Tiger Woman on Wall Stree (29 page)

WMPs are bank-generated investment products that are sold to the banks’ retail and institutional customers. Similar to money market funds, WMPs pool funds with a relatively short investment horizon (as little as five days) and invest them in longer-duration assets to arbitrage the difference in returns. Disclosure on these products, including the assets they invest in and the likely returns
of each, is limited. WMPs essentially circumvent China’s tight control of interest rates by rewarding investors with higher returns than deposit rates.

Everbright Bank first pioneered this form of shadow banking in September 2004 as a way to attract retail deposits—the bank would require a customer to open a savings account before buying WMPs. Other banks followed suit, and competition among WMPs heated up. WMP issuance surged in 2010 as inflation accelerated; real interest rates dipped into the negative, and depositors who realized they were actually paying for the privilege of depositing their money in the bank moved money out of their savings accounts in droves. As China further tightened monetary policy in 2011, banks scrambled to attract deposits to meet their required loan-to-deposit ratios, and WMP growth accelerated further. Ratings agency Fitch estimated that China had around 13 trillion RMB of WMPs outstanding by the end of 2012, an increase of over 50 percent
on the year
.

In principle, with authorities capping deposit rates at below-market levels, the emergence of financial products that circumvented the cap and offered a higher rate of return did not necessarily compromise stability. In other words, the excess return on a WMP over the officially controlled deposit rate did not necessarily imply that the WMP was riskier than a bank deposit. Instead, the higher return could be a reasonable approximation of what the real deposit rate would have been without an artificial ceiling.

However, WMPs rapidly moved beyond that point, offering returns well in excess of an appropriate level for a depositlike investment. The trust funds and other providers of WMPs invested in high-risk projects in order to offer spectacular returns. Most investors in WMPs—typically, average middle-class households—didn’t realize that these returns included a significant risk premium. Like so many before them, in different times and places, these investors considered “excess returns” to be evidence of their
acumen as investors—what financial pundits call alpha—rather than compensation for increased risk that would likely materialize at some point—what financial pundits call beta.

Central to the WMP structure is the pooling of investor funds. The general pool will fund a variety of assets across the risk spectrum, many in the shadow banking sector. The average Chinese people who buy WMPs basically have no idea what they are buying. Xiao Gang, the chairman of the Bank of China, wrote a controversial op-ed in the state-run
China Daily
newspaper in October 2012, in which he called WMPs a
Ponzi scheme
. But most investors overlooked these warnings until several WMPs started to default.

One WMP in particular became infamous. The Chinese investment vehicle known as Zhongding promised investors a short-term return as high as 11 to 17 percent, many times what Chinese investors typically earn on bank products. Even though the investment threshold was at least 500,000 RMB, customers still flocked to the product. Huaxia Bank, which marketed the Zhongding product, provided exceptional service for the VIP clients the product targeted. Those interested in the product would be ushered into a VIP room for a pleasant conversation with the lobby manager and only had to sign on the dotted line.

Banks sold all kinds of WMPs, but they guaranteed roughly only half of them. Many WMP investors realized this fact for the first time on November 25, 2012, when Ms. Wu, one of those well-served Zhongding investors, was told that she wouldn’t get her money back. The managing partner of the product, Tongshang Guoyin Asset Management Company, told the banks that had marketed the product that the company could pay customers neither the interest nor the principal. Crowds of angry investors who had bought Zhongding and other WMPs formed outside the Huaxia branches in Shanghai. State media quickly painted the default as a one-off event: according to the press, the fault lay with Chengyang
Wei, who ran the Zhongding Wealth Investment Center and who had spent seven years in prison due to financial fraud in the past. Huaxia Bank’s management was outraged and put the blame on “a rogue salesperson” for selling those problematic products without permission from headquarters.

Other defaults soon followed the Huaxia incident, calling into question the safety of other WMPs. That same month, customers at a branch of China Construction Bank in the northeastern province of Jilin suffered a loss of 30 percent of their principal claim from a WMP. Soon after, Citic Trust Co, a unit of China’s biggest state-owned investment company, missed a biannual payment to investors in one of its trust products after a steel company failed to make its interest payments on the underlying loan.

I began to investigate the WMP offerings from various banks as investor anxiety over WMPs grew. My company started to monitor the websites of banks and third-party marketers to track new issuances, including the volume, rates, and maturity dates. We also registered with major banks as WMP clients so we would get the updates on their promotions. We regularly called their hotlines, and we monitored online discussions on WMPs from all major social networking and news sites. Based on this, I believe that default risk is significantly underpriced for most WMPs. Retail investors who view them as a safe deposit with higher rate of return stand a good chance of losing their money. For Chinese retail investors, the lesson should be clear: if something looks too good to be true, it almost surely is. The lessons for foreign investors should be clear as well: U.S.-listed Chinese banks are simply not suitable investments. The stocks may look cheap compared with the companies’ book values, but the book value could be miscalculated. I often call China’s economy a black box, but the banking sector is the darkest part of all. Chinese banks need to be cleaned up, be recapitalized, and become much more transparent before they can be investible.

In fact, the leading American banks recently sold stakes in Chinese banks. Bank of America sold part of its stake in China Construction Bank, while Goldman Sachs sold a $2.3 billion stake in Commercial Bank of China last year, following a similar sale of its holdings in ICBC. The American banks claimed they were just raising cash, but I believe opacity and corporate governance issues played a major part in their decisions.

By 2013, anxiety over a bubble in China’s economy was beginning to grow in the United States. The TV show
60 Minutes
aired an exposé on the Chinese real estate bubble, and known China bears like hedge fund manager Jim Chanos and economist Michael Pettis gained airtime. The world was tuned in to see whether China’s economic miracle would crash and burn.

  *  *  *  

The shortcomings of China’s financial system pose potential near-term risks that could trigger a deep recession with profound global implications—what traders like to term a high-frequency risk. I believe that the real source of China’s long-term vulnerability, or low-frequency risk, lies in the country’s education system, which undermines the integrity and creativity of young minds and ultimately the nation’s labor productivity. Many people in the West believe that China is rising because Chinese kids are more competitive than kids in America. But I view the education system as China’s Achilles’ heel.

When foreigners visit China, they are often impressed by the country’s spectacular hardware: the modern architecture of the coastal areas, the fancy international hotels and luxury shopping malls, a high-speed railway that is faster and more comfortable than Amtrak in the United States, the brand-new subways with Wi-Fi access. The continuous news cycle on America’s economic stagnation and Europe’s structural decline reinforces this
shortsighted view. Visitors to China leave after their short stay, thinking that China is going to take over the world.

What they do not see is the lagging “software” beneath the surface. China scores very low when it comes to the rule of law, accountability, governance, and most importantly the quality of its citizenry. China’s educational system has failed to produce either an honorable or an innovative society.

Investing in a business is ultimately about investing in the people who run it. I often say to investors that a business is first and foremost about its managers. The integrity and quality of management should be an investor’s top concern, above all other factors including the business model, market opportunities, and competitive landscape. If the manager is a crook or has a defective character, none of the other factors will make the target a good investment.

China has succeeded based on a single economic mode, that of mass production of low-value manufacturing products. But the country’s changing demographics make this system increasingly unsustainable, as China’s aging population and rising wage costs eat away at the abundant supply of cheap labor. To continue growing, the country needs to transition to a more value-added, service-oriented economic model. In order to do so, however, China needs stronger institutions and more dynamic and innovative workers.

China’s ultracompetitive education system, which prioritizes propaganda and memorization above critical thinking, is ill suited to meeting that demand. The country needs to undergo major institutional changes—some of which will compromise the state’s tight control over its citizens—to produce a labor force compatible with the advancement of the economy.

The process of upgrading China’s software, or its human capital, must start with the educational system. In the years since I left China, the overall structure and content of a Chinese education
has remained basically the same, despite the dramatic changes in Chinese business and society.

Instead of encouraging independent thinking, education is first and foremost a device for drilling party ideology into impressionable minds. The stories told in Chinese textbooks exemplify and glorify the party—how it takes care of its people, the way a parent does for a child, and how society should therefore be appreciative and obedient, ready to put self-interest aside when the party asks.

One story that recently went viral on Chinese social media—a hypothetical comparison of how
Cinderella
would be taught in China and in the West—demonstrates the rigid and painful way literature is taught in Chinese schools. In the Western school, students would be encouraged to speak their minds after reading the story. Some of the kids would remark that Cinderella’s stepmom was horrible, while some would say the lesson was that a girl should dress up so that she can catch the attention of a prince. Others would notice that at the end of the story everything, from the mice to the pumpkins to the rags, turned back to its original form, except for the glass slippers—a potential error on the author’s part. Then they might put on a play based on the story. The kids would come away from the lesson with the impression that learning is fun.

In comparison, the teachers in Chinese schools would divide the story into a few major parts, boiling down the events of each into a thesis that students could memorize for a test. One thesis would be that capitalistic society is superficial and divided by class—after all, Cinderella had to exchange her maid’s rags for a ball gown in order to receive love. If the students were to question this conclusion, the teacher would tell them not to worry because other answers wouldn’t show up on the test. The students would all soon be so bored, they would fall asleep in the middle of the lesson.

Teaching ideology in itself is not a problem, but dictating which idea is right or wrong is a problem. Every school in the world
teaches some sort of ideology. American schools normally prioritize freedom of choice and individualism, for example. They encourage students to dare to be different, to think outside the box, to take risks, and to lead. The products of those ideologies include some of the world’s greatest innovators, such as Bill Gates, Mark Zuckerberg, and Steve Jobs.

My sister Jasmine has a toddler, Audrey, about whose education she is already agonizing. Living in the modern, international city of Shanghai, she sees that more skills are needed in life than just rote memorization and militaristic discipline. She is concerned that Chinese schools will all but extinguish Audrey’s sense of creativity and passion and has begun thinking about enrolling her in an international school.

To assist my sister with her decision, I called up a close friend who is a senior executive in China’s private education industry to get her opinion. A mother of two teenagers, she cited the government’s conformist ideology as a major factor influencing her choice to switch her children out of the local public schools to privately run international schools featuring a liberal arts curriculum—an increasingly desirable option for Chinese parents who have the required foreign passport and can afford the tuition, which can range in the tens of thousands of U.S. dollars.

“The government worries that if we don’t build a universal Communist ideology, their control over citizens will be significantly weakened,” she told me. “So Chinese textbooks are designed to indoctrinate students to serve the party—not for our children’s edification. That’s my main problem with the Chinese system.”

The government, represented by the Ministry of Education, still holds onto Marxist and Maoist teachings because it is afraid to part with the bygone era—parting with it would mean reform, and the party inherently fears reform. The party also wants to ensure that certain lessons regarding loyalty to it are continually
enforced, especially among liberal, imaginative college kids, such as those who led the Tiananmen protests.

The members of the younger generation are bored of these tedious lessons, but they do not complain. Since their educations have been dictated to them from an early age, few feel they can protest; nor do they know how to protest. They come away from these lessons believing that the purpose of education is to pass tests, no more, no less. Education is a series of hoops to jump through, not a process of self-improvement or self-discovery.