monies immediately. China’s Ministry of Labor and Social Security also announced coming changes to the management of China’s approximately $12.6 billion local pension funds, which are currently invested as seen fit by local officials, much of which goes into the real estate sector. The Shanghai pension scandal will have a significant impact. On a broad level, it shows Hu has finally decided to have a showdown with Jiang at the October plenary meeting. This showdown is more than simply a battle of personalities, since Hu and Jiang represent drastically different economic paths for China. Jiang champions the Deng Xiaoping program of relatively decentralized and unrestricted growth, where local and provincial leaders do whatever is necessary to bring money and technology into China. There is a recognition this will create uneven growth patterns and further exacerbate the redundancies and inefficiencies in the system, but in the long run, the hope is that all boats eventually will float on the rising (economic) tide. Hu, on the other hand, backs the so-called “New Left” program, re-centralizing economic policies and control, closely managing the type and location of investment and shifting resources and manufacturing jobs inland, leaving the coasts to focus on high-end technology. Whichever path is ultimately followed, China’s leaders face a widening wealth gap, a growing migrant labor population, rising unemployment and increasing social tensions. But on the more immediate level, the gutting of the Shanghai leadership will leave a massive gap in the network of personal businesses and political relations, leaving foreign and domestic firms scrambling for new connections and reassessing their current political friends. While Hu is not planning to punish foreign firms for their past dealings with Chen or the broader “Shanghai gang,” he is shaping an environment in which local political relations become much less important that those with the paramount leadership — particularly Hu and his premier, Wen Jiabao. In the meantime, the ripples in the Shanghai real estate sector are unlikely to die down soon, and the pension scandal may let the air out of the Shanghai real estate bubble. Those who have used real estate as collateral for their loans may soon see their own net worth diminishing and their borrowing power dropping. In other coastal cities, there will be a rapid reassessment of where local pension fund monies have gone, and a scramble either to find a way to make a political and economic accommodation with Beijing or to take the money and run. If Beijing is successful, a wave of mistrust and uncertainty will careen through the various personal political and economic networks, favoring those with closer relations to Hu and Wen and turning others toward the central leadership. But those who have made their fortunes in heady days of unrestrained investments and entrenched corruption, collusion and nepotism are not likely to take the assault from Beijing lying down. While some seek political accommodation and others seek a new house in Vancouver, a few are likely to fight back. Hu may have employed his own shock therapy in Shanghai but, as he moves to the even wealthier provinces, he might find some willing to hit back. THAILAND: The Stock Exchange of Thailand has rebounded 1 percent in the wake of Thailand’s military coup. The Thai baht has also rebounded from lows of around 37.94 to the dollar to 37.49 to the dollar, having traded around 37.00 before the coup. The Thai economy is still expected to meet growth projections for 2006 of 4 percent to 4.5 percent despite the coup. CHINA: The China Securities Regulatory Commission gave its final approval for the Industrial and Commercial Bank of China (ICBC) to go public by selling 13 billion shares, Bloomberg reported Sept. 26. ICBC, China’s largest lender, also received permission to sell 35.4 billion shares in Hong Kong. When trading begins Oct. 27, the initial public offering is expected to be a record $19 billion. RUSSIA: Work at Royal Dutch/Shell’s Sakhalin-2 oil and natural gas project could continue while the project undergoes a month-long full-scale environmental probe beginning Oct. 25, Russian Natural Resources Minister Yuri Trutnev said Sept. 26. Although Trutnev is allowing this reprieve for Shell, the pressure from the Russian government and state-controlled natural gas monopoly Gazprom is unlikely to let up. INDIA: Indian Prime Minister Manmohan Singh will travel to South Africa and sign seven bilateral cooperation agreements ranging from technology exchanges to eased visa requirements. These agreements will pave the way for South African trade delegations that will journey to India in October to seek $17 billion worth of investment. BOLIVIA/BRAZIL: Bolivia and Brazil resumed energy talks Sept. 25. The negotiations are related to the full implementation of Bolivia’s nationalization decree to Brazil’s state-run oil company Petroleo Brasileiro, which operates in Bolivia. In addition, the two nations will negotiate gas prices. SWITZERLAND: Switzerland ratified new laws making it more difficult for refugees to receive assistance and blocking non-European unskilled workers from entering the country. Approved by the government in December and by 67 percent of citizens Sept. 24, the laws will make it easier to deport immigrants. Some estimates have said the laws will be the strictest in Europe and could lead to the deportation of hundreds of thousands of immigrants. POLAND: Dell Computer Corp. signed a deal to build a $250 million plant in Poland, its second plant in Europe. The plant will create 1,000 jobs. Polish President Lech Kaczynski said the deal is a good way to keep the best-educated people in Poland. ENERGY: Russia’s Gazprom and Italy’s ENI are planning to sign an agreement by Oct. 15 for the construction of a natural gas pipeline, dubbed “BlueStream 2,” across Turkey to southern Europe. The project would run along the existing route of the Blue Stream pipeline to Turkey, but then west to Europe. It will allow Gazprom to supply Italy, Greece and possibly Hungary and Bulgaria. Global Market Brief: The Ernst & Young Controversy May 19, 2006
Consulting house Ernst & Young on May 15 retracted a report on the Chinese banking system first issued May 3, calling portions of the report “factually erroneous.” The recall came shortly after the People’s Bank of China (PBoC), the Chinese central bank, rejected some of the report’s findings as “ridiculous.” Ernst & Young insists that its withdrawal of the report had nothing to do with the PBoC’s criticism but is instead due to a breach in internal quality standards that somehow slipped though the company’s editing. Regardless of the reason for the temporary withdrawal (Ernst & Young says it plans to reissue a corrected version later in the month) the issue of Chinese finance is a critical one. The Chinese system does not operate on the Western belief that money is a scarce resource. In the West one takes out a loan in order to pursue an opportunity that generates value, and that loan has to be paid back with interest; in China loans are handed out to entities for political and social reasons at a far faster rate, and repayment is not critical. The result is that a large percentage of those loans go “bad” when applied to the rigors of a functioning market, as they were made to entities that did not use the money efficiently. In China this is an ongoing issue that threatens the very foundation of the Chinese system. The core of the Ernst & Young/PBoC dispute is about the total value of such bad loans. According to the PBoC, China’s load of nonperforming loans at the Big Four state banks has dropped from 31.1 percent of outstanding loans in 2001 to 8 percent in early 2006 — only $133 billion. The PBoC asserts that the overall banking sector’s official bad loan total was only slightly more: $165 billion. These are numbers the government pointed to in order to contradict the May 3 Ernst & Young report. Those numbers, however, are questionable to say the least. As in all things, the measure is in large part determined by the measurer, and since China’s financial reform program is heavily predicated on getting foreign banks to inject both cash and skills into Chinese banks, getting the bad loan numbers as low as possible is a top-tier issue. The official numbers have decreased so rapidly so quickly for two reasons — neither of which has anything to do with improved banking practices or the $105 billion in cash the government has spent since 1998 to recapitalize the financial system. First, 59 percent of that reduction is due to the transfer of some $150 billion in bad loans from the state banks to asset-management corporations — with the four largest being Cinda, Orient, Great Wall and Huarong — between 2001 and 2006. (The number is $307 billion if one goes back to 1998.) In exchange, those asset-management corporations handed back government-backed bonds equal to the bad loans’ face value. Since those loans have so far demonstrated they have a cash recovery rate of only 20.5 percent, this, in essence, amounts to the government transferring assets worth some $120 billion to the Big Four’s accounts during the past four years. Second, most of the remaining reduction was not a reduction at all, but came about because the banks surged fresh lending, indirectly reducing the overall percentage of the loans classified as nonperforming. Since 2001 the Chinese government reports that total lending has increased by an average of 21 percent per year, a rate that has roughly doubled the total pool of loans — and thereby halved the effect of the bad loans on China’s bad loan ratio to the central bank’s current celebrated ratio of “8 percent.” And that is assuming one takes all of the government statements and statistics about the Chinese financial system at face value. There has been no claim of, nor evidence for, more traditional means of reducing bad loan totals, such as the adoption of rigorous lending policies, legal reform or changes in bank management. All that has changed is that the government has those asset-management corporations to officially move the debt to another part of the government. All of the problems that China’s banks faced in 2001 they still face today. The only question is: How big is that problem? The Chinese government says it is $165 billion and falling; the now-retracted Ernst & Young report put the number at $911 billion. Which brings up the reasons Ernst & Young presented for the retraction. The consulting giant serves as the auditor for the state-owned Industrial and Commercial Bank of China (ICBC), one of the country’s four largest banks. According to Ernst & Young public relations staff, the report was withdrawn when their staff on the ICBC account contradicted the report’s findings, specifically arguing that the level of bad debt they had seen on the ICBC’s books did not justify a number as high as $358 billion for China’s Big Four banks, and by extension $911 billion for the entire sector. (Remember, the PBoC pegs the Big Four’s combined bad debt at only $133 billion.) Ernst & Young’s London headquarters dispatched a team to its China offices May 16 to investigate the discrepancies. The apparent source of the difference lies in what happened in the big banks’ activities during the past four years: The Chinese banks doubled their total lending portfolio, and the PBoC seems to be asserting that all of the loans granted during that period are solid. The $225 billion difference between the Ernst & Young report and the PBoC figures comes from a different consultancy, UBS, which figured that of new $1 trillion in loans, $225 billion is the amount that are actually just more bad loans. The PBoC obviously disagrees, and apparently, at least at some level, so do some Ernst & Young staff who have been working with the ICBC, one of the PBoC’s biggest charges. Which raises a likely outcome for this little story. The Chinese — either via the ICBC, Ernst & Young auditors working with the ICBC or the PBoC directly — have likely pressured Ernst & Young to back off. Such pressure would not be surprising. The ICBC is by some measures China’s largest financial institution, and it plans on launching its initial public offering (IPO) in September. Another one of China’s Big Four, the Bank of China, is actually in the midst of a marketing blitz for its planned June 1 Hong Kong IPO, in which it hopes to raise $9.9 billion. The Ernst & Young report came out at a damned inconvenient time, and the ICBC is a damned important client. What would be surprising is if the pressure worked. If it turns out that Ernst & Young’s auditors have been complicit in helping the ICBC to cook its books, that will come tumbling out in short order. This is not something the corporate headquarters would try to hide. Major consulting firms such as Ernst & Young remember full well what happened the last time one of their peers played a similar role: the accounting firm Arthur Andersen became wrapped up in the Enron scandal and fell alongside their client, and the Big Five global consulting oligarchy became the Big Four. If pressure of any kind were involved, the most likely outcome will be some fired auditors and a very public statement to that specific effect. But before anyone mistakes this discussion as condemning corruption or lauding honesty at Ernst & Young, remember that the Ernst & Young report shined an uncomfortably bright light on what is a deeply uncomfortable problem in China — even by China’s own statistics which, safe to say, are certainly the most optimistic evaluation available. The PBoC asserts that the bad loan problem is less severe, but it can only make that assertion because most of those bad loans have been moved elsewhere and no new ones have been “found” in the time since. STRATFOR is certainly anticipating a fresh report, but not one from Ernst & Young. IRAQ: The World Bank announced May 16 it will establish a permanent office with a country director in Iraq to play a more central role in coordinating donor assistance. Joseph Saba, the bank’s director for Iraq, said up to three other international employees would be appointed for the office, which until now has been managed by a consultant contracted through the U.K. Department for International Development. Saba said the World Bank’s offices would be in the same building as the Iraqi Planning Ministry and Ministry of Finance. Saba said the bank would rely mainly on Iraqi staff and consultants to supervise bank-sponsored projects. AUSTRALIA: Australia’s Northwest Shelf liquefied natural gas (LNG) project sent an LNG tanker to Guangdong, China. The LNG shipment — China’s first — is expected to arrive the week of May 21. China’s entrance into the LNG markets could greatly disrupt existing trade flows simply by sheer bulk, just as China’s growth has disrupted the oil markets. Though the Guangdong facility is China’s first operational gasification facility, the Chinese government plans to expand it and is constructing a similar facility in Fujian province. Japan, South Korea and Taiwan fill nearly all of their natural gas needs via LNG. U.S./VIETNAM: The United States and Vietnam reached an agreement May 16 that paves the way for Vietnam to enter the World Trade Organization. The agreement marks more than a political warming. Vietnam shares many of the characteristics of China in 1980: a large, relatively well-educated population, a long coastline, a fierce desire to develop and an authoritarian political system firmly in control. Vietnam stands to become a powerful economic competitor to China in the years ahead. EUROPE: EU regulators raided European utilities May 17, including E.On, Gaz de France and Eni. The European Commission is working to improve competition by weakening the Continent’s politically connected energy majors, without weakening them to the point at which they cannot play hardball with Russian state natural gas giant Gazprom. INDIA: Mass countrywide protests led by medical students wracked India the week of May 14. The students are protesting a government proposal to implement a quota system for India’s higher universities to allow more lower-caste Indians to gain admission. The anti-quota protesters claim that such a policy would undermine the country’s merits in key professions such as medicine and engineering, and that it would only contribute to a larger brain drain in the country since students would be more inclined to study overseas. ITALY: Italian Prime Minister-designate Romano Prodi nominated his government May 17 and named European Central Bank founding member Tommaso Padoa-Schioppa as finance minister. Padoa-Schioppa is widely recognized as the most competent and nonideological member of the Cabinet, and faces the unenviable task of shaping up the finances of the worst-performing member of the eurozone. It is a task he almost certainly will not complete. The instability of Prodi’s coalition makes it likely that Padoa-Schioppa will — at most — have six months to get his work done. ECUADOR: The Ecuadorian government May 15 ejected U.S. energy major Occidental Petroleum Corp. from the Block-15 project, where it had been producing approximately 100,000 barrels per day of crude oil, roughly one-fifth of the country’s output. The government also is seizing approximately $1 billion in directly related assets and handing them over to state oil firm PetroEcuador to operate. The nationalization de facto ends negotiation with the United States on a free trade agreement, despite statements to the contrary from Washington.
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