Thomas J. Byrne, Moody’s Investors Service

U.S.-China Commission
China’s Capital Requirements and U.S. Capital Markets
December 6, 2001

China’s Paradoxical Foreign Capital Regime: An Open and Closed System

Moody’s ratings are intended to provide capital market participants with a framework for comparing the credit quality of debt securities. A credit rating compresses an enormous amount of diverse information into a single symbol. Credit quality embraces relative default probability, loss severity, financial strength and transition risk (large rating movements). In addition to economic and financial factors, ratings also reflect political and other systemic features, particularly for sovereign ratings. In corporate ratings, similar factors are described as the operating environment. This paper addresses how these features also play a role in determining the composition of capital inflows into China.

The ordinal ranking of sovereign ratings will not necessarily indicate how much foreign capital a country will attract. Relatively low rated Latin American countries have dominated emerging market capital inflows because of other features at play in addition to default probability of the sovereign. Although the analytical emphasis on sovereign ratings is primarily on default probability (or severity of loss for lowly rated countries such as Argentina), sovereign defaults are rare. The Asian crisis produced no sovereign bond defaults. The three sovereign international bond defaults in recent years happened outside East Asia—Ecuador, Ukraine and Pakistan (Argentina has not defaulted, yet). The analytical emphasis for the banking sector also includes financial strength. This is because, in the case of bank ratings, the regulatory safety net in most countries provides outside support independent of the intrinsic financial strength of the particular bank.

In regard to China, Moody’s ratings universe is relatively small, although it is gradually increasing as state-owned companies seek to tap the international bond markets. Sovereign foreign currency securities are rated A3, indicating very low probability of default over a 5-10 year horizon, in Moody’s opinion. Only about 40 issuers in China, including the sovereign, have ratings—these are dominated by financial institutions; only a handful of corporations have ratings. The number of issuers in a particular country having a rating by an international credit rating agency is a function of the existence of globalized corporations and the degree of development of the domestic capital markets and their integration into the world economy. That is why Korea has more rated issuers than China, and why Japan has hundreds of rated financial and non-financial corporations and the United States has thousands.

China attracts huge amounts of foreign capital for an emerging market, but the composition of the inflows is paradoxical. China’s Open Door Policy, remains selective and restrictive, encouraging certain forms of foreign capital, but discouraging and preventing others. Industry can be modernized, but financial markets have not yet been allowed the freedom to fly outside the birdcage that Mao’s orthodox economist, Chen Yun, imposed on non-state economic activity.

This strategy has served China well in its early stage of transition towards capitalism, fostering fixed capital formation and protecting systemic stability. For example, capital controls, together with prudent external debt management by the central government, prevented an overhang of foreign-bank-financed credit and vulnerability to sudden shifts in creditor confidence. China was largely unscathed by the Asian financial crisis. The heavy reliance on domestic financing intermediated by the state-owned banking system and, increasingly, by the state-controlled and dominated stock market, provides key support to the state owned enterprise system as it is gradually restructured and commercialized.

China has a wide, open door to foreign direct investment, typically in the form of joint ventures with state owned non-financial firms. Such inflows, which have been sustained at about $40 billion annually in the past five years, and show signs of rising further in the post-WTO environment, are by far the largest in Asia, and are multiples of FDI inflows into Japan even (see appended Table A). This has served China well in its acquisition of technology and addition of export capacity. Indeed, the value of China’s exports may surpass that of Japan’s before the end of this decade if recent trends continue. The rapid growth in foreign-invested enterprises has also helped boost official foreign exchange reserves, generate employment, and bolster the government’s weak fiscal capacity.

Foreign portfolio investment inflows, in contrast, are very small, and foreign debt inflows have become marginal in recent years. Government policy still does not seek to develop the domestic bond market, and together with capital controls, prevents foreign investment in corporate or even government bonds. The domestic bond market in China is growing, but only because of government issuances. Corporate bonds account for only 1 percent of the market, and their place has diminished in recent years. While China’s domestic stock exchanges are the star performers in Asia this year, and market capitalization has risen to more than 50 percent of GDP from zero in the past decade, foreign participation remains relatively minor, and non-state listings are a very small part of the market.

China’s investment regime and capital markets will remain segmented and suppressed, in my opinion, until the government allows the private sector to assume the leadership role in the economy. Amendment to the Constitution in 1999 stops well short of that. The Communist Party, acting through the government, remains reluctant to relinquish its dominance in the banking system, corporate sector and even stock market. My guess is that this will remain the case, although WTO-induced liberalization will speed up the commercialization of the state sector. Increased competition in the financial sector from a greater foreign presence, perversely, could weaken the post-Open Door banks that are not under the direct control of the central authorities. On the other hand, the large state-owned banks, which are intrinsically very weak, but too big to fail, remain protected and supported by the central government and will likely continue to dominate the financial sector.

Vulnerabilities to crisis in a closed system such as China are domestic, not external (unless some unforeseeable development chokes FDI inflows and export performance). The low level of exposure to foreign bank credit dampens contagion effects such as those seen in the Asian crisis. In fact, the large reduction in foreign bank debt in the wake of the Guangdong Investment and Trust (GITIC) bankruptcy in 1998 did not affect FDI inflows, which remained large while official foreign exchange reserves continued to rise. The Chinese economic system will remain stable as long as the workers and bank depositors, and increasingly individual stock market investors remain confident that the economic and social policies of the government will continue to lead to a rising standard of living.

If, however, the Chinese authorities shift policy, and decide that large foreign portfolio equity is good for the economy, formidable institutional obstacles will need to be removed. Market-determined interest rates and credit risk judgements will need to allocate financial resources. Corporate governance, in all its facets, will need to be promoted. Limits not only on foreign participation in the stock market will need to be reduced or eliminated, but also government ownership of banks and firms will need to be downsized or relinquished to enlarge the scope for the private sector. Growing fiscal strains, or rising unemployment, may prompt the government to take the next quantum leap in reform, which would provide an even wider opening for foreign capital, potentially.

However, the record in Asia shows that, in government-directed economies, the course of reform was not predictable and gradual, but rather evolved discontinuously. Financial and capital market reform was a by-product of crisis. Korea, pre-crisis, had a precise blueprint for liberalization, but the system was only marginally changed. Rather, the dire effects of the 1997 crisis galvanized political will and led to liberalization measures which induced unimaginably high FDI inflows and portfolio investment inflows compared with the pre-crisis regime. This helped stabilize the balance of payments and boost Korea along its V-shaped economic recovery. Reform-induced capital could still play an important role in cushioning the Korean economy from the downturn in global economic conditions, and in enhancing its competitiveness in the global economy. But the political consensus for reform would need to be refreshed.

As I noted early, China has fewer rated bond issuers than Korea and much fewer than Japan. This is not strictly due to size, the Chinese economy is much bigger than Korea, nor is it strictly related to trade, as China’s exports are greater than Korea’s and catching up to Japan’s. Other factors are the reason. One is that China has relied heavily in the past on using financial institutions and conduits of foreign debt capital, namely, the investment and trust companies. But the bankrupt GITIC and other near-bankrupt ITICs in other regions are no longer active windows for the inducement of foreign capital. The government has allowed there institutions to falter and, accordingly, they have very low ratings from Moody’s. Other financial institutions in China that continue to receive relatively high ratings from Moody’s are those that are important enough to receive government support so as to maintain systemic stability—such as the four large state-owned banks. Prudence on the part of the government will prevent the extension of such support to other, new institutions. In the wake of the ITIC debacle, the government has taken a very cautious approach to introducing new institutions or markets to attract other forms of capital, particularly portfolio investment. The government determines and controls which state owned firms or banks are allowed to seek and international rating, as a prelude to an IPO and eventually to raise funds from international bond markets. And the government is not eager to throw open the door of the birdcage. Moody’s does not have a rating on any truly private entity in China, yet.

Moreover, another factor determining the openness of an economy to foreign portfolio capital inflows has to do with the existence of a domestic bond market that is hospitable to foreign participation. These means capital and interest rate controls must be relaxed, and the institutional framework and legal system must offer protection for private sector investor rights. An indication of such protection is embedded in Moody’s ratings for domestic currency ratings of the government (see Table B). The government of Japan, like all advanced countries, has a rating for its bond obligations; and Japan has a very active domestic bond market in which Moody’s provides ratings consistent with its internationally recognized rating system. The government of Korea was assigned a domestic currency rating for its bonds and notes post-Asian crisis. Weak institutional features in this market have, however, continued to hamper foreign participation and have prevented Moody’s from extending its international rating system to the domestic Korean bond market.

In the case of China, Moody’s has not assigned a domestic currency rating for the government, in part because of lack of investor interest (interest and capital controls discourage foreign participation), but also because of the lack of protection for creditors under the current legal system in China. Before China can benefit more fully from greater access to the international capital markets, there will need to be fundamental changes in the Chinese economic, legal and political systems. China has much unrealized potential; if WTO means that China has chosen liberalization, China will increasingly attract portfolio investment from the large pool of global capital.