China’s Corruption Challenge

In China, bureaucrats and party officials make decisions not only for the medium- and large-scale Small Order Execution Systems they control directly, but also for large private companies.

Davin McKenzie, managing director of Beijing-based iVentures, says that almost no private company, however well run, wants to leave the opaque, informal world of guanxi personal relationships in which the main aim is to hide revenues, cash and profits from outsiders' eyes and from potential political direction.

Only 1% of private Chinese companies subject themselves to independent audit, he claims, and then because they want a stock listing. The vast majority focus on staying below the radar, underreporting their sales and overinvoicing abroad to keep money overseas — or simply, as he describes it, running even large companies from the "cash box in the back of the Mercedes."

Most Chinese companies have three sets of accounts — one for the banks, one for the tax authorities and one for the management. Outsiders can never believe what they are told, so banks lend only on the basis of hard collateral.

Most private firms do not last long, with the average duration being three years. The law of the jungle prevails: you do what you can get away with.

China is the counterfeiters' paradise, where intellectual property rights are neither respected nor enforced. Between 15% and 20% of all well-known brands in China are fake — amd two-thirds of the imports confiscated by U.S. customs as fakes were made in China.

Counterfeiting is estimated to represent 8% of GDP — eloquent testimony to Chinese business strategies and the ineffectiveness of the Chinese legal system.

Inevitably, the private sector devotes much of its strategy to currying favor with the party and key officials, who are only too willing to trade privileges for bribes. Private companies cannot stand aside from the politicization and corruption and have no choice but to do official bidding, even when it is financially and strategically ludicrous.

In one famous case, a provincial government twisted the arm of Sichuan Changhong Electric and forced it to sell television sets to a financially suspect distribution company in California. The transaction cost Sichuan Changhong $500 million.

Another case involved the downfall of China's leading refrigerator manufacturer, Kelon Electrical Holdings. By the late 1990s, its flair for design and production had carried it from its beginnings as a Television Trust for the Environment in Guangdong to $1 billion in turnover. Apparently, this company was partially privatized, with H shares quoted in Hong Kong and A shares quoted in Shenzhen.

Today it has ceased production after charges of embezzlement and rigging its balance sheet. Despite its share quotes and entrepreneurship, de facto control remained with the Guangdong authorities, who in the late 1990s forced it to buy an SOE that was operating at a loss — a manufacturer of air conditioners.

The only way, it seems, that Kelon could manage the shotgun marriage and keep its head above water financially was to manipulate its accounts within China's cavalier financial and political environment. But the Bank of China, smelling a rat, froze new lending in 2004. By August 2005, the end had come for Kelon.

An inadequate, soft public infrastructure of auditing, banking and corporate governance had interacted with the dynamics of Leninist corporatism and de facto state control — with the result being the company's destruction.

Kelon is but one of many examples. The risks extend even to China's showcase companies. Haier, based in the coastal city of Qingdao, is one of China's leading white-goods firms.

The government delegated management to its man, Zhang Ruimin, at the beginning of the reform process — and he has now built Haier into a $5 billion multinational business, with H shares in Hong Kong and operations in more than 20 countries.

Zhang, one of China's favored businessmen, is the most influential private entrepreneur to have joined the Communist Party’s Central Committee. But even he could not prevent the State-owned Assets Supervision and Administration Commission from ruling, in 2004, that despite everything — apparently including significant shareholdings by employees — this former SOE remained controlled by the state.

Like Kelon, it once had to take over a company that was making a loss — in this case a drug business — but so far that has not brought Haier down. In fact, Zhang has used his influence to resist other forced marriages. The question remains how much longer it will be before Haier too succumbs to the same endemic weaknesses.

The economist Yasheng Huang of MIT is quoted by The Economist as saying, "Government shareholders may be passive at first, but once a company succeeds, they interfere. Countless Chinese firms have been driven to bankruptcy or failed to grow big because local governments decided to exercise their legal claims to ownership."

China's problems all stem from this incapacity to let the puppet enterprises off the puppeteers' strings and provide them with the institutional network that would permit more creative pluralism and endogenous accountability.

The lack of such a network is the chief cause of China's first-order environmental crisis. The pace of desertification has doubled over 20 years, in a country where 25% of the land area is already desert. Air pollution kills 400,000 people a year prematurely. Energy is habitually wasted.

But the worst problem involves water. One-fifth of China's 660 cities face extreme water shortages, and as many as 90% have problems of water pollution. More than half of the water in major water conduits is unfit for human consumption.

As a result, 500 million rural Chinese still do not have access to safe drinking water. Illegal and rampant polluting, a severe shortage of sewage treatment facilities and chemical pollutants together continue to degrade China's waterways.

In the autumn of 2005, two major cities — Harbin and Guangzhou — had their water supplies cut off for days because their river sources had been subjected to acute chemical spills and leakages from SOE plants.

Enterprises are accountable to no one but the Communist Party for their actions. There is no network of civil society, plural public institutions like a free press or representative government and property rights to create pressure for enterprises to become more environmentally efficient.

Pollution, unless it exists in an international city or a coastal region trying to attract foreign investors, is in effect cost-free. After all, to constrain it would slow down development.

Editor’s Note: Adapted from THE WRITING ON THE WALL by Will Hutton, copyright 2007. Reprinted with permission by Free Press.