It remains to be seen if 2014 really will be the year in which the Chinese authorities grapple with the country`s freewheeling financial system. The government`s current policy of kicking the can down the road means ever-larger piles of credit, slowing growth and the rising risk of financial crisis.

Some market participants thought the potential default at the end of January of a CNY 3 billion product sold by China Credit Trust would be the epiphany, in which investors learned the painful lesson of the risks involved in blindly ploughing funds into the shadow banking system. There were those who thought the collapse of a major institution might trigger a systemic reaction, forcing the government to take drastic action.

It turned out to be neither. The trust company, the bank which marketed the product, the local government and investors reached agreement where the principal and at least some of the product`s final-year interest payments were paid out. Moral hazard continues to rule the financial system.

This isn`t the first bullet the authorities have dodged. The actors in China`s financial system – the local government officials, regulators, issuers and lenders – are complicit in avoiding failure, even as lending has boomed. Chinese bank assets have more than doubled since the end of 2009 to CNY148 trillion (US$24.3 trillion), nearly three times last year's GDP. By comparison, U.S. commercial bank assets are just over $14 trillion, even though its economy is more than a third larger than China`s.

Bears see a crisis approaching.
For the growing number of China bears, the dramatic expansion of the financial system, coupled with its suspiciously low failure rate, is prime evidence of a brewing financial crisis. Government advisors acknowledge that the longer debt is allowed to grow, the greater the risk of a crisis and the greater that crisis could be.

For a central bank staring down the barrels of a financial crisis, however, the People`s Bank of China doesn`t sound overly concerned. Large chunks of its latest monetary policy report are devoted to explaining the rise of shadow banking, including the kinds of activities pursued by China Trust, and warn of more market volatility to come. Market participants will "need to tolerate reasonable money rate volatility," the PBOC said in the report released last weekend.

The pressure to make profits in the face of regulatory curbs on traditional lending has pushed overstretched banks to borrow short and lend long, making them more sensitive to changes in liquidity availability, the PBOC explained. Meanwhile, the growth of bank assets and "off-balance sheet innovations" are eating up increasing amounts of liquidity, and this explains periodic bouts of tight liquidity despite expanding M2. "The more active the financing activity, the more banking system liquidity is digested, leading to rising liquidity demand," the report said.

Money market rates were driven to record levels last June after the PBOC moved suddenly to cut off the flow of liquidity into the interbank system. Officials said that the goal was to force deleveraging, but the central bank`s sudden, poorly-communicated move sent panic through the system and forced the authorities to back off and make direct liquidity injections. The PBOC may have lost that battle, but the war is ongoing.

Rates Rising.
Market rates have risen, increasing financing costs and opening up fissures in the interbank market which are expected to lead to more and more investment products getting in trouble. The seven-day repo rate – which is a candidate for a market benchmark rate under the government`s financial reform plans – averaged 3.78% during the first half of last year and 4.38% in the second half. The 10-year Ministry of Finance yield has also risen sharply, reflecting a shift into riskier paper amid tighter liquidity conditions.

’Moral hazard continues to rule the financial system.‘
Despite its anodyne wording, the PBOC report does indicate once again that the authorities are aware that a badly mismatched system stands an ever-greater risk of getting into trouble. Market participants are braced for a fresh wave of regulatory curbs, particularly in the wake of a State Council notice at the end of last year suggesting that management of the policing of the shadow banking system has now been elevated to the executive body.

The PBOC itself provided few clues about its plans, saying only that it will step up monitoring of financial system risk and "explore market mechanisms to solve local government debt problems.” That will help tackle the existing stock of debt, but doesn`t explain how Beijing is going to deal with the dramatic rise in Chinese financing while delivering the growth needed to create jobs and maintain social stability.

The Communist Party is pledged to a sweeping economic and financial system overhaul, but the PBOC report suggests that it sees little change for now. "The Chinese economy's reliance on debt and investment, the high investment model and the overconcentration of resources in real estate and other sectors mean it is easy for debt levels to increase,” it said, before drawing the underwhelming conclusion that: "The massive local financing-construction model has strengthened in recent years, increasing the potential for risks to the economy's performance."

Despite signs of a credit splurge in January, market participants are already betting on whether the PBOC will actually ease policy in the first quarter to offset signs of sharp disinflation and slowing economic growth. That doesn`t bode well for attempts to grapple with the risks posed by shadow banking.

Pragmatism Rules
China avoided potential calamity by effectively bailing out China Credit Trust. Supporters of the government`s refusal to allow for defaults would call this approach pragmatic, that the known unknowns of failure warrants caution. Besides, in allowing Lehman to fail, the U.S. Treasury arguably worsened the global financial crisis, they argue.

But not everyone agrees with this approach. In China default has its supporters. A source familiar with discussions at the level of the State Council said he had been hoping that a China Credit Trust default would teach the market a "profound lesson."

But he is in the center, and provincial governments tend to have greater influence because they`re closer to the action. "Local governments don't want their financing costs to get too high because of a default and they're worried about accounting to the central government," he said. China has been kicking cans and dodging bullets for years, to the extent that its banking system is nearly the size of the U.S. and Japan`s combined ($30.68 trillion). The government has made the right noises about cleaning up the financial system, but the China Credit Trust agreement suggests that it is not yet ready for action.

China Hands can be awful bores at the best of times, the China Brain team included. Here’s a quick guide for those of you who come across one at a dinner party, or more likely, propping up the bar of an unwholesome establishment, desperately hoping to engage someone in a deep, philosophical conversation.

First things first – the basics: Be aware, of course, that if a China Hand is found outside of their comfort zone – for some that is the 6^th Ring road of Beijing, for others just China in general - they will undoubtedly be feeling nervous and uncomfortable that they can’t hold court on the Middle Kingdom. If the conversation is ranging from, for instance, the upcoming London mayoral and US elections, to the continuing downfall of Tiger Woods, or even to what baby stroller to purchase for a new arrival, the China Hand will be pretending to listen. He or she may even utter the odd word, but rest assured, the Hand is simply waiting.

What is the Hand waiting for you may ask? They are waiting to hear the key words that will allow them to demonstrate their cavernous knowledge of what is of course the most important country in the world at the most important moment (since the last most important moment) in its very, very long history. These words are too numerous to list in full here but obvious examples are of course ‘China’, ‘Beijing’, ‘Communist’ (be careful when discussing Ken Livingstone), and somewhat mysteriously to those not in the know, ‘Hu’, ‘Wen’ and ‘Xi’. By simply avoiding the key words, you may stave off any China Hand’s attempts to wade into the conversation for a little while.

Basic deflection will only last so long. At some point, the China Hand may catch you unaware or the conversation may naturally move towards the most populous country in the world, which as you may be aware is soon going to be the biggest economy in the world. The very fact that China is so very important now means that the China Hand’s ability to link China to almost anything is assured.

For instance: You: ‘Who do you think will win the London mayoral election?’ China Hand ‘Well I’m not too sure, seeing as I actually live in Beijing, but whoever does win it will be making a beeline straight for the Chinese over there as the City wants to become the global centre for trading the Renminbi”. Or, You: “What do you make of Tiger’s shambolic behavior in the US Masters?” China Hand : “Well I’m not that into golf, but I did hear that in China, they were mystified by his fall from grace, because your success over there is kind of measured by the number of mistresses you have”.

At this point, it’s highly likely that you cannot avoid asking the China Hand a bit more about what he or she does in China and this is the point where you have a key decision to make.

Option A is you pretend (or not as the case may be) that you know little or nothing about China and are therefore ready to be ‘(re)educated’ by the great sage before you. This is the path of least resistance and will probably lead to around 20 minutes of listening to the China Hand about what life is ‘really like’ in China, no doubt helping you to understand that the Chinese are not going to take over the world quite yet and that yes, the pollution really is as bad as they say. But why would you want to be anywhere else right now as it’s currently the most important place in the world, the opportunities are endless and no, Mandarin really isn’t quite as hard as everyone says it is, blah blah blah.

Option A is safe and easy, but let’s be honest, why not spice things up a little? Here again, you have two options, as you can be sure that whatever you do say, the China Hand will disagree with you. Your first option is to say that you think that China’s rise has been overplayed and it’s all going to come crashing down pretty soon. As economic growth slows and social instability rises, the Party will no longer be able to keep control of all the different emotions and desires that exist within a very tightly controlled society. If you throw in the names Gordon Chang and Minxin Pei (or better yet, Pei Minxin as he would be known in China), that will undoubtedly impress. A China Hand would rarely completely agree with their particularly doom laden predictions, which incidentally have been wheeled out again recently after the rumours of a new schism at the heart of the Communist Party. That is unless of course you’re actually having dinner with Mr. Chang or Mr. Pei.

Option B is to say that we all might as well just give up now because China is going to take over the world soon anyway. It’s buying up our companies on the cheap, it’s grabbing whole swathes of Africa, its military is expanding at an alarming rate, alongside it’s confidence in diplomatic circles. You could even throw in the fact that it’s going to smash all records of gold medal hauls at the London Olympics with its platoon of 9 year old gymnasts.  This will probably force the China Hand into a slight corner, where he will feel duty bound to point out some of the frailties that still exist within China: continued growth is by no means guaranteed, the US still holds the dominant position by a very long way in terms of military power, innovation and entrepreneurship, and they promised not to do that thing with the 9 year olds again so don’t worry too much.

Your final option is what we call the social hand grenade. You turn to the China Hand and tell him or her in no uncertain terms, that you find Brazil a far more interesting, exciting, enticing topic of conversation. The China Hand will look stunned, shocked and perhaps a little bit hurt -- before responding with, “Did you know who Brazil’s largest trading partner is these days?”

At an impasse

China’s economic challenge at the moment is probably the greatest it has faced since Deng Xiaoping embraced market reform in the early 1980s. Thirty years on, “Socialism with Chinese Characteristics” has passed through several stages before arriving at its current plateau in the 2010s. Without a major evolution in the national growth model, the pressures facing the Chinese economy could destabilize the achievements of the past decades.

Until now, China relied upon low-value exports and major investments to grow its economy. This model has resulted in diminishing returns in recent years. Low wages, the key ingredient to its global competitiveness in low-cost manufacturing, are no longer part of the economic equation (on average, wages rose 12% in 2012). Countries like Bangladesh and Cambodia, with rock-bottom pay and a rapidly expanding industrial base, will continue to reap the benefit of this increase as foreign companies shift production from China to maximize profits.

This trend exacerbates the problem of China’s already-excessive industrial capacity. Private companies and state-owned enterprises (SOEs) have long had easy access to credit from China’s state-owned banks. China’s population is notoriously thrifty, a characteristic that has stymied the kind of domestic consumption growth the nation sorely needs. Instead, the banks have played the essential distributive role in the economy, using the population’s saving accounts to provide cheap credit to Chinese companies, in particular the SOEs, who have been under little pressure to use this capital effectively.

Financial reform in the works

            Fortunately, the news from the Third Party Plenum in mid-November was mostly positive. Plenums in China happen on an annual basis as part of the five-year Party Congress, and the third one is often policy-focused – indeed, the market-based economic shift initiated in 1978 was similarly announced at a Third Party Plenum.

            Contemporary China may indeed be at a decision point that is in some ways as important as the one 35 years ago. Good, then, that the result of November’s plenum was a strong affirmation of market-led development. The single most talked-about sentence in the summit’s main document is that the market should play a “decisive function in resource allocation,” a deliberate rhetorical upgrade from the status quo, which declared that the market had a “basic” role in directing resources. From The Economist to Avery Goldstein, a professor at the Center for the Study of Contemporary China at the University of Pennsylvania, those whose job it is to read the semantic tea-leaves in Chinese government communiqués insist that this is a significant symbol of policy evolution. Pieter Bottelier, a professor of China Studies at Johns Hopkins, even characterized the plan as “the most ambitious reform [...] I’ve ever seen.”

            Aside from finance, other aspects of the reform include the dismantling of the labour-camp penal system, the end of the one-child policy, reform of the hukou system that defines the population’s right to live in the city, and the establishment of an elite council to execute these reforms.  

            Such a dramatic announcement of reform required Xi to amass significant political capital. To that extent, at least in the short term, “political reform” is off the table. On the contrary, Xi has increased surveillance and repression–the surveillance apparatus now costs nearly as much as the entire military budget ($111 billion USD versus $114 billion). But, notes Goldstein, further market reform may lead to political opening down the road – just not right away.

            That may be for the best. It would no doubt be practically impossible for Xi to unleash economic reform on this scale while simultaneously throwing the hegemony of the Party into jeopardy. As for the SOEs, the administration is almost certainly attempting to address the problems created by cheap credit and its economic effects (excess industrial capacity and a bloated real-estate market) by insisting on the market distribution of resources. Here Xi is admirably taking on state-owned companies that are controlled by family members of the highest-ranking government officials. With the publishing of the post-plenum document, he seems to be announcing his dominance over this gilded class to both China and the world.

Charting the way forward

Replacing China’s investment-powered growth engine with a vibrant domestic consumer market will require a cultural change if Chinese people are to part with their wages, of which they currently save about one-third. In contrast, profligate Americans manage to save only between two and three percent of their annual income.

Various government policies, including  its anti-corruption measures, which has reduced conspicuous consumption among China’s 60 million party members, and the spread of automobile limits to more cities, a measure intended to reduce China’s choking urban pollution, will also continue to exert downward pressure in various sectors.

These issues demand a strident government response. For one thing, China’s deposit savings rates, usually between three and four percent, are much higher than in most developing East Asian countries. Lowering this would encourage Chinese people to leave less money sitting in the bank. Continued de-incentivizing of real estate investment is a must: property prices have increased nearly 10% year-over-year. Thankfully, the administration’s plethora of mechanisms designed to cool the housing market, seem to be taking effect, as November 2013 showed a slowdown in property inflation compared to the rest of the year.

The hackneyed adage about “crisis” and “opportunity” being the same character in Chinese, a mainstay in Western motivational speeches, has an undeniable relevance at this historical juncture. China seems more confident and powerful than ever, while the world’s financial markets fret about grave structural problems and images of smog-choked cities shock the rest of the world. The concerns won’t cease until China sees itself past the current challenge into an economy that is driven chiefly by consumers rather than cheap government credit and ever-increasing industrial output. In this process, there is the potential to forge a nation that is more sustainable economically, socially, and environmentally. To fail to capitalize on this opportunity would be grave for an administration that has set out its stall to achieve a historical transformation.

Whilst Africa as a continent continues to grow at a modest pace, 6.6% GDP growth in 2012 (4.8% and 5.3% are forecast for 2013/14), the fact remains that this growth is not high enough to alleviate poverty and move countries up the Human Development Index (HDI). Growth alone has proved to have little impact on poverty reduction. Whilst resource rich African countries continue to benefit from relatively high commodity prices, this represents a short-term positive. It`s infrastructure, power production and intra-African trade (via locally manufactured goods) that will push countries up the HDI on a durable and sustainable growth path and this is where China could prove to be the making of the continent.

Whilst China-African relations have been shaped in the past by China securing the supply of resources and financing the infrastructure to obtain them, the future will be a far more expansive relationship, involving both the state sectors and private entrepreneurs selling to Africa’s consumers, and not just outsourcing production there. To facilitate this, China currently deploys some 150 commercial attaches throughout the continent..

Africa represents about half of the 25 fastest growing economies of the world, meaning rapidly accelerating consumption of made in China products: everything from low cost textiles to up-stream advanced technologies are suitable for African markets and the rapidly growing middle classes. Private investment is simultaneously taking advantage of the wage cost differential and adding value to products on African soil, if not carrying out the full manufacturing process there. On a recent visit to Ethiopia, the landscape I encountered transported me back to Guangdong with its neat lines of machining factories.

Surprisingly China currently lies in 6^th place behind the UK, India, USA, UAE and France in terms of greenfield investment, however the ambition is there to increase this dramatically. Chinese FDI is currently re-focusing on the manufacturing and infrastructure sectors, and current Chinese governmental subsidies are now aimed at developing industrial parks, to both enhance manufacturing capacity as well as facilitate technology and skill transfer. In return African Nations will increasingly be expected to support China`s policies in international forums. China increased its share of total African exports from 3.2% in 2000 to 13% in 2011, whilst investment has gone from US$100 million to more than US$12 billion in the same period.

Potential stumbling blocks that must be addressed now by the new Government are: environmental concerns, worker safety, compliance with local labor law and corporate social responsibility. Currently Chinese businesses on the continent often rely on imported Chinese labor, offer limited job training or opportunities for Africans to rise beyond unskilled work and continue to have image problems among the local populace.  China is not unaware of such issues and is actively addressing its image problem in Africa with vigorous soft power initiatives: 5,000 fully paid scholarships to Chinese Universities, technical training for over 30,000 Africans, the launch of the very slick CCTV Africa as well as numerous local grants for infrastructure projects. China is fast addressing its image in order to reverse hostility towards deeper economic engagement.

China, not only has the supply chain in place, the FDI, the political will, but also a multitude of both smaller and state run companies well placed to provide the skills, technology and materials needed to realize Africa’s structural transformation: the reallocation of economic resources from activities with low productivity – such as small farming and informal trading – to more productive ones – such as manufacturing, will ultimately define the rate of development of the African Continent as China’s demand for African raw materials  grows at a slower pace each year.

Human development in Africa

Very high and high human development

Algeria, Libyan Arab Jamahiriya, Seychelles, Tunisia.

Medium human development

Botswana, Cape Verde, Egypt, Equatorial Guinea, Gabon,

Ghana, Morocco, Namibia, South Africa, Swaziland.

Low human development

Angola, Benin, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Comoros, Congo, Congo, Demireps. Côte d’Ivoire, Djibouti, Eritrea, Ethiopia, Gambia, Guinea, Guinea-Bissau, Kenya, Lesotho, Liberia, Madagascar, Malawi, Mali, Mauritania, Mozambique, Niger, Nigeria, Rwanda, São Tomé and Príncipe,

Senegal, Sierra Leone, Sudan, Tanzania, Togo, Uganda, Zambia, Zimbabwe.

Source UNDP 2013

During the year of China`s Economic & Social rebalancing, this report examines brand building in China. Whils the list is still dominated by SOE`s in the first 50, the next half show an interesting prominence of private companies where Chinese entrepreneurs have been developing market-driven companies and valuable brands accross many product and service categories which will only increase in value as reblancing unleashes competition.

Comparing the brand equity of Chinese brands and foreign brands in China. Chinese brands have caught up. They lag in only one crucial aspect: meaningful differentiation. That’s the missing piece for Chinese brands; it’s a critical element for the brands ranked 51 to 100 to move into the upper tier of the BrandZ™ Top 100 Chinese ranking. For the full PDF report, please click here.

China has over 100,000 State Owned Enterprises (SOE`s), mostly controlled at a local government level. The list below comprises the largest 117 supervised by SASAC. These are some of China`s largest and most influential companies, powering and supplying the headline growth rates not to mention the vtal role they play in povding Social Security for ther employees. The success or failures of this group will define the current re-balancing of the Chinese economy.   

The year ahead could see companies focus on driving productivity, CIOs becoming a hot commodity, shopping malls going bankrupt, and European soccer clubs finally investing in Chinese ones. McKinsey director Gordon Orr makes his annual predictions. Please click here to open the report.