Page 1 of 5 CHINA'S DOLLAR MILLSTONE, Part 2 Developing China with sovereign credit
By Henry C K Liu
The two key factors preventing the use of sovereign credit to finance
sustainable development of the domestic sector of the Chinese economy are
China's high export dependency operating under dollar hegemony and the
ill-advised blanket privatization of the public sector.
The term "privatization" is generally defined as any process aimed at shifting
government functions and responsibilities, in whole or in part, to the
profit-driven private sector. Privatization of government responsibilities is
touted by both conservatives and neoliberals as the remedy for government
inefficiency and corruption. Yet the
record shows that both public and private sectors, given the opportunity, have
shown equally high propensity to become inefficient, corrupt and unethical,
each in its own way.
In the shadow of the 1930s Great Depression and chastened by the horror of
global modern war, Western societies in the 20th century sought to redefine
social provision and the notion of public good. There was renewed concern with
the rights of citizenship and entitlement to basic services (health care,
education, public housing, subsidized mass transport and unemployment
insurance) as part of a "social wage". These programs were purposely removed
from the pressure of the market, to be funded by general taxation at
progressive rates for the benefit of all.
The strength of the welfare state varied from one country to another. It had
its weakest foothold in the United States. But the rationale was the same:
social cohesion and economic progress were furthered by a shared sense of
community. Forty years later ideology took an about-face. The welfare state
came under attack and nowhere more so than in Britain, one of the countries
where it was most advanced, led by prime minister Margaret Thatcher. President
Ronald Reagan jumped on the reactionary train in the US. (See
The privatization wave, Asia Times Online, February 12, 2005.)
Privatization of the public sector, generally taking the form of sale or lease
of public assets or property rights to private interests, is a path toward
failed-state status even for a sovereign state with a capitalist market
economy. By definition, the public sector exists because there are elements of
the economy that the private sector cannot handle efficiently without
externalizing some major costs to the economy as a whole.
Operationally, privatization of the public sector generally takes the path of
corporatization of state-owned enterprises by offering shares for sale in the
capital market to those who have access to money. This approach presents
ideological as well as practical problems for a socialist society such as
China's, in transition towards a socialist market economy. In a socialist
economy, state-owned-enterprises (SOEs) are owned collectively by all the
people. Ideally, everyone enjoys all the consumable wealth he/she needs and no
one needs to personally worry about savings for rainy days as excess wealth to
invest. Savings in a socialist society are done collectively, with the need to
Privatization of SOEs that operate in the public sector through corporatization
via initial public offerings of shares raises issues of equity and social
justice, aside from the fact that it drains private capital unnecessarily from
the part of the private sector that otherwise serves a legitimate economic
function. This drain of private capital causes interest rates in the private
sector to rise needlessly and reduces the efficiency of the entire economy.
Without an institutional framework in place to transfer state-owned property
fairly to all members of the owning public with low transaction costs, the
initial uneven private allocation of state-owned property and the lack of
fluidity in secondary markets can and often do undermine social justice and
welfare by exacerbating wealth and income inequality.
A practical problem for socialist countries such as China is from whence would
the potential domestic buyers with money come? Surely not from members of the
proletariat class who by definition have no money for private investment, not
even from latent capitalists since they were not allowed to exist before the
age of reform toward market economy.
Domestic buyers then must come from a small circle who are in a position to
manipulated finances to gain access to bank loans collateralized by the very
shares they intend to buy. Foreign buyers, albeit now still limited in the
amount they can purchase, end up buying the best state-owned-enterprises at
bargain prices in a buyer's market. The problem has been a lightning rod of
public complaint for the past decade.
Some Eastern European transitional economies have used complicated voucher
schemes in which public assets could be distributed broadly among private
citizens and collectively owned institutions with legitimate claims on them.
Voucher holders could then trade these new instruments of ownership at market
value as pseudo-stocks of the public assets being privatized. Such voucher
systems inevitably suffer from high transaction costs and other market
inefficiencies caused by the unmanageably large number of individual voucher
recipients, uneven market information, and the difficulties in organizing and
regulating a fair market.
The net result has been to provide legal but unfair opportunities for unsavory
and manipulative speculators, often foreigners with sophisticated experience
and expertise in financial engineering, to buy up the dispersed vouchers at
high discount and use them to subsequently acquire control of the privatized
SOEs on the cheap. Such privatization processes are vivid examples of
free-market fairness not adding up to economic justice.
Many East European states transitioning from socialist economy to market
economy thus rely on auction mechanisms to both value and privatize state-owned
property. Auctions can better determine the fair market price of assets based
upon a number of factors: earning history and future potential, industry
trends, auction rules and process, and availability and cost of money.
Restructuring of the entity before it is suitable for sale is usually necessary
before an auction can proceed.
External factors affecting market value involve anticipated post-privatization
contractual relationship with governmental customers, the stage of
privatization within the economy, potential competitors and market competition
environment, and the degree of continuing government control of and regulation
on the privatized entity, the industry and the private sector generally.
The auction process itself can influence market values by the way the state
packages a SOE or parts of it for sale. Macroeconomic policies also affect
enterprise market value. Bidding qualifications such as restricting auctions to
buyers that meet eligibility qualifications set by the state can also affect
market value. Such qualifying restrictions can include buyer citizenship and
other non-financial requirements to preserve socio-economic justice.
Pre-auction restructuring efforts that require management changes, layoffs,
debt absorption, efficiency improvement measures, investment priorities, bridge
capital and loans and adjustment in contracts with other state-owned
enterprises placed prior to the auction can raise transaction cost and lower
the transaction value. For example, one determinant in pricing is the prospect
of unionization of labor and workers' right to strike against a private
Aside from the issue of social justice, transitional economies need to weigh
the social cost of privatization because a privatized entity often gains
operational efficiency by externalizing part of its cost to society at large.
Also, state-owned-enterprises are mistakenly viewed in neo-liberal circles as
inevitably failing to operate efficiently as a result of nebulous property
rights, uneconomic pricing due to government subsidies and intervention in
management. This view leads reformers to seek misguided blanket privatization
as a cure-all to stimulate more growth.
SOEs do need reform to improve their performance as a category, but
privatization is not the answer. More to the point is to allow SOE salaries and
wages to rise to levels competitive with private companies to retain and
attract talent, to introduce meritocracy in management and to provide superior
enterprise-financed training and education for career advancement. Also, SOE
efficiency will improve if social benefits, such as health care, employee
housing, children education and so forth, are not provided by each enterprise
separately but outsourced to special function SOEs that can better capture
economy of scale.
Ownership and management have been separate in market economies for more than a
century. In fact the separation is recognized as the most significant factor in
the growth of free-market capitalism. Also, profit-based pricing often adds
aggregate inflationary pressure to the economy as a whole while producing
profit only to individual units to be distributed to shareholders. Subsidized
food prices are a clear example of this dilemma. Further, government bailouts
of failed private enterprises are commonplace in free-market capitalism.
In the US, where free-market capitalism operates as a religious faith and the
private sector dominates the economy, glaring examples of failed enterprises
emerge repeatedly whenever government regulation fails. The most serious giant
corporate failures invariably require government bailouts to prevent systemic
damage to the economy. This is known as the "too big to fail" syndrome. The
most recent examples in the finance sector are Fannie Mae and Freddie Mac, Bear
Stearns, Countrywide and IndyMac. In recent history, the list of failed
companies included Drexel Burnham & Lambert, Enron, WorldCom, Global
Crossing, Pan Am Airline, Macy's, Delphi Auto Parts, Continental Illinois
National Bank and Trust Company and numerous other bankruptcies.
Penn Central filed for bankruptcy and its passenger lines were nationalized as
Amtrak in 1971 and its freight traffic nationalized as Conrail in 1976.
Chrysler required a US$1.5 billion government guaranteed loan in 1979 to avoid
The case of Enron illustrates the systemic fraud on a large scale that could
occur in an under-regulated market with major banks as eager participants in
dubious financial manipulation. In 1985, taking advantage of a weakened
antitrust regime, Enron was formed from a merger of Houston Natural Gas and
InterNorth Gas of Omaha, Nebraska. By 2000, Enron had grown into the largest
natural gas merchant in North America, eventually branching out from a pipeline
company into a major trader of energy, electricity and other commodities such
as water, coal and steel. The company attracted eager investors and its stocks
Unfortunately, Enron's spectacular success came from its strategy of
fraudulently manipulating its financials to achieve unsupported market value
for its stock, resulting in the ultimate and inevitable collapse of the company
as the fantasy bubble based on fraud burst and public trust in it evaporated.
A more recent example of widespread fraud is the promotion and marketing of
auction rate securities (ARS), debt instruments with long nominal maturities
for which the interest rate is regularly reset through a Dutch auction by
bidding investors betting on money market movements.
Major banks and brokerage houses market ARS's as safe and liquid instruments,
almost the equivalent of cash, to institutional investors, including pension
funds, and charities, individuals, and small businesses, by promising to be
bidders of last resort. But in early 2008, as the credit crisis that began in
August 2007 caused the failure of up to 80% of the ARS market, the four largest
investment banks that normally make a market in these securities (Citigroup,
UBS, Morgan Stanley and Merrill Lynch) declined to act as bidders of last
resort, as they had promised to do, causing losses to investors.
On August 1, 2008, New York State Attorney General Andrew Cuomo notified
Citigroup of his intent to file charges over alleged Citigroup
misrepresentation in the sale of troubled auction-rate securities as safe
instruments. Investigators also accused Citigroup of illegally destroying
A week later, on August 7, in response to state and federal regulators charges,
Citigroup was reported as having agreed in principle to settle the auction rate
securities charges by buying back about $7.3 billion of auction-rate securities
it sold to charity organizations, individual investors, and small businesses.
The agreement also calls for Citigroup to use "best efforts" to make all of the
$12 billion auction-rate securities it sold to institutional investors,
including retirement plans, liquid by the end of 2009. The settlement allowed
Citigroup to avoid admitting or denying claims that it fraudulently sold
auction-rate securities as safe, liquid investments.
On the same day, a few hours after the Citigroup settlement announcement,
Merrill Lynch announced that effective January 15, 2009, and through January
15, 2010, it will offer to buy back at par auction rate securities sold by it
to retail clients. Merrill's action provided critically needed liquidity for
more than 30,000 investor clients who hold municipal, closed-end funds and
student loan auction rate securities. Under the plan, retail clients of Merrill
would have a year-long option in which to sell back to Merrill at face value
should the market value fall below that the auction rate securities they
There is also the issue of the settlement's focus on points of sale rather than
on the underwriting institutions that broke their promise of making markets for
the auctions, which is a much larger problem than the settlement had so far
Also the liquidity provided by the Federal Reserve through its discount window
is accessible only to the large national investment banks but not to regional
brokerage firms that acted as the large investment banks' agents. Further, the
settlement is not global in the sense that investors who bought from regional
firms that were not included in the settlement are not offered any buybacks.
There was also a full-disclosure issue, in that when the auction market first
began to crack, not all potential buyers were in possession of the critical
information that the market might seize up or they would not have bought ARS's
if they had known.
The State Attorney's office is also probing the relationship between Fidelity
Investments, the nation's largest mutual fund manager and Goldman Sachs on the
sale of ARS's. Most of the SAS's sold by Fidelity were underwritten by Goldman.
There was a question of conflict of interest in terms of undue incentive to
sell Goldman-underwritten instruments to Fidelity retail customers because
Fidelity was protecting its other lucrative services from Goldman, including
other Goldman underwriting of private offerings of instruments Fidelity
developed for accredited investors.
In short, this is crony capitalism at work. What is amazing is that this
practice has been going on for years, yet it takes until now before those in
charge of fair and equitable markets to catch on. Better late than never, and
it could have been never if a crisis had not broken out.
In the same month, the Securities Exchange Commission's Division of Enforcement
engaged in preliminary settlements with