China's Visible Hand

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China’s Visible Hand: An Analysis of the Chinese Government’s Intervention in its Economy During 2015–17

Kerry Liu

University of Sydney, Australia

Author Note

Kerry Liu, Associate at the China Studies Centre, University of Sydney, Australia

The author would like to thank Xiaoming Feng, the Managing Editor Scott Jeffrey, and three anonymous referees for helpful comments. This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.

Correspondence concerning this article should be addressed to Kerry Liu, [email protected]

Abstract

While the Washington Consensus supports limited government involvement in economic life, the new structural economics holds that government can play a facilitating role. This paper contributes to this debate by examining examples of the Chinese government’s intervention in its economy during 2015–2017. The Chinese government’s intervention has been generally successful, including significant reduction in overcapacity in the steel and coal industry, reduced liquidity of Chinese real estate as an asset class, and change in investment style through direct intervention in stock markets. Under President Xi Jinping, the governance model of China Inc. resembles family ownership and family management; thus, with Xi Jinping as an owner–manager, it is expected that the current government would outperform its predecessors, under presidents who were mainly managers. This study is the first of its kind to examine the performance of Chinese government intervention from the perspective of financial economics.

Keywords: Washington Consensus; new structural economics; China; government intervention; overcapacity; real estate market; stock market; family ownership; Xi Jinping

CHINA’S VISIBLE HAND

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The rise of China is one of the most important events in world economic history since

the Industrial Revolution, and the Chinese government is believed to have played a highly positive role in the process (Wen, 2015). For example, China has a capable mercantilist government with both highly centralized command power and a highly decentralized administrative structure. The Chinese government can mobilize, organize and manage its national economy through both central planning and decentralized intra-national competition among local administrative regions for economic growth and governance; and it can self-correct major policy errors through controlled nationwide experiments and pragmatic institutional innovations at both the upper and lower administrative levels (Wen, 2015). These aspects of the Chinese government are aligned with the new structural economic framework, which recognizes a facilitating role of the state in the process of industrial upgrading (Lin, 2011; Lin, Monga, Velde, Tendulkar, Amsden, Amoako, & Lim, 2011). The China Model’s powerful state has a hand on the levers of capitalism (The Economist, 2009). This contrasts with the focus of the Washington Consensus on open markets and limited government involvement in business (Williamson, 1989), an approach that has been criticized for resulting in economic collapse and stagnation in many transition economies and “lost decades” in other developing countries in the 1980s and 1990s (Lin, 2015), and for exacerbating inequality and unleashing violence (SCMP, 2017). China is trying to export its development model, such as by helping the government of Grenada prepare a national development plan (Chen, 2017). For all these reasons, the role of government in economic development is a hot topic.

This paper contributes to the debate on the role of government – especially the Chinese

government – in economic development by examining evidence from 2015–17. The first section presents recent evidence of government intervention in the Chinese economy during 2015–17, with respect to overcapacity in the steel and coal industries, the property market and the stock market. The second section presents some theoretical analysis of the performance of Chinese government. The third section concludes this paper.

Chinese government intervention in the economy, 2015–17

Xi Jinping was elected as the President of China on 14 March 2013. During the early

stages of his first 5-year term, he gradually consolidated his power through an anti-corruption campaign, and by 2015 had assumed responsibility for the Chinese economy, which was traditionally the responsibility of the Premier. At the Third Plenary Session of the 18th Central Committee of the Communist Party of China (CPC) held in November 2013, it was stated that China would let the market play the decisive role in resource allocation. However, few noticed the following statement; that China would also let the government play its role (Xinhua News, 2013). At the 19th Central Committee of the CPC held in November 2017, these two statements were reiterated (Xinhua News, 2017). They imply that China’s visible hand has been playing and will continue to play a significant role in Chinese economy. In this section, three examples from 2015–17 are examined: interventions in the property market, the stock market, and the steel and coal industries.

Overcapacity in steel and coal

Capacity utilization is defined as the ratio of an industry’s actual output to its estimated potential output. China’s National Bureau of Statistics (NBS) assesses aggregate capacity utilization by surveying over 90,000 industrial firms (NBS, 2018). Starting from early 2016,


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China’s NBS also began to publish capacity utilization by sub-sector. Various government departments such as the State Information Centre also sporadically publish such information through news reports, articles and conference proceedings.

Since the 1990s, the Chinese government dealt with five separate overcapacity

problems – in 1999–2000, 2003–04, 2006, 2009–10, and 2013 (Yu and Cui, 2016). The industries that most often experienced overcapacity were steel, coal, cement, electrolytic aluminium and flat glass, but primarily the steel and coal industries (Yu and Jin, 2017). In 2015–17, a 6th program sought to resolve overcapacity in the steel and coal industries.

During 2011–15, China’s annual steel output was around 1.13 billion tons. However,

capacity utilization for crude steel declined from 79% in 2010 to around 70% in 2015. The whole steel industry had been running at low profitability, and experienced an overall loss in 2015 (Y. Liu, 2018). Similarly, the coal mining industry had been struggling for a long time as the result of overcapacity. Its gross profit margin, defined as the ratio of revenue minus cost of goods sold to revenue, reached its peak level of 31.1% in November 2008, and continuously declined to an historic low of 14.2% in August 2015. During the same period, the growth rate of industry-level profit declined continuously from 91.9% to negative territory in mid-20161.

There are multiple and complicated reasons for industrial overcapacity in China. As Yu

and Jin (2017) argued, while structural factors and restructuring can cause overcapacity and fluctuations in capacity utilization are part of the economic cycle, Chinese economic characteristics are also important. First, Chinese firms tend to invest in industries which have been successful in more developed countries. However, many Chinese firms made investment decisions based on incomplete information, forming a "wave" that resulted in concentrated investment in particular industries. Product prices dropped, leading to overcapacity (Lin, Wu and Xing, 2010). Second, Chinese governments play a significant role in driving overcapacity. For example, local governments vie to attract investment to increase local GDP, taxes and employment. Accordingly, low-cost land supply and tax relief have become main methods of promoting investment and have boosted capacity expansion. Some local governments even set up bankruptcy exit barriers to help firms reorganize in order to protect local investment and employment, which have further increased the difficulties of resolving overcapacity issues (Yu and Jin, 2017; Zhou, 2004). Furthermore, the Chinese central government played a significant role in the 2008–09 global financial crisis (GFC), launching a massive economic stimulus program characterized by heavy investment in infrastructure projects, which significantly expanded the capacity of upstream industries including steel and coal (Zhang, 2014). Third, the incompleteness of the entire market mechanism in China is an underlying driver of overcapacity. The pricing mechanism for the factors of production is very distorted and the market is not fair and competitive. The exit channels for overcapacity are premature. For these reasons, overcapacity in China has worsened over time (Yu and Jin, 2017).

The Chinese government has been very concerned about the consequences of

overcapacity, such as downward pressure on product prices causing deflation, restricting economic growth and discouraging further investment (Yu and Jin, 2017). Capital formation is a major contributor to Chinese GDP growth, accounting for 41.6%, 42.6% and 32.1% in

1 Data Source: Wind Info, National Bureau of Statistics


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2015, 2016 and 2017 respectively2. Overcapacity has become a major factor suppressing economic growth. Yu and Jin (2017) also argued that overcapacity can increase corporate debt, potentially triggering systemic financial risks. Also, overcapacity can trigger international trade disputes. China is facing numerous international anti-dumping cases related to its steel industry, which has been suffering serious overcapacity.

Government policies. The Chinese government’s response to the overcapacity issue is part of the so-called “supply-side structural reform” initiated in November 2015 at the Central Economic Work Conference (CEWC) (Xinhua News, 2015), a high-level annual meeting of policymakers and senior Chinese Communist Party leaders, including the president, Xi Jinping. The reform process followed official recognition that Keynesian demand-side policies had run their course. Years of boosting the economy with monetary and fiscal stimulus had given rise to structural imbalances and financial risks. Easy credit had caused “zombie companies” to proliferate in industries with overcapacity, the financial system was exposed to a massive property overhang caused by overinvestment, and domestic firms were not producing the goods and services that local consumers demanded. The 2015 CEWC identified five areas of focus: cutting industrial overcapacity, destocking the property inventory, corporate deleveraging, lowering corporate costs and improving “weak links” (EIU, 2017).

There are two main ways to deal with overcapacity. The first is through the mechanism

of market clearing: through competition from the market, the less efficient capacity will be forced out of the market by bankruptcy or restructuring. The second is through government action: through enforced compliance with industrial policy and work health and safety regulations, or administrative measures, the less efficient capacity will be forced out of the market. Chinese government mainly relies on the second approach, for two reasons. First, overcapacity is closely associated with overinvestment, and overinvestment is associated with the low-cost factor of production; therefore, reform of the pricing of factors of production is essential (an ongoing and probably lengthy task). Second, many overcapacity firms are either state-owned or closely associated with local government taxes and employment, and thus, are partially insulated from market forces.

Professor Justin Yifu Lin from Peking University cited an example of how the Chinese

government deals with high inflation (China News Weekly, 2017). In the 1980s, China faced very high inflation; the typical market-oriented response would have been to raise interest rates, but because most projects were state-funded, raising rates would have caused substantial losses. In order to support employment, government would have to provide subsidies, the Chinese government’s deficit would rise, and this would have to be resolved by issuing more money, thereby exacerbating inflation. Instead, the government simply cut investment projects through administrative measures.

In the same way, the Chinese government relied mainly on administrative measures and

compliance requirements to cut recent overcapacity in the steel and coal industries. In February 2016, the State Council (China’s central government) issued a guideline on resolving overcapacity issue in the steel industry (State Council, 2016a). This document stated that starting from 2016, China would reduce its crude steel production capacity by 100–150 million tons over five years. By end 2016, 65 million tons of steel capacity had already been eliminated3. In February 2016, another State Council guideline on resolving overcapacity in the coal

2 Data source: Wind Info, National Bureau of Statistics of China 3 Data source: Ministry of Industry and Information Technology, China


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industry (State Council, 2016b) stated that China would reduce coal production capacity by 800 million tons in 3–5 years. By end 2016, 290 million tons of coal capacity had been eliminated4.

Effect of government policies. Capacity utilization has improved significantly since the beginning of the most recent round of overcapacity reduction. Capacity utilization for the ferrous metal smelting and rolling processing（steel）industry gradually increased from 72.3% in Q2, 2016 to 77% in Q4, 2017. In addition, the capacity utilization ratio for the non-ferrous metal (such as aluminium and magnesium) smelting and rolling processing industries increased from 75.7% in Q4, 2016 to 79.6% in Q4, 20175. In the coal industry, capacity utilization increased from 58.4% in Q2, 2016 to 70.5% in Q4, 2017.

The Producer Product Price (PPI) has also improved significantly. Starting from

December 2011, the PPI for the metallurgical industry (steel industry) remained in negative territory continuously for 56 months until June 2016, when it rebounded. Starting from June 2012, the PPI for the coal and coking industry remained in negative territory continuously for 51 months until August 2016, then gradually rebounded6. As a result of rising prices, profits in these industries have also rebounded significantly.

Generally, the Chinese government’s approach to overcapacity in the steel and coal

industries has been successful. The Economist (2017) stated that growth normally comes from investment in new facilities, not the closure of those in use, showing that China’s case is a rare one. By taking on extreme overcapacity, its cutbacks have provided an economic boost for China and for the global economy. However, Chinese state-owned enterprises (SOEs) still face a soft-budget problem. If low-efficiency SOEs continue to receive preferential treatment in the form of credit support from Chinese banks and government guarantees, there is a risk that the overcapacity issue will re-emerge.

Conclusions. China’s steel and coal industry had been suffering from serious overcapacity issues for a long time. Starting from 2016, the Chinese government began to address this issue through compliance and administrative measures as a part of supply-side structural reform. This has been successful so far, but while administrative measures are quick and effective, there are some prominent drawbacks. In the coal industry, overcapacity reduction caused a 50% hike in the coal price in the summer of 2016, which brought large volatility to downstream industries. With respect to steel, it has always been very challenging for the government to accurately forecast the market demands (Ji, Zhang and Zhao, 2017). The Chinese real estate market

There has been considerable academic discussion of China’s booming real estate market (e.g. Chen and Wen, 2017; Glaeser, Huang, Ma, & Shleifer, 2017). Official data from the NBS of China show that between June 2010 and December 2017, the real estate price in tier one cities (Beijing, Shanghai, Shenzhen and Guangzhou) increased around 100%, while tier two cities (including 22 cities such as Chongqing and Tianjin) increased around 50%, and tier 3 cities (74 smaller cities) increased around 30%. However, these data do not give a full picture of the Chinese real estate market: Deng, Girardin and Joyeux (2016) argued that government housing prices may suffer from the well-documented downward bias. Moreover,

4 Data source: Ministry of Industry and Information Technology, China 5 Data source: Wind Info, National Bureau of Statistics of China 6 Data source: Wind Info, National Bureau of Statistics of China


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China has the second highest price-to-income ratio, just behind Hong Kong, among eighty-nine countries in one leading database7.

The stock market provides more information. Table 1 below shows the performance and risk-adjusted performance of the MSCI China Real Estate Index and MSCI China Index. The MSCI China Real Estate Index is designed to capture the large and mid-cap segments of the China equity markets. All securities in the index are classified in the Real Estate Sector according to the Global Industry Classification Standard. The MSCI China Index captures large and mid-cap representation across China H shares, B shares, Red chips, P chips and foreign listings (e.g. American Depositary Receipts). With 152 constituents, the index covers about 85% of the China equity universe. H Shares are securities of companies incorporated in the People’s Republic of China (PRC) that trade on the Hong Kong Stock Exchange. They are traded in Hong Kong dollars. B Shares are securities of Chinese incorporated companies that trade on either the Shanghai or Shenzhen stock exchanges. They are traded in US dollars on the Shanghai Stock Exchange and Hong Kong dollars on the Shenzhen Stock Exchange. A Red Chip is a company incorporated outside the PRC that trades on the Hong Kong Stock Exchange and is substantially owned, directly or indirectly, by Mainland China state entities with the majority of its revenue or assets derived from Mainland China. A P Chip is a company controlled by Mainland Chinese companies or individuals, with the establishment and origin of the company in Mainland China. It must be incorporated outside the PRC and traded on the Hong Kong Stock Exchange with a majority of its revenue or assets derived from Mainland China.

Table 1. performance and risk-adjusted performance of MSCI China Real Estate Index and MSCI China Index

Table 1 shows that China’s real estate sector has consistently, significantly, outperformed the market. The average gross return of China’s real estate sector during the past

7 Data source: Numbeo, a collaborative online database which enables users to share and compare information about the cost of living between countries and cities.

Index performance – gross return (%, 31 January 2018)

1Y 3Y 5Y 10Y

since 30 December 1994

MSCI China Real Estate Index 120.27 30.87 13.77 8.67 12.74

MSCI China Index 62.57 16.61 11.88 6.98 4.14

Sharpe ratio

MSCI China Real Estate Index

0.96 0.56 0.39 0.42

MSCI China Index

0.79 0.66 0.38 0.2


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23 years is around 13%, higher than the market return of 4.14%. This high performance is especially significant during the past three years. Table 1 also shows the Sharpe ratio – the average return earned in excess of the risk-free rate per unit of volatility or total risk. The greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. The Sharpe ratio indicator confirms that China’s real estate sector has significantly outperformed the market during the past 23 years.

The GFC showed the role of the real estate market. After a sustained boom, real estate

prices collapsed, triggering a financial crisis and fall in household expenditures which – paired with macroeconomic frictions – led to a slump in employment (Mian and Sufi, 2014). In the case of China, movements in housing prices affect fixed investments, magnifying business cycle fluctuations (Pesenti, 2016). The major near-term risk of the real estate market is the housing bubble in top-tier cities expanding to smaller cities, which increases the likelihood and costs of a sharp correction in house prices. This would weaken growth through slowing real estate investment and private consumption, and affect financial stability by reducing developers’ funding and mortgages of financial institutions (Ding, Huang, Jin, and Lam, 2017). Chen, Liu, Xiong, and Zhou (2017) showed that rising real estate prices affect investment by mitigating the financial constraints firms face, called the “collateral channel”. The increased real estate prices may induce firms, particularly those with land holdings and thus access to finance, to speculate on real estate price appreciation at the expense of their other investments, called the “speculation channel”. In response to an increase in real estate prices, banks may grant more credit to land-holding firms, crowding out credit to firms without land holdings, called the “crowding out channel”. Chen, Liu, Xiong, and Zhou (2017) concluded that netting out these channels means a 100% increase in commercial land prices leads to a loss of 9% to aggregate total factor productivity due to misallocation of capital. Chinese governments have launched a series of policies in response to the risks posed by this real estate boom.

Responses from Chinese governments. During the two decades to 2017, Chinese governments launched monetary policy, credit policy, tax and fee policy and land usage policy to manage the property boom. Nevertheless, the Chinese real estate market is still one of the most inflated in the world, and its fundamental issues are not resolved.

There are three main reasons for the Chinese real estate boom. The first consists of fundamental factors that drive rising demand, such as China’s unprecedented income growth (Chen and Wen, 2017), as well as increasing population and urbanization (Bian and Gete, 2015). China’s urbanization rate increased from 33.4% in 1998 to 58.5% in 20178, driving house prices upwards. This urbanization process is part of China’s economic transition, which features labor reallocation from the traditional low-productivity sector to the newly emerging high-productivity sector. However, this reallocation will eventually end when surplus labor is depleted.

Second, the working-age population (defined as people aged 15–59 years) ratio reached its peak of 69.8% in 20119, then gradually decreased. The Chinese government’s policy on real estate market tightened from 2011–13 (Cooper and Cowling, 2015; Ren, 2017). The booming Chinese property market since 2014 has been mainly driven by expansionary monetary policy. Real-estate has increasingly become a preferred asset class for household and institutional investors (Ren, 2017).

8 Data source: Wind Info, National Bureau of Statistics 9 Data source: Wind Info, National Bureau of Statistics


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Third, the Chinese government has played a significant role in the real estate boom. As Shatkin (2016) argued, land price increases present states with opportunities and challenges, leading them to develop new land management strategies that seek to exploit urbanization processes in the interest of extending state power. Governments in much of Asia, including China, have sought to monetize land – to use government land management powers to realize substantial increases in land values, in order to extend state power either by directly extracting revenue for government from land development, or by distributing the profits of land development to powerful corporate backers of the state. This explains why Chinese governments before 2017 had no intention of cooling the real estate market.

The Chinese public sector retains control over future prices and real estate construction

(Glaeser et al., 2017). Thus, Chinese governments’ previous policies toward the real estate market aimed to monetize it further and promote it as an asset class for individual and institutional investors. However, things began to change from the end of 2016. During the CEWC held in December 2016, the Chinese central government’s stated position on real estate was that houses are for living in, not for speculation. This statement was reaffirmed in the communique of the 19th National Congress of the Communist Party of China held in October 2017 (Xinhua News, 2017).

As part of this new position, the Chinese government announced restrictions on real

estate sales. Once a buyer purchases a property, it cannot be traded for a certain period thereafter – in most cases, two years. As of the end of September 2017, 50 cities have adopted the policy. The policy seeks to reduce the liquidity of this asset class; accordingly, an investor will ask for a higher liquidity discount. This illiquidity can be valued as an option: when you are not allowed to trade an asset, you lose the option to sell it if the price goes up (and you want to get out) (Damodaran, 2005). Investing in illiquid assets also introduces additional risks, the most famous example being the Harvard University endowment case. After a prolonged period of good performance, the endowment’s illiquid asset investments suffered heavy losses during the turmoil of 2008. The liquid part of the portfolio had become too small to meet running expenses. In need of cash, the Harvard endowment tried to sell some private equity investments, and had to sell at 50% discounts in the secondary market. The Harvard case showed the world the dark side of having a large a portfolio invested in very illiquid assets (Ang, Papanikolaou, & Westerfield, 2014; Sadka, 2014). As a result of the reduced liquidity of Chinese real estate, investors will be more cautious to further invest in this market. Effect of government policies. Figure 1 below shows that real estate price growth in China has slowed significantly since 2017. At the same time, the accumulated growth of real estate development investment completed and accumulated growth of housing new construction area have been relatively stable. During previous real estate cycles, real estate prices were generally associated with the amount of completed real estate development investment and new housing construction. The weakening of this association from 2017 onwards seems to be the result of the reduced liquidity of property due to the restrictions on sale. The real demand – that is, demand for living space – seems to account for a larger share of the real estate market than before 2017.


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Figure 1. Real estate price, development investment completed and new construction area: June 2011 – December 2017 Source: Wind Info

Conclusions. The Chinese real estate market has been booming for a long time, posing risks to Chinese economy and financial system. Before 2017, Chinese government policies toward this sector had been about further monetizing this real estate market and the real estate become an asset class for investment. The Chinese government’s policy from 2017 is that real estate is for living in, not for speculation. Accordingly, Chinese governments adopted restrictions on sale policy designed to reduce the liquidity of this asset class. As a result, Chinese real estate price growth has slowed, while investment remains still stable.

The stock market since 2015 The Chinese stock market entered turbulence with the popping of the stock market

bubble on 12 June 2015, which ended in early February 2016. The Shanghai Stock Exchange Composite Index (SSE Composite Index, a stock market index of all stocks traded at the Shanghai Stock Exchange) reached its peak level of 5166 points on 12 June 2015, then fell to 2927 points on 26 August 2015, a fall of around 43% in just two months. The Shenzhen Stock Exchange Component Index (SZSE Component Index, an index of 500 stocks traded at the Shenzhen Stock Exchange) lost around 49% between 12 June and 15 September 201510.

On both 4 January and 7 January 2016, the Chinese stock market experienced sharp

sell-offs of about 7%. During the first 15 minutes of the first trading day, the stock market fell by 5% before regulators halted trading. It was eventually reopened, and stocks fell until trading was again halted after 15 minutes (Xie and Hong, 2016). During the whole of January 2016, the SSE Composite Index lost around 23%, and the SZSE Component Index around 26%11.

In January 2016, Chinese stock markets traded A shares in 2,809 listed companies12.

When the market was in most serious situation, around 2000 companies fell to the down limit 10 Data source: Wind Info 11 Data source: Wind Info 12 Data source: Wind Info

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of 10%13, and 1,346 companies’ shares were suspended (Apple Daily, 2015). The whole Chinese stock market was encountering serious liquidity issues.

Policy response from Chinese governments and regulatory authorities. The

Chinese government and regulatory authorities enacted many measures to stem the losses. For example, the Chinese State Council decided to allocate over RMB 250 billion collected from unused and illegal funds into areas in urgent need (State Council, 2015a). China’s Ministry of Finance requested that stated-owned financial companies should buy back stocks when their shares were below reasonable prices (State Council, 2015b). China’s Ministry of Public Security, which is the principal police and security authority in China and the agency ultimately responsible for day-to-day law enforcement, also stepped in to investigate any illegal and/or market manipulating activities. The State-owned Assets Supervision and Administration Commission of the State Council requested over 100 SOEs under direct supervision of Chinese central government not to sell shares (State Council, 2015b). The People’s Bank of China (China’s central bank) announced a Reserve Requirement Ratio cut of 25 base points to release extra liquidity to the market. The China Insurance Regulatory Commission decided to increase insurance funds’ ability to invest in blue-chip stocks. The China Securities Regulatory Commission also launched a series of measures, including reducing the number and fund-raising amount of IPOs; increasing the registered capital of China Securities Finance Corp (CSFC) to RMB 100 billion from RMB 24 billion, allowing it to provide further funds to brokerage firms to buy back shares (CSRC, 2015a); increasing the margin ratios of short selling through financial futures; forbidding blockholders with more than 5% shares outstanding from selling their own shares within six months (The Paper, 2015); and after this six-month period, requiring that the total number of shares sold within 3 months by the major shareholders of a listed company through a centralized bidding transaction did not exceed 1% of the total number of shares of the company (CSRC, 2015b).

However, the most important measure was the direct intervention from the so-called

National Team, which has four members: Central Huijin; the CSFC; investment platforms under the State Administration of Foreign Exchange (SAFE); and five mutual funds with full subscription from the CSFC. Central Huijin is an organization through which the Chinese government acts as a controlling shareholder for the Chinese financial system, including the China Development Bank, the “Big Four” commercial banks (the Bank of China, the Industrial and Commercial Bank of China, the China Construction Bank, and the Agricultural Bank of China), major insurance and reinsurance companies, major security brokerages, and major asset management firms. However, Central Huijin is not a newcomer to the Chinese stock markets; its shareholdings are relatively stable, so it is excluded from my calculation of National Team investments in Chinese stock markets in 2015 and afterwards. The CSFC was founded in 2011 with shareholders including the Shanghai Stock Exchange, Shenzhen Stock Exchange, China Securities Depository and Clearing Corporation, Shanghai Futures Exchange, China Financial Futures Exchange, Dalian Commodity Exchange, and Zhengzhou Commodity Exchange. Initially, the CSFC only provided margin financing loan services to qualified brokerage firms, but starting from 2015, it began to buy shares directly from the market as a special-purpose vehicle for government intervention and play a major role in stabilizing the markets. The SAFE has three investment platforms for investing in domestic stock markets. Figure 2 below shows the market capitalization of the stocks held by various government

13 There is a daily price limit of general: ±10% in Chinese stock markets. Source: Shanghai Stock Exchange http://english.sse.com.cn/investors/shhkconnect/mechanism/rules/


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vehicles and the aggregated fractions of government holdings in stocks over total market capitalization during Q3, 2015 – Q3, 2017.

Figure 2. Market capitalization of the stocks held by various government vehicles and the aggregated shares of government holdings in stocks over total market capitalization during Q3, 2015 – Q3, 2017

Source: Li (2017), Wind Info

Figure 2 shows that the shares held by the Chinese National Team were valued at RMB 800–1,150 billion during Q3, 2015 – Q3, 2017. These shares account for 1.5%–2.5% of total market capitalization of Chinese stock markets. The total market capitalizations and fractions of these market capitalization have decreased from its peak level in Q3, 2015, but are still at a high level.

The CSFC mainly invested in the financial service industry (45.3%); the five mutual

funds also mainly invested in the financial service industry (41.6%), and the SAFE mainly invested in the banking industry (87.9%) in Q3, 2017. Together with other industry allocations, it seems that these National Team Investment managers prefer blue-chip companies (Li, 2017). In fact, from the very beginning of the Chinese government’s intervention in Chinese stock markets, blue-chip companies were the key line of defence (Financial Times, 2015).

Effects of government intervention. In academic literature, although achieving price

stability and restoring investors’ confidence are the main goals of intervention, the general view is that governments should avoid intervening in stock markets since intervention transmits negative signals and carries market-related side effects (Khan and Batteau, 2011). So, the question is, what are the effects of Chinese government interventions in stock markets? To answer, we examine the performance of the SSE 50 Index.

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% of Government Holdings over Total Market Cap (RHL)


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The SSE 50 Index is the stock index of the Shanghai Stock Exchange, representing its top 50 companies by "float-adjusted" capitalization. The objective of the SSE 50 is to give a complete picture of those good-quality large enterprises, which are the most influential in the Shanghai stock market (SSE, 2004). It consists mainly of financial service firms, including 12 banks, 10 security brokerage firms and four insurance companies. The others include major airlines and automotive, construction, energy, real estate and telecommunication firms. The SSE 50 index is regarded as blue-chip, and its return on equity has consistently outperformed the SSE Composite Index, which includes all stocks (not reported; data available upon request). Figures 3 and 4 below show the performance and volatilities of these two indices respectively. The volatility is defined as the 200-trading day standard deviation of the daily percentage change of index.

Figure 3. The performance comparison between SSE 50 Index and SSE Composite Index: 31 January 2013 – 31 January 2018

Source: Wind Info

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Figure 4. Volatilities of SSE 50 Index and SSE Composite Index: 31 January 2013 – 30 June 2017 Source: Wind Info

Figure 3 shows that before Chinese government’s direct intervention in 2016, the blue-chip SSE 50 Index had generally underperformed the market (SSE Composite Index); after the intervention, this situation reversed. Figure 4 shows that before 2016, the blue-chip SSE 50 Index had higher volatility than the market, but after intervention, it generally had lower volatility than the market until May 2017. During June 2017 – January 2018, the risk-adjusted return of the SSE 50 Index also outperformed the market. It seems that Chinese government’s direct intervention in the stock markets, with a special focus on blue-chip companies fundamentally changed Chinese stock markets. It is also widely believed that the A share market has undergone a huge shift of investment style, away from extremely overpriced small and mid-caps to high-quality, reasonably priced blue-chips (Mooney, 2018).

Conclusions. The Chinese government’s direct intervention from 2015 changed the stock markets and, accordingly, their investment style. Value investing became more popular than momentum investing. However, it should be noted that government intervention can also damage stock markets, for example by endangering their integrity and voiding their basic principles of functioning, namely, risk transfer and price discovery (Khan and Batteau, 2011). The long-term effect of the Chinese government’s intervention into the stock markets should continue to be examined as data accumulates.

Theoretical explanations

Market mechanisms are deemed essential for valuing the basic ingredients of production and providing the right price signals and an appropriate incentive system for the efficient allocation of resources (Lin et al., 2011). Nevertheless, the Chinese government has successfully managed its overcapacity issues, a booming property market and stock market fluctuation through direct intervention. There are three arguments as to why these non-market-based and theoretically harmful measures have proved successful.

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The first argument is that, generally speaking, government intervention has its own merits. Lin (2015) argued that many firms in a transitioning economy are not viable in an open, competitive market because they lack the comparative advantages determined by the economy’s endowment structure. Their survival relies on the government’s protections and subsidies through various interventions and distortions. So, through the provision of information, coordination of hard and soft infrastructure improvement, and compensation for externalities, government intervention is equally indispensable for helping economies move from one stage of development to another (Lin, 2010). However, while this argument provides some general justification for government intervention, it does not address the uniqueness of the Chinese government, which is discussed below.

The second argument is that the Chinese government has its own special merits. Being

built on a politically stable one-party system that avoids some of the dilemmas of both democracy and dictatorship that face developing countries, the Chinese government can draw from its administrative talents and gain support from the majority of the population based on a merit-based leader selection system. Such a system is not perfect, but has been China’s great comparative political advantage (Wen, 2015). Wen (2015) also argued that the Chinese government understands the nature of capitalism and the developmental history of the West; therefore, it can take a very long historical view of the evolution of human societies as it designs and implements its development strategies. In contrast, democratically elected politicians, who are often incompetent economic managers, are prone to the manipulation of powerful interest groups and constrained by voters’ short-sighted immediate self-interests. However, this argument still does not answer the question of how the incumbent Chinese government has successfully managed the economic issues discussed in this paper, while previous governments failed to do so. The answer lies in the following argument.

The performance of the Chinese government under President Xi Jinping differs from

that under his predecessors such as Hu Jintao and Jiang Zemin. For example, overcapacity has been a problem for a long time – why did previous governments fail to resolve it? Chinese government intervention in its stock markets also has a long history; why did previous interventions not turn Chinese stock markets towards value investing? Why had previous Chinese governments’ interventions helped the country’s property market become highly unaffordable? K. Liu (2018) argued that the Chinese economy can be regarded as a single corporation – China Inc., and that it is appropriate to assume that the function of China Inc. is maximization of stockholders’ wealth (output growth). China’s previous leaders, Hu Jintao and Jiang Zemin, did not belong to the founding families of modern China; Xi Jinping does. In the past, China Inc. was like a firm controlled by management but with limited supervision from shareholders; China Inc. under President Xi is more like a family-owned and managed corporation. Academic researchers have overwhelmingly concluded that family ownership outperforms non-family ownership, and having a family member as CEO is also positive associated with economic performance. This is the fundamental reason why the Chinese government under President Xi differs from previous ones, and why Chinese government’s interventions into its economy during 2015–17 were successful.

Xi Jinping, as the CEO and President of the China Inc., would consider overcapacity to

be an inefficient allocation of resources. A CEO’s natural response is to terminate the unnecessary investments through internal orders (administrative measures). Regarding the real estate market, if a firm’s business is concentrated on housing construction and speculation, it risks losing its competitive advantage against other firms. As the CEO and a member of the controlling shareholder (group) of China Inc., Xi Jinping has the incentive to restructure the


50

business model by implementing heavier regulation on this sector. He (and his family) may suffer personally from the resulting slowdown of the real estate market, but will ultimately gain as the (controlling) shareholders of China Inc. Finally, the stock market is supposed to play the role of price discovery and risk transfer. The asset allocations of the Chinese National Team have conveyed signals of rational stock selection, serving to guide small investors’ investments. This is essentially a means of more efficiently allocating resources than is possible through market mechanisms alone.

Final conclusion

The economic rise of China is indisputable, and the significance of the role of the

Chinese government in the process also seems indisputable. While the Washington Consensus holds that government involvement in business should be strictly limited, the new structural economics recognizes that government can play a facilitating role. This paper contributes to this debate by examining examples of the Chinese government’s intervention in its economy during 2015–17, specifically to address overcapacity issues and reform both the property market and stock market. These interventions seem to have been successful to date, although some problems remain.

This paper also provides some theoretical explanations for the success of the Chinese

government’s intervention. Lin (2010, 2015) argues that government intervention has its merits, and Wen (2015) that the Chinese government has its own special merits. Another novel analysis is from the perspective of financial economics. K. Liu (2018) argued that since the governance model of China Inc. under President Xi Jinping is more like family ownership and management than a publicly held corporation, Chinese government under President Xi would outperform his predecessors, who were essentially just managers. Accordingly, the main conclusion of this paper is not that China’s government-controlled model performs better than market economies, but rather that the Xi Jinping government outperforms previous Chinese governments.

One limitation of this study is that it is based on a very short time span and few

indicators. Readers are advised to be cautious in drawing strong conclusions about the role of government intervention in the Chinese economy and the performance of the Chinese economy under President Xi Jinping’s leadership. Confirmatory studies can be conducted when more data spanning a longer time horizon are available.


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China's Visible Hand

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China's Visible Hand