Hedging Financial Bets In China: Will ‘ITIC’s’ And Other Entities With P.L.A. Connections Be Bailed Out By Beijing?

(Washington, D.C.): The Chinese government — wracked with a potentially serious liquidity
crises afflicting its roughly 240 International Trade and Investment Corporations (known as
ITICs) — subtly effected a major policy reversal last week. Officials indicated that
some of the
country’s ITIC’s may be bailed out in the weeks and months ahead. While investors
anxiously
await word whether the Guandong International Trust and Investment Corporation (GITIC) will
be one of those, an ominous prospect looms: GITIC and other provincial ITIC’s may
well be
permitted to fail, but Beijing will probably not allow national ITICs and
other entities with
direct or indirect ties to China’s vast military- industrial complex (the People’s Liberation
Army or PLA) and intelligence services to default — or even to be subjected to increased
scrutiny.

The Casey Institute has long argued that China’s penchant for secrecy and non-transparency in
its
international financial dealings mirrors the crony capitalism that have brought such grief to
economies throughout East Asia. If Beijing now uses PLA-affiliation as the determinant of which
failing ITICs are eligible for central government intervention, there are likely to be significant
national security, as well as financial, implications for U.S. and other Western investors.

No ITIC Bailouts?

Over the past two weeks, foreign banks and investors have been sweating the details of
GITIC’s
closure in the wake of the central governments’s announcement that foreign debt obligations may
not be met in full. Having committed billions of dollars (often through ITICs) to
China’s development efforts over the past decade, confident that the PRC would never let such
organizations fail, Wall Street received a double shock: Not only would GITIC cease operations;
a formal announcement followed that there would be no government bailouts for the
ITICs.
Instead, as the Financial Times reported on 30 October:

“Foreign banks, which have been told they cannot expect the central government to bail them
out
of loans with bankrupt provincial investment companies, will ultimately have to negotiate
repayment with the Guandong provincial government, which owned and ran GITIC.”

Clintonesque Wordsmithing

China appears to be taking a page from President Clinton’s playbook in trying to have it both
ways: It seeks to permit mismanaged and over-extended state-owned enterprises to fail while
trying to preserve market confidence in China as a whole. The answer: Fob responsibility off
onto provincial authorities and their foreign creditors.

In this connection, China’s Finance Minister, Xiang Huaicheng, recently declared: “I do not
know how [the province of Guandong] will handle GITIC’s bankruptcy. In terms of foreign debt,
this issue should be handled according to Chinese laws and regulations.” Unfortunately, as the 30
October Financial Times article on the GITIC default points out, Mr. Xiang’s logic
leads the
hapless Western investor or creditor to a dead-end: “The legal process, though, is unclear.
Foreign banks are required to register claims for loans to GITIC with full documentation, but in
many cases the documentary evidence is lacking. On some loans, banks have failed to
do the
necessary paperwork; on other short-terms loans,
registration was not generally required.“
(Emphasis added.)

It fell to Wang Xuebing, President of the Bank of China — one of China’s “big four”
government
banks tasked with overseeing GITIC’s closure — to make plain the bottom line for foreign
creditors: “Foreign financial institutions should also bear the responsibility in this area.
Foreigners should take some responsibilities and should learn some lessons.” (Emphasis
added.)

Whoops, Did We Say No Bailouts?

To the dismay of the Beijing regime, foreign banks and financial
institutions took Wang’s advice
to heart and quickly sought to protect their now-vulnerable interests. As reported by the Casey
Institute on 29 October 1998,⁽¹⁾ Western bankers and
investors, fearful of further losses, reacted
with a two-pronged response to China’s GITIC announcement: 1) they turned off the valve to
new financial flows to the provincial ITICs and 2) canceled critical “rollovers” of debt repayments
to such institutions coming due, in order to reduce their credit exposure.

The immediate effect of GITIC’s default on a Merrill Lynch bond repayment was to create a
liquidity squeeze in parts of China more quickly than anticipated by Beijing. This knee-jerk
reaction by foreign creditors — still licking their wounds from the meltdown in the global
emerging markets — appears to be causing a financial train wreck among certain other Chinese
ITIC’s struggling to service their hard currency debt. The result could be a series of ITIC
financial problems which could damage China’s standing in international markets.

Realizing belatedly the debilitating consequences of such a financial undertow, China sought
to
soothe frayed nerves on Wall Street with a course-correction late last week. At a meeting of
Hong Kong bankers, Dai Xianglong, China’s central bank governor, announced a policy shift,
stating, “[Troubled ITIC’s] will be merged, reorganized and some may be
injected with
capital.” (Emphasis added).

China’s “Consolidation” Roadmap?

Although it is too early to identify which of China’s ITIC’s will be deemed worthy of receiving
such “capital injections” from the central government, the Casey
Institute suspects a pattern may
emerge over the course of the next 12 to 24 months:

• First, China will likely permit troubled provincial (e.g., local) ITIC’s to “merge” or
  collapse altogether. This would serve the dual objectives of demonstrating financial
  “prudence” to international lenders while sparing Beijing billions of dollars in unaffordable
  capital expenditures. The Chinese can safely expect the international markets quickly to adjust
  to the new reality that some of these local ITIC’s will be permitted to go under —
  without
  unduly undermining investor confidence in China’s sovereign creditworthiness.
  

• The second prong of this “consolidation” policy will probably involve not allowing
  national ITIC’s (e.g., China International Trust and Investment Corporation or CITIC),
  to
  fail. Put simply, these national financial conduits provide China with too many legitimate —
  and “off-the-books” — benefits to hold back government bailouts (i.e., making Western funds
  available to critical, militarily-relevant projects throughout China, serving as market indicators
  of China’s economic stability and financial solvency, providing access to sophisticated Western
  technologies, etc.) in the event of prospective liquidity crises. By intervening to save these
  entities, such sensitive operations would be spared the close scrutiny that would likely follow
  missed foreign debt repayments.

• The third and final component of China’s future bankruptcy/corporate consolidation policy
  will
  likely be to merge surviving provincial ITIC’s and channel Western credit and
  investment flows into either these merged entities — or, better yet from Beijing’s
  viewpoint, the national ITIC’s and banks (like CITIC and Bank of China).
  Western
  investors and creditors would likely be given assurances, or at least “a-wink-and-a-nod,” by the
  regime that these categories of enterprises will be eligible for “capital injections” should they
  encounter financial difficulties.

The danger is that this seemingly “responsible” Chinese response to the present ITIC
problems would greatly increase the “moral hazard” associated with Western investments in the
PRC. Through such a system of incentives, Beijing would effectively be able to vector more
Western financing and investment to Chinese entities most likely to be involved (at least
part-time) in military-related procurement and intelligence-gathering activities. href=”#N_2_”>⁽²⁾

Bottom Line

As China seeks to manage the solvency problems of its network of ITIC’s, it is important to
avoid
the aforementioned scenario of Wall Street and other Western creditors and investors being left
with the stark choice of either investing safely in national ITIC’s and banks — some of which are
associated with China’s Military Commission and/or intelligence services — or investing in local,
genuinely commercial enterprises at the risk of unrecoverable losses.

One achievable way to help ensure that American investors and creditors are not drawn into
(via
Chinese bail-out incentives) ever-larger commitments to the wrong sorts of “national” ITIC’s,
banks and enterprises would be for the newly elected Congress to enact legislation introduced in
the 105^th: S.1315, “The U.S. Markets Security Act of 1997.” This bill would
strengthen
reporting and disclosure requirements with respect to all foreign government-controlled entities
seeking to enter the U.S. debt and equity markets as well as establish an Office of National
Security at the Securities and Exchange Commission to facilitate this enhanced surveillance and
transparency. Failure to take this non-disruptive, prudent step will increase substantially the
prospect of new, unwelcome surprises for Wall Street and other market players in the period
ahead.

– 30 –

1. See the Casey Institute’s Perspective entitled
Market Confidence In ‘China Inc.’
Appropriately Shaken — G.I.T.I.C. Bond Default A Taste Of What Is To Come?
(No.98-C
177, 29 October 1998).

2. The Casey Institute has long argued that at least one national
Chinese ITIC, Chinese
International Trust and Investment Corporation (CITIC) has, at minimum, indirect links to
China’s Military Commission. Wang Jun, CITIC’s Chairman, is not eligible for a visa to enter the
United States stemming from allegations of gun-smuggling to West Coast street gangs via an
associated company of CITIC, Poly Technologies, which Wang Jun also chairs. Since it’s entry
into the U.S. capital markets in March 1993, CITIC has raised some $800 million. Overall,
CITIC has raised a total of some $3.6 billion in global capital markets since 1980. The Bank of
China has been caught up in the current campaign-finance scandal in Washington after it was
learned that the bank was the conduit for money transfers for Charlie Trie, who has been indicted
by federal prosecutors, and Johnny Chung, who has pleaded guilty to campaign finance-related
violations. Since entering the U.S. capital markets in 1985, Bank of China has raised roughly $2
billion. Interestingly, Morgan Stanley was the lead manager in three Bank of China offerings
totaling some $800 million.