Lehman’s Analyst Melcher Breaks The News For The Markets: China Must Clean Up Its Act — or Search Elsewhere For Much-Needed Capital

(Washington, D.C.): In his first Lehman Brothers column to fund managers world- wide, Mark Melcher, the respected political and economic analyst formerly with Prudential Securities, addressed an increasingly sensitive issue in the field of global finance: Whether certain Chinese and other global “bad actors” will succeed in funding their insidious activities in the U.S. debt and equity markets. This analysis takes on increasing importance in light of subsequent revelations in the Financial Times that China hopes to fob off some $2 billion in “bad loans” onto foreign investors and the Securities and Exchange Commission has moved dramatically — via Acting Chairman Laura Unger’s historic letter to Representative Frank Wolf (R. Va.) on May 8 — to increase transparency about the nature and uses of such foreign offerings in our markets.

In addressing the implications of and prospects for China’s strategy for meeting huge capital requirements in the period ahead, Mr. Melcher cites the work of the Casey Institute’s Chairman, Roger W. Robinson, Jr. and its Senior Analyst Adam Pener. He credits the Casey Institute’s Capital Markets Transparency Initiative — a five-year effort to illuminate and address the growing challenge represented by some Chinese and other foreign entities that are engaged in activities harmful to U.S. security interests and are seeking to fund themselves in America’s capital markets — with complicating Beijing’s bid to make the privatization of state-owned enterprises and their listing on international exchanges a “centerpiece of China’s strategy to overcome [its acute economic] problems.”

Indeed, as Melcher’s visionary piece suggests, the Chinese could find certain elements of their broader capital markets strategy in jeopardy in the coming months. Notably, the SEC’s expanded disclosure requirements (see Casey Perspective, No. 01-C 28) make it likely that investors will be better able to determine whether the true identity and global activities of a foreign country, government or entity listing in the U.S. might elevate the risk associated with its offering.

In addition, the new congressionally mandated, blue-ribbon U.S.-China Security Review Commission, of which Mr. Robinson is a member, is mandated to evaluate this new portfolio. The Commission is likely to provide far-reaching recommendations to Congress regarding the nexus between the capital markets and U.S. security interests.

Mark Melcher has, as usual, identified an important market-shaping development long before his competitors, particularly given the seismic shift last week in SEC disclosure requirements for foreign registrants with significant business operations in countries under U.S. sanctions regimes. His analysis should be required reading in both policy and financial circles.

…The Chinese made a huge mistake in the way they handled the [EP-3] situation. There already exists a community of interests that want to place restrictions on relations with China because of that nation’s sword-rattling against Taiwan, its arms sales to U.S. enemies, and its poor human rights record. And I think it is accurate to say that these people were elated at the public relations bonanza that Chinese hardliners handed them.

This is not a novel observation on my part. What I think I can add to the picture is that the fallout will not be confined to trade relations and military spending, as most of the talking heads on television have indicated. It has also greatly strengthened the hand of those individuals and organizations that are trying to illuminate and discipline China’s access to U.S. capital markets.

This effort is less well publicized than the one directed at trade. But it could be potentially more damaging to China’s long-term economic health. No matter what the outcome of the trade debate, China will continue to sell goods in the American marketplace. If, however, China’s access to U.S. capital markets is impeded, the country could fall well short of its capital needs over the next decade, which could doom its hopes for modernization and social stability.

I first wrote about this new element in the controversy over United States-China relations in a November 1999 article entitled “PetroChina Dustup: The Start of Something Big.” The impetus for the piece was an IPO for PetroChina, a subsidiary of China National Petroleum Co., China’s largest producer of crude oil and natural gas. The offering was initially supposed to raise $10 billion. But, because of the efforts of what has come to be known as the PetroChina Coalition, the offering raised only $2.89 billion, most of which was sold as private placement.

Two things made the battle interesting to me. The first is that the Coalition focused its efforts on convincing large institutional investors that they would be taking a serious fiduciary risk by buying PetroChina stock. Numerous arguments were offered to support this contention, but the big one was that the issue could be socially toxic to own, given that some of the money could be used by its parent company to drill for oil in Sudan, a nation often accused of sanctioning slavery, genocide, and terrorism.

This campaign was so effective that before the road show had been launched, CalPERS, CREF, the New York City Employees Retirement system, and Kansas Public Employees Retirement System, to name a few, had already announced that they would not participate in the offering.

The second fascinating aspect of this story is the bipartisan makeup of the Coalition, which makes it both highly unusual in Washington and potentially very powerful.

The Coalition is the brainchild of Roger Robinson. A former member of President Reagan’s National Security Council, Robinson is currently chairman of the William J. Casey Institute, which concentrates its efforts on “the nexus between national security and global financial flows.” Other Coalition members include the AFL-CIO, Friends of the Earth, the American Anti-Slavery Group, Freedom house’s Center for Religious Freedom, the International Campaign for Tibet, and the U.S. Business and Industrial Council. I noted the following in my piece on this unlikely Coalition.

“To some observers this is little more than an amusing dust-up between one of Wall Street’s most powerful firms and a motley assortment of economic Luddites from the nether world of politics, whose hand has been temporarily strengthened by an unfortunate, but transitory, cooling of relations between China and the United States, due to some short-lived political jostling related to an election in Taiwan.

“I think these folks are dead wrong. I think this is, as the song goes, the start of something big. Simply stated, I think when the dust settles on this dispute, the gurus of international investment banking will find that their jobs have been made permanently more difficult by the appearance of a new social investment category that has been declared taboo by some of their largest customers, and by the addition of a new and highly complicated variable to their already crowded due-diligence agendas.”

The dust has yet to settle. In fact, it is becoming dustier all the time. In addition to the problems created by China during the dispute over the downed U.S. aircraft, two recent events have strengthened the PetroChina Coalition’s efforts.

The first was the election of a president who is openly sympathetic to the fundamental concerns of the members of the Coalition. The second was a provision in the National Defense Authorization Act, signed into law October 30, 2000, which established the United States-China Security Review Commission, with a mandate to provide Congress with “a full annual analysis, together with recommendations for legislative and administration actions, of the national security implications for the U.S. of trade and current balances in good and services, financial transactions [emphasis added] and technology transfers.”

Within the “financial transactions” category, specific lines of inquiry include “the use of financial transactions, capital flows and currency manipulations to enhance China’s national power, and the extent of its dependence on the U.S. market and financial institutions in this regard.”

This new Commission has 12 members, one of whom is none other than Roger Robinson. Roger and five other members were chosen by Republican congressional leaders Trent Lott and Dennis Hastert. One might think that their generally hawkish view toward China would be offset by the appointment of six other members by Democratic leaders Dick Gephardt and Tom Daschle. But one might be wrong, given that one of the members appointed by Gephardt is George Becker, a member of the executive council of the AFL-CIO, which has taken a decidedly hostile attitude toward China.

One could also assume that the recommendation of this commission will fade into the general din of Washington babble, like those of so many other similar advisory Commissions. But one might be wrong on this also.

There is increasing evidence that the issues of interest to the Commission have already prompted calls by several members of Congress for expanded SEC disclosure requirements. A principal question being raised is whether investors are receiving sufficient information about the risks of investing in companies that have questionable records on human rights, religious freedom, and issues that affect U.S. security interests. This is of more than academic interest, given that the PetroChina Coalition has already demonstrated its ability to negatively affect the value of certain foreign securities.

Many observers think this effort will have little, if any, impact on China’s ability to raise funds via stock and bond offerings. Alan Greenspan, for example, told a congressional committee last year that Chinese firms would just raise money elsewhere if their access to U.S. financial markets were restricted.

In response, Robinson argues that any Chinese firm that is denied access to the U.S. markets would automatically acquire an elevated risk profile, and thus would pay a higher cost for raising funds elsewhere. In addition, he argues, Chinese firms might find it difficult to raise the large-scale funds they will need in the near future in the thinner-volume foreign markets. This is especially so, he maintains, if large American Institutional investors stay on the sidelines in response to a social investment campaign similar to the one that helped bring down the apartheid government of South Africa.

Time will tell as the saying goes. In the meantime, it is worth considering that China and its major industries will, by all accounts, need vast amounts of capital in the years ahead to successfully deal with the extraordinary social and economic problems it faces.

The following information, provided by Adam Pener, a senior analyst from the Casey Institute, will, I believe, provide some insight into the capital problems facing China.

• China’s banks are in deep trouble. Estimates of the percentage of nonperforming loans in China’s Big Four banks run between 25% and 40%. Nicholas Lardy of the Brookings Institute reportedly claims that three of these four banks are technically insolvent by international standards.
• According to the Stratfor Global Intelligence Update, the most daunting short-term banking concern in China is the insolvency of the country’s 40,000 rural credit cooperatives. With more than 800 million rural inhabitants, these banks represent the principal savings institutions for rural Chinese. The People’s Bank of China reported last year that these cooperatives have a combined negative net worth, due primarily to bad loans.
• In 1993 China became a net importer of oil; in 2000 it imported approximately 70 million tons. Regardless of China’s plans to boost domestic energy production, the bottom line remains clear: China will divert considerable capital outlays to pay for imported energy in the coming decade.
• While capital expenditures mount, the government has intensified its borrowing. State debt, some 5% of GDP in 1993, skyrocketed to about 20% of GDP in 1998.
• The business climate in China has also led to concerns from some analysts. According to a recent PricewaterhouseCoopers’ Opacity Index, China was determined to be the world’s most difficult place to do business.
• China may not be “going broke,” as one recent report claimed, but barring massive near-term infusions of capital, the chances of macroeconomic dislocation for the government are considerably greater.

A centerpiece of China’s strategy to overcome these problems is the privatization of state-owned enterprises (SOEs). By listing these companies on international exchanges, the PRC is able to raise billions of dollars from diverse sources of lenders.

In addition to providing critical capital and helping underwrite both healthy and faltering SOEs, the listings provide legitimacy for China’s centrally planned economy and create a global constituency with a vested interest in ensuring that these companies not only survive, but prosper.

That is, of course, unless the PetroChina Coalition and its friends in Congress have something to say about it.