Corporate Finance in China

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. I’ve thus tried to educate my self about the Chinese economy, and earlier posted introductions to corporate governance in China and capital markets in China. This post is an introduction to corporate finance in China – capital structure, corporate investment, payout policy (dividends and repurchases) and cash holdings. It is taken from Jiang, Fuxiu, Zhan Jiang and Kenneth A. Kim (2018): “Capital Markets, Financial Institutions, and Corporate Finance in China.” Journal of Corporate Finance, forthcoming. All of these points I learned from the original article, so please cite it (not me) if you use anything from this post.

Capital Structure

  • 2015: average total liabilities / total assets of 46%, total debt / total assets of 20%. Not an outlier compared to other countries. But debt is unusually short-term
    • Government reserves long-term debt to finance projects consistent with national interests.
    • China Banking and Regulatory Commission (CBRC): to obtain long-term loans, firms must be engaged in industrial / land development / environmental / long-term investment management projects
    • SOEs are more likely to be engaged in such projects, so have higher long-term debt ratios than non-SOEs
  • Firms prefer external equity to debt – the opposite pecking order to Western firms. Reasons:
    • Firms pay little dividends, so equity involves a lower cash cost
    • P/E ratios are high, so raising equity is attractive
    • Loans are short-term, so equity is the primary source of long-term financing
  • While Chinese firms prefer to issue equity, the equity market is small and the regulatory hurdles are high: firms can only issue an SEO if they’ve paid dividends for three consecutive years and have an ROE of at least 6%. So they end up borrowing from banks, which explains they high bank financing documented in the “Capital Markets in China” post
  • Traditional capital structure determinants are unlikely to matter in China:
    • Bankruptcy.  Largely irrelevant given expectation that local or national government will bail out large firms and SOEs
    • Market Timing. Firms must meet China Securities Regulatory Commission (CSRC) requirements to issue SEOs; rejected, must wait another 6m. So, hard to time the market precisely
  • Contrary to common belief, little evidence that Chinese banks discriminate in lending in favor of SOEs: non-SOEs have higher debt ratios
  • Firms headquartered in west (east) have higher (lower) debt ratios
    • Since 2000, Western Develoment Strategy to increase credit to the west
    • Western firms are young, and many don’t meet the 6% ROE threshold to issue SOEs
Corporate Investment
  • China’s mean investment ratio is the highest among > 40 countries. Unsurprising given growth rate of Chinese economy
    • Manufacturing firms invest more than non manufacturing firms, due to high industry competition
  • Non-SOEs invest as intensely as SOEs, contrary to common belief that China’s high investment comes from SOEs
    • SOEs invest more in absolute terms because they’re bigger, but not when scaled by firm size
  • Government policy has a large effect on investment. Last two elections were 2002 and 2012
    • 2002: incoming government emphasized growth and investment; investment jumped from 2002 to 2003 for both manufacturing and non-manufacturing, SOEs and non-SOEs
    • 2012: incoming government deemphasised growth for the sake of growth, given overcapacity and environmental concerns. Investment fell in from 2012 to 2013 across all categories
  • High investment in R&D, with R&D/sales rising for both SOEs and non-SOEs in recent years
  • SOEs may be over investing – lower ROA than non-SOEs despite high investment
  • 1/3 of listed firms acquire other firms in a given year; most targets are unlisted private firms
Payout Policy
  • Number of firms paying dividends was 30% in 1998, 70% in 2015
    • Jumped from 32% to 64% in 2000 due to CSRC rule that a firm must pay dividends for three years in a row to issue SEOs.
      • CSRC then required dividend payout ratios of at least 20% (30%) from May 2006 (October 2008) so satisfy the 3-year rule
    • Contrasts the US, where the number of firms paying dividends is falling
  • Dividends are sticky, but for different reasons for the US
    • US: dividends are sticky as dividend cuts are a negative signal
    • China: dividends are sticky due to the 3-year rule
  • Payout ratio fell from 44% in 2005 to 30% in 2007 since 2005 split-share reform made nontradable shares tradable. Thus, investors could sell shares to realise returns, and had less reliance on dividends
  • Dividend yield of only 1%, low compared to other countries
    • Firms pay the minimum to satisfy the 3-year rule
    • Investors don’t demand dividends; their focus is short-run speculative gains
  • 97% of firms pay dividends in their first year of listing, compared to 5% in the US. Reasons:
    • Satisfy the 3-year rule
    • Shares held by executives and controlling shareholders are locked up for 3 years, so dividends are the only way to realise a return
    • IPO is often oversubscribed, increasing the offer price and leading to surplus capital
    • Paying dividends reduces book equity and helps meet the 6% ROE requirement
  • Overall, dividends are driven by regulation (3-year and 6% requirements) and catering (investors don’t want dividends) rather than signalling or free cash flow, unlike in Western firms.
Cash Holdings
  • Average cash holdings of 20% in 2015. Following shocks, Chinese firms increase cash for precautionary reasons (just like non-Chinese firms)
    • 1999-2001 after 1997 Asian financial crisis
    • 2008-2010 after 2008-9 global financial crisis
    • Increase strongest for non-SOEs, because SOEs are less risky due to government ownership
  • Dividend payers have more cash due to non-paying firms, since only dividend payers can conduct SEOs
    • Normally, dividend payers have less cash since they pay out their cash
  • Productive firms hold more cash, due to financial frictions – inefficient to pay out cash and raise it again
    • Normally, productive firms hold less cash as they invest it

How a World Cup Defeat Could Wipe Billions off the Stock Market

The World Cup, which starts today, will spark a huge range of human emotions, from the excitement of victory to the despair of defeat. The effect of football results on national mood is so strong that it can spill over into the stock market and cause swings of billions of pounds. Why?

While the World Cup pits arch-rivals against each other, raring to settle scores of decades past, there are also long-standing feuds in the halls of academia. The equivalent of England-Germany is the debate over what drives financial markets. The “efficient markets” camp argues that the price of a share incorporates every single piece of relevant information: management quality, product mix, growth options, and so on. Prices end up at the theoretically “correct” fundamental value, as if calculated by an infinitely powerful computer.

The “behavioural finance” team points out that traders aren’t computers, but humans. They’re prone to mistakes and psychological biases. Thus, share prices are affected not only by fundamentals, but also by emotions. Internet shares were wildly expensive in the late 1990s, not because these companies’ prospects were stellar, but because investors had become irrationally exuberant.

Refereeing the “efficient” versus “behavioural” match is extremely difficult. One way to settle the tie would be to compare actual prices against the theoretical “correct” value based on fundamentals. But we don’t know what the “correct” value is. It could be that, based on information at the time, internet shares were fairly valued in the late 1990s, and the subsequent crash only occurred because bad news unexpectedly came out afterwards.

But there is another tactic we can use – study whether prices are affected by emotions. Previous papers looked at whether weather affects the stock market. However, weather isn’t correlated across a country. If it’s sunny in London but cloudy in Manchester, it’s not clear what will happen to the overall stock market. Moreover, the effect of weather is unlikely to be strong enough to drive your trading behaviour, particularly since traders work in insulated offices.

That’s why I chose to look at sports. Sports have huge effects on people’s emotions, these are far stronger than the effects of weather, and they can’t simply be neutralised by the office environment. When England lost to Argentina in the 1998 World Cup, heart attacks increased over the next few days. Suicides rise in Canada when the Montreal ice hockey team loses in the Stanley Cup, and murders go up when the local American Football team loses in the playoffs. International sports, like the World Cup, affect the whole nation in the same way, and lead to a large effect on national mood that is correlated across a country.

Together with co-authors Diego Garcia and Oyvind Norli, I investigated the link between 1,100 international football matches and stock returns in 39 countries in our paper Sports Sentiment and Stock Returns. The results were striking. Being eliminated from the World Cup leads to the national market falling by 0.5 per cent on the next day – controlling for everything else that might drive stock returns. Applied to the UK stock market, this translates into £10bn wiped off the market in a single day, just because England loses another penalty shootout.

The effect is stronger in the World Cup than the European Championship, which makes sense because the World Cup is the bigger stage and conjures up even more emotion. It’s stronger in the elimination stages than the group stages, because if you lose you’re instantly out. It’s also stronger in football-crazy countries like England, France, Germany, Spain, Italy, Argentina and Brazil. We also studied 1,500 other international sports matches and found a similar effect in one-day cricket, rugby, and basketball. We ruled out the explanation that the market declines are due to the economic effects of losses (e.g. reduced sales of replica merchandise, or reduced worker productivity).

Depressingly, we found no effect of a win in any sport. One reason could be that sports fans are notoriously over-optimistic about their team’s prospects. If fans go into each game expecting they’ll win, there’s little effect if they do win, but they become depressed if they lose. Another is the asymmetry of the competition: winning an elimination game merely sends you into the next round, but losing leads to instant exit.

The 2014 World Cup

How did this play out in the 2014 World Cup? Excluding the anomalous Brazil defeat (which I explain below), out of the 39 losses by a country with an active stock market, 26 (= two thirds) were followed by the national market underperforming the world market. A loss was followed by underperformance by 0.2% on average; a loss by the seven football-crazy countries was followed by underperformance by 0.4% on average. A series of three interviews I did with CNN’s Richard Quest is here.

Some examples of declines following defeats are below:

  • Germany 1-0 Argentina (Final). Argentina’s market rose 0.2%, while the world market rose 0.6%.
  • Holland 0-0 Argentina (2-4 on penalties, Semi-Final). Holland’s market fell by 1.7%, while the world market fell 0.7%.
  • France 0-1 Germany (Quarter-Final). The French market fell by 1.4%, while the world market fell 0.5%. Clash of two leading nations, both of which harbored hopes of winning the competition.
  • Spain 1-5 Netherlands. The Spanish market fell by 1%, while the world market went up by 0.1%. This was a crushing and surprising defeat by the reigning world champions.
  • England 0-1 Italy. The English market fell by 0.4%, while the world market was flat.
  • Japan 1-2 Ivory Coast. The Japanese market fell by 1%, while the world market was flat. Japan went into the tournament with high expectations since the general consensus was that they had an easy group.
  • Italy 0-1 Costa Rica. The Italian market fell by 1.5%, while the world market was flat. This was perhaps the biggest shock of the World Cup so far, and severely jeopardized Italy’s chances of qualifying.
  • Italy 0-1 Uruguay. The Italian market fell by 0.5%, while the world market was flat. Italy were eliminated from the World Cup.
  • Japan 1-4 Colombia. The Japanese market fell by 0.7%, while the world market was flat. Japan were eliminated from the World Cup. A win would have seen them through against an already-qualified Colombia team that rested several players.
  • Korea 0-1 Belgium. The Korean market fell by 0.3%, while the world market was up 0.2%. Korea were eliminated from the World Cup by a Belgian side that rested several players and was down to ten men for half of the match.
  • Nigeria 0-2 France. The Nigerian market rose 0.3%, while the world market rose 0.7%. Nigeria were eliminated from the World Cup.

But, after Brazil’s 7-1 humiliation by Germany in the semi-finals, the stock market rose 1.8%, while the world market fell 0.4%. Surely this disproves the theory?!

Actually, the Brazil situation has an interesting twist. Here, the market rose because the defeat was so bad that investors thought it significantly increased the chances that socialist President Dilma Rousseff would be ousted in October’s elections and be replaced by Aecio Neves, the leader of the more pro-business PSDB party. The economy had been mired in stagflation under Rousseff’s presidency. Her popularity was particularly tied to the football team because she chose to spend billions on stadiums for the World Cup instead of keeping her pre-election promises to spend on schools, hospitals, and general infrastructure. So, for this game also, sports results affected the stock market, but for very different reasons.

Capital Markets in China

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. I’ve thus tried to educate my self about the Chinese economy, and earlier posted a summary of an excellent article on corporate governance in China by Professors Fuxiu Jiang and Kenneth Kim. This has turned out to be one of my most-viewed posts, so in this post I provide an introduction to the capital markets in China. It’s taken from another paper by Fuxiu and Kenneth, also with Zhan Jiang. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu, Zhan Jiang and Kenneth A. Kim (2018): “Capital Markets, Financial Institutions, and Corporate Finance in China.” Journal of Corporate Finance, forthcoming.)

This post covers only the “capital markets” and “financial institutions” parts of that paper. In a future post I will cover “corporate finance”.

Stock Markets
  • Shanghai Stock Exchange (SSE) and Shenzhen Stock Exchange (SZSE) started trading on 12/19/90 and 7/3/91, respectively
    • Common features:
      • Two trading sessions (9:30-11:30am, 1-3pm)
      • Completely order-driven – no specialists or market makers
      • 10% limit on daily price change
      • Allow short-selling and margin trading since March 2010
    • SZSE has:
      • Main board
      • Board for SMEs (5/7/04)
      • Board for fast-growing firms called Growth Enterprise Market / GEM / ChiNext Market (10/30/09)
    • SSE has only a main board
  • Over-the-counter trading on National Equities Exchange and Quotations (NEEQ) from September 2012
  • Two share classes
    • A-shares are regular domestic shares
    • B-shares are in USD or HKD. Same cash flow rights as A-shares but initially restricted to foreign investors. Less than 0.5% of total market cap
    • Since 2001, local Chinese can own B-shares
    • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
  • Government often interferes in Chinese stock markets
    • China Securities Regulatory Commission (CSRC) has restricted firms’ ability to conduct SEOs and IPOs, for long periods of time
    • At present, firms can only issue an SEO if they’ve paid dividends for three consecutive years and have an ROE of at least 6%
    • Number of IPOs and SEOs fluctuate wildly year to year, and are generally low, both due to government intervention
  • Most non controlling shareholders (both individuals and institutions) are short-term speculative investors
    • Mutual funds have an average turnover rate of above 200% (they turn over their shares at least twice per year)
    • Average turnover on main exchanges was over 500% in 2015
  • High P/E ratios (48 in SSE in 2015) due to
    • CSRC restricting IPOs and SEOs, limiting supply of shares
    • Short-term speculation
  • Little market for corporate control
    • Initially, most shares were nontradable shares, held by the state, so hard for outsiders to take control
    • April 2005 split-share reform transformed all nontradable shares to tradable shares, but still hard for outsiders to get control
      • State or families own large stakes
      • Regulatory hurdles to changes of control
  • Stock markets aren’t the primary venue for raising new capital. Bank loans are a much bigger source of capital
    • Many Chinese firms list abroad (1,003 in HK, 158 in US as of mid-2017), perhaps because raising equity capital in China is difficult
Bond Markets
  • Three types of bond, identified by regulatory agency and investor types rather than maturity:
    • Corporate Bonds: > 1 year maturity, traded on stock exchanges, regulated by CSRC
    • Enterprise Bonds: > 1 year maturity, traded on stock exchanges and interbank bond market (commercial banks, credit unions, financial firms), regulated by National Development and Reform Committee (NDRC)
    • Midterm Notes: > 1 year maturity, traded on internbank market, regulated by Central Bank of China
  • Bond market has exploded: > 1,000 times between 2000 and 2015, 27% from 2014 to 2015
    • But still < 20% of new external financing is from bonds. Bank loans dominate, which are more short-term
  • Reasons for slow development of bond market:
    • Government largely determines interest rates. Yield curves aren’t market determined and so may not accurately reflect risk
    • Credit ratings aren’t well established; SOE may get a good credit rating despite not being creditworthy
    • Three different types of bonds, with different regulatory agencies and investors, complicates the decision to issue bonds
    • Powerful Chinese banks impede bond market development
Financial Institutions
  • Prior to mid-1980s, banking sector very concentrated. Only the central bank and four state-owned commercial banks known as the Big Four: Bank of China, China Construction Bank, Agriculture Bank of China, Industrial and Commercial Bank of China
  • Now, banking industry is much more competitive
    • Large commercial banks: not just Big Four but also Bank of Communications
    • New national commercial banks, e.g. China Merchants Bank, CITIC Bank
    • Urban commercial banks: city banks such as Bank of Nanjing / Changsha / Chongqing
  • Nonbank financial institutions have also grown, e.g. mutual funds. 3 open-ended funds in 2001, 2,559 in 2015
  • Despite more financial institutions (banks and mutual funds), they don’t play a governance role
    • Mutual funds, insurance funds, QFIIs each own < 5% of shares outstanding; largest shareholder (state or family) owns 25%
    • Some are speculative short-term investors
  • VC/PE has grown dramatically and are very important, especially for GEM

Is Short Termism Really A Problem?

“Myopia [short-termism] is a first-order problem faced by the modern firm. In the last century, firms were predominantly capital-intensive, but nowadays competitive success increasingly depends on intangible assets such as human capital and R&D capabilities (Zingales (2000)). Building such competencies requires significant and sustained investment. Indeed, Thurow (1993) argues that investment is an issue of national importance that will critically determine the U.S.s success in global competition.”

So I wrote in my 2007 “job market paper”, later published in the 2009 Journal of Finance. The “job market paper” is the signature paper from your PhD thesis, that you take on the academic job market and often ends up seeding your future research agenda as a faculty member. Indeed, most of my work over the last 10 years has focused on the causes of and potential solutions to short-termism. These include short-term executive contracts, excessive disclosure requirements, the stock market ignoring intangibles, and investors owning too small stakes. So, I have a vested interest in claiming that short-termism is a massive problem. With The Purposeful Company, I have been applying these insights from research to propose policy reforms that will encourage companies, investors, and stakeholders to think more long-term.

But, as with all issues, it is important to consider different perspectives. This will help address the problem of “confirmation bias” – only accepting evidence or arguments that reinforce your viewpoint and rejecting those that contradict it – that I discussed in a recent TED talk, “What to Trust in a Post-Truth World“. Here I summarise an excellent, contrarian article entitled “Are U.S. Companies Too Short-Term Oriented?” by Chicago’s Steve Kaplan, one of the world’s leading authorities on corporate finance. Steve presents a number of cogent arguments for why the problem of short-termism may be exaggerated, which I summarize here.

  1. The Boy Who Cried Wolf

Short-termism is not a new allegation, particularly in the US. My job market paper opened with a 1992 quote from renowned Harvard professor Michael Porter:

The nature of competition has changed, placing a premium on investment in increasingly complex and intangible forms—the kinds of investment most penalized by the U.S. [capital allocation] system.

Porter argued that the US stock market was excessively liquid, leading to shareholders buying and selling companies based on short-term profits rather than long-term value. He advocated a move towards the Japanese system of long-term, stable stakes. However, the evidence of the past 25 years has suggested that the Japanese model has not been the panacea previously thought. While this may be for reasons other than its illiquidity, more direct evidence shows that liquidity has many beneficial effects on firm value.

Steve also includes a 1979 quote from renowned corporate lawyer Marty Lipton, and a 1980 quote by Harvard professors Robert Hayes and William Abernathy, alleging the problem of short-termism. If companies were underinvesting since the 1980s, surely they’ll feel the effects today, after nearly 40 years? But, Steve uses data from 1951 to show that US corporate profits are now near all-time highs, and that the long-term growth in profits has easily outstripped supposedly more “long-term” countries such as Japan. Moreover, the growth in profits was faster after than before 1980s – indeed in the period in which the financial sector, and the focus on shareholder value maximization – both alleged drivers of short-termism – started taking off. Thus, critics alleging short-termism may seem like the boy who cried wolf.

One may argue that corporate profits are not the best measure of value creation, since they are narrowly focused on shareholders. However, evidence suggests that, in the long-term, shareholders and stakeholders are aligned: serving stakeholders ultimately benefits shareholders – and 40 years is a long time period. More direct evidence suggests that society has benefited. Steve cites numbers from the World Bank suggesting that, in 1980, 2 billion people lived in extreme poverty (44% of the world’s population), which by 2012 fell to 900 million (13%). The World Bank projected last year that, for the first time, this number was expected to have fallen below 10%. Steve writes that “while causality is hard to prove and many factors have contributed to this result, US companies – through international outsourcing and globalization – have played an important role in these outcomes.”

  1. No Open Goal
Those who believe that investors are too myopic should celebrate, rather than lament, this behavior. If investors are indeed too focused on the short-term, and thus not financing companies with superb long-term prospects, this gives critics an open goal – the critics can put their money where their mouth is, address the financing gap, and make a killing.

And that’s what venture capital (VC) tries to do. Its end investors commit their capital for 5-10 years, allowing a VC fund to make long-term investments that address the financing gap. So, if (a) short-termism has increased over time, the scope for venture capital has increased over time, and (b) if short-termism is a problem, then venture capital should be unusually profitable.

Steve shows that neither hypothesis is true. Starting with (a), the capital committed to VC funds as a fraction of the stock market has fluctuated in a relatively narrow band of 0.10-0.20% over the last 35 years. This does not suggest there are huge untapped opportunities to invest in innovation. Turning to (b), numerous studies suggest that, while VC funds outperform the market, this outperformance is relatively modest. For every 1% increase in the stock market, VC earns around 1.1-1.2%, and this modest outperformance may not fully control for the greater risk of VC nor be scalable.

Similar results also hold for private equity, which – like VC – also has committed capital and thus the ability to make long-term investments. Also – like VC – it invests in private firms, which are shielded from the alleged short-termism of the stock market, such as the need to report quarterly earnings.

  1. Unicorn Valuations
The Price/Earnings ratio compares the price of a share to its current earnings. If the P/E is high, then the stock market is valuing a firm much more highly than can be justified by its current earnings, because it is taking into account the potential for future profits. The current P/E ratio of the S&P 500 is 25, versus a historical median of 15.  Indeed, the high valuations of unicorns, despite them making little or even negative earnings, suggests that the stock market must forward looking and valuing something other than current profits.

Relatedly, U.S. companies are increasingly less likely to be profitable when they go public. This holds not only for tech IPOs and biotech IPOs. Investors are increasingly likely to back biotech and fracking firms, even though they have significant periods of negative cash flows.

So Why Is Short-Termism Seen As A Problem? 

Given the evidence above, why is short-termism seen as such a problem? Steve points to a number of potential causes:

  • Executives may have a vested interest in claiming that short-termism is a problem, to make them less accountable. Claiming that they shouldn’t be evaluated until 3 years down the line guarantees them employment for at least 3 years.
  • Companies are seen as focusing excessively on share buybacks and dividend payouts rather than investment. In Steve’s words, “This argument is something of a non sequitur. It suggests that in a buyback or dividend, the money simply disappears rather than going to investors who spend it or use it to make other investments. It also suggests that companies that don’t need money should invest it anyway, rather than give it back to shareholders.”
    • Indeed, I believe that the current criticism of dividends and, in particular, buybacks,  stems from substantial misunderstandings. I discuss these misunderstandings (in non-technical language) in p7-8 of my supplementary evidence to the UK House of Commons.
  • Confirmation bias. In the current political climate, many people see companies as evil, and are very willing to accept evidence that supports this view and reject evidence that contradicts it. As Steve writes, “the short-termers ignore a lot of evidence that goes against their position”.

Where Do We Stand?

Has Steve’s paper wiped out a large chunk of my research agenda and policy initiatives? No – it reinforces the need to take an evidence-based, circumspect approach to reform. It points to short-termism being a much more nuanced problem than the media or politicians claim. It is very tempting to make sweeping, unqualified statements (e.g. “all firms are short-termist”), as these are more likely be turned into headlines or Tweeted in 140 characters. But, doing so is very dangerous. Few issues are black-and-white; indeed, despite being a staunch Remainer, I posted on the case for Brexit. Conveying the view that all executives are crooks who sacrifice long-term value for short-term profit contributes to an anti-business sentiment which in turn is a potential contributor to the rise of populism, Trump’s election, and the Brexit vote. Being fast and loose with the evidence has serious consequences. Moreover, the view that short-termism is a universal and pervasive epidemic has supported calls to “throw the baby out of the bathwater”, i.e. abandon the current system – that has led to substantial technological process, rising corporate profits, and diminishing poverty – by mandating workers on boards, making managers less accountable by reducing shareholder rights, and tearing up current corporate forms for untried, untested alternatives.

Instead, diagnosis precedes treatment. Before deciding whether to amputate, a doctor will study whether a condition is local and can instead be spot-treated. Similarly, the optimal response to short-termism depends on how pervasive the problem is, and what the causes are. All the reforms that I have been proposing aim to work within the system, since my reading of the evidence is we do not have an epidemic, and so we do not want to tear up the system that has created many long-term unicorns. Moreover, the specific dimensions to reform should be driven by the evidence, which seems to suggest that buybacks and stock market liquidity are not causes of short-termism, but short-term executive pay and fragmented share ownership may be.

Corporate Governance in China

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. Moreover, the vast majority of research on corporate governance is on the US. We often assume that these findings will apply throughout the world, but this assumption is unwarranted – the institutional setup is very different across different countries.

I thus sought to educate myself on China, and came across an excellent article by Fuxiu Jiang and Kenneth Kim of the Renmin University of China. In addition to providing a non-technical survey into Chinese corporate governance in its own right, it also introduces a special issue of the Journal of Corporate Finance with many papers on Chinese corporate governance. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu and Kenneth A. Kim (2015): “Corporate Governance in China: A Modern Perspective”. Journal of Corporate Finance 32, 190-216). I hope you find this as helpful as I did.

Institutional Background

Capital Markets

  • On December 19, 1990 and July 3, 1991 the Shanghai and Shenzhen Stock Exchanges were launched. Shanghai is analogous to NYSE and Shenzhen to Nasdaq.
  • Regular domestic shares are A-shares, denominated in RMB. A small fraction of firms have B-shares, denominated in foreign currency (US or Hong Kong dollars).
    • B shares have the same cash flow rights as A shares, but were originally restricted to foreign investors.
      • Since 2001, Chinese can own B shares
      • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
    • B shares are less than 0.5% of the total market cap on the two exchanges
  • Regulator is China Securities Regulatory Commission (CSRC), the equivalent of SEC
  • Shares are divided into tradable shares (TS, 1/3) and nontradable shares (NTS, 2/3). Initially, controlling shareholders (often the state or legal persons) held NTS, and domestic individual investors held TS.
  • Individual investors are typically uninformed speculators, leading to stock market volatility. Government has thus promoted institutional investors
    • In April 1998, the first closed-end fund was introduced. Open-end mutual funds and index funds were subsequently introduced.
    • October 27, 1999: insurance companies were approved to own stocks indirectly through a securities investment fund. October 24, 2004: insurance funds were allowed to invest in stocks directly.
    • As above, QFIIs could hold A-shares from 2003
    • Thus, tradable shares became held also by domestic and foreign institutional investors
  • Split share structure was to ensure that the government could retain control of firms. But, government realised that non-tradability is a problem – since NTS holders don’t benefit from stock price appreciation, they had little incentive to pursue shareholder value maximisation. Thus, conflict between TS and NTS
  • April 2005: government initiated the Split Share Reform, to transform all NTS into TS. Since this would dilute the value of TS, NTS holders had to negotiate a compensation plan with TS holders (typically additional shares)
    • Pilot programs conducted in April and June 2005. Reform expanded to all listed firms in August. By end of 2007, almost all firms had established a plan and timetable to convert NTS into TS. Since 2005, NTS are called “restricted shares” to convey the fact that they will eventually become tradable
  • Turnover is high. Even though it’s fallen, it still remains high by international standards. Average holding period of 1 year (4 months) on Shanghai (Shenzhen) Stock Exchange

Corporate Governance

  • For listed firms, a shareholder meeting is required once per year
    • Interim meetings can be called by large shareholders
  • A listed firm must have 5-19 directors
    • Board must meet at least two times per year
    • Since June 30, 2003, at least 1/3 of the board must be independent (can’t be related to the manager, be one of the top 10 shareholders or own 1% of shares, or have a business relationship with the firm).
    • Since China has concentrated ownership, primary duty of independent directors is to monitor large controlling shareholders on behalf of minority shareholders. In countries with dispersed ownership, it’s to monitor management on behalf of all shareholders.
  • Board structure is two-tier: in addition to the board of directors, there is a board of supervisors. Must have at least three supervisors, include representatives of shareholders, and at least 1/3 must be employees
  • Note that it’s the board chair who’s typically in charge of a company, not the CEO or General Manager (GM is often the title given to the CEO)
    • Chairs typically work full-time and go to work every day, unlike in the UK and US

Internal Governance: Stylized Facts and Interpretation

  • Ownership concentration
    • In 2012, largest shareholder owns, on average, 1/3 of the firm; 5 largest own over half of the firm
    • Ownership concentration has declined over time, particularly from 2005 to 2006 since common compensation in the Split Share Reform was to transfer shares from NTS to TS holders
    • Firms where the large shareholder owners > 50% have higher ROE but lower Q than other firms. Thus, even ignoring causality, it’s hard to say whether large shareholders are good or bad for firm value
    • From 2007, firms with multiple large shareholders outperform firms with single large shareholders in ROE. This may be because 2007 is the first year when firms have more TS than NTS, so governance through exit is strong (one large shareholder can threaten to sell if another large shareholder doesn’t cooperate with it)
    • When the government is a large shareholder, it does not tunnel for private benefits (e.g. perks), but it may sacrifice shareholder value for political objectives such as maintaining employment or overinvesting to prop up GDP
  • Managerial ownership
    • SOEs: managers have very little stake, typically because the manager is a government official appointed by the state
    • Non-SOEs: average ownership is 16%, since most non-SOEs are family firms or founded by entrepreneurs. But, median ownership is 0% in most years and 1.1% in 2012. Managers are rarely given shares or options as compensation; managers only become significant shareholders if it’s a family firm or if they buy the shares personally
  • Managerial pay
    • Pay has rapidly increased in a short period of time, but remains modest globally. In 2012, median pay for top manager of SOEs is RMB 470k ($77k)
    • Pay is not an important incentive for SOE managers. They’re government employees, so are incentivized by being promoted to high-level government positions when their term says firm managers has finished. Also, poorly-performing SOE managers are fired. Thus, incentives still matter, but aren’t provided by pay
  • Institutional ownership
    • Has risen over time, largely driven by emergence of mutual funds
    • But, ownership remains small.
      • In 2012, total institutional (mutual fund) ownership averages 17.4% (7.6%).
      • Median ownership of a mutual fund was 0.067% in 2011
    • In 2011, average holding period for a mutual funds is less than 6 months
  • Board structure
    • CEOs are chairs 25% of the time in non-SOEs, 10% of the time in SOEs
  • Capital structure
    • Average leverage in non-financial firms is 1/3. High compared to UK and US
    • Debt is unlikely to discipline managers in China since creditor rights are weak. Thus, bankruptcies are extremely rare
    • Banks don’t appear to monitor. Qian and Yeung (2015: even when controlling shareholders are tunneling from minority shareholders, banks continue to lend, and loan terms aren’t unfavorable.
  • Dividend policy
    • Dividends are very small: around 1%. Potential reasons:
      • Minority shareholders aren’t able to pressure firms to pay out earnings as dividends, since minority shareholder rights are weak.
      • Turnover is high, and so minority shareholders are speculators going after capital gains rather than caring about dividends
    • Dividends are largely driven by regulations.
      • E.g. Number of paying firms more than doubles in 2000 because a CSRC regulation, with effect from March 2001, required a Chinese-listed firm to pay dividends for three consecutive years if it wants to sell new shares

External Governance

  • As China has transitioned from a centrally planned economy to a market-oriented one, China has issued many laws and securities regulations, but China remains internationally weak in its laws, enforcement, and punishment
  • Government recognizes this and is taking steps. 2002 is referred to as the “Year of Corporate Governance of China”
    • Released Code of Corporate Governance
    • CSRC enacted many governance reforms and regulations, e.g. Improving disclosure requirements when large shareholders change
    • CSRC undertook an unprecedented large-scale review of 1,175 listed firms. Found that 30% had significant governance problems. Many CEOs were fired, many firms were fined.
  • Unlike other countries, little governance through managerial labor market, which is nascent
    • SOEs don’t compete among themselves for the best managers, since the government is the only demand-side entity
    • Many non-SOE firms are family firms, so little external hiring historicallly. May change going forwards as firms become more complex, and China’s one-child policy limits number of family candidates
  • Unlike other countries, little governance through corporate control market, which is nascent
    • State won’t sell SOEs to a raider
    • For non-SOEs, ownership is so concentrated that it would be hard for a raider to gain control
    • But, this may change going forwards given that almost all shares are now tradable
  • Like other countries, product market competition is an effective governance mechanism
  • Many Chinese firms engage in CSR to curry favor with the government, since one of the government’s main roles is to promote social welfare (like other countries). Lin et al. (2015): firms that engage in CSR are more likely to receive government subsidies
  • Cross-listings are likely an effective way for Chinese firms to obtain good governance

China’s Corporate Governance Code

  • Like most codes, contains broad and vague language that describes guiding principles rather than explicit regulations. There are eight chapters
  1. Shareholder rights
  2. Rules for controlling shareholders, including advocating a “reasonably balanced shareholding” (multiple sizable blockholders rather than a single large blockholder)
  3. Rules for directors and board of directors
  4. Duties and responsibilities of the supervisory board. Board is accountable to all shareholders and oversees both directors and senior management
  5. Performance assessments for directors, supervisors, and management
  6. Stakeholders. Firms should be good corporate citizens and cooperate with, inform, listen to, and honor the legal rights of stakeholders
  7. Disclosure. Firms must fully and accurately disclose all information required by law
  8. Code comes into effect on the date of issuance

Blockchains: How they work, and how they may transform the world

(This post was originally featured in the Review of Finance Managing Editor’s blog, which summarizes the lead article of each issue in a non-technical manner.)

We hear blockchains mentioned all the time, but very few people know what they actually are, how they work, and what effect they may have.  The paper “Corporate Governance and Blockchains”, by David Yermack of NYU Stern and published in the Review of Finance, is an excellent “go to” reference that answers these questions in a clear and non-technical manner.  The following is a very incomplete overview; I strongly recommend the full paper.

What is a Blockchain?

A blockchain is a database of information, used to keep records in a non-falsifiable way. These records can include the ownership of assets (stocks, bonds, real estate, cars, art), birth certificates, driving licenses, and votes in elections.  Blockchains have been most notably used to keep records of Bitcoin ownership, but their potential applications are much wider. They offer three main advantages over current methods of record-keeping:

  • Cost. Records can be updated electronically, saving the costs of lawyers changing land titles, or of casting and counting votes.
  • Speed. Records can be updated almost immediately. In contrast, a company’s accounts may be updated only annually; votes take time to be counted.
  • Data Integrity. Land records can be falsified, corporate income statements can be manipulated, and option grants can be backdated. Data on the blockchain is indelible.

How Does It Work?

A block is a bundle of records.  For example, a Bitcoin block contains all the Bitcoin transactions that take place in a 10-minute interval (Tx_Root in the above diagram); the record for each transaction contains the sender, the recipient, the amount of Bitcoins transferred, and the time. The timestamp records when the block is created.

A blockchain is a series of blocks chained together by a hash function. A hash function is cryptography that transforms data into a hexidecimal code that cannot be inverted to recover the original input. The header of block 12 contains a hash function reflecting the contents of block 11, whose header contains a hash function reflecting the contents of block 10, and so on. As a result, it is impossible to forge a prior block, since this would cause changes in the hashes of all subsequent blocks and be easily noticeable. Someone wishing to forge old transactions would have to find valid hashes for all subsequent block headers.

A public/open blockchain can be updated by any market participant – there is no central authority (unlike the Land Registry for land titles). To create block 13, a participant must bundle data from new transactions (not included in any prior blocks) together with the hash code of block 12, the timestamp, and a nonce. A nonce is a random number which, combined with the other information in a block, generates a new hash. To be valid, the hash must be below a certain critical value, i.e. have a certain number of leading zeroes. A participant searches, by trial-and-error, for a nonce that will generate the required hash for block 13. Once the first participant has succeeded, other network members verify and acknowledge that block 13 is complete, and then begin working on block 14.

The winning participant is awarded 12.5 Bitcoins (in the Bitcoin blockchain); thus, would-be participants are known as miners. This reward encourages miners to work on bundling together new transactions and creating the next block – it is effectively a fee for providing bookkeeping services. Miners can encode whatever transactions they want into their next block attempt; no two miners will select the same set. Agents seeking fast verification of transactions can pay voluntary user fees to miners who successfully include their transactions in the next block.

The paper also describes private and permissioned blockchains, where the updating is done by a party or a group of parties. The governance of such blockchains is a whole interesting issue in itself, which the paper also addresses.

How Will It Affect the Real World?

Most interesting is the paper’s discussion of the potentially transformative impact of blockchains.

  • Greater Transparency of Ownership. Share records will be immediately observable to everyone. Currently in the US, 13F filings of an institutional investor’s positions are only made once a quarter. In addition, there are three different shareholder lists (company, exchange, proxy voting); firms often do not know who their own shareholders are.
    • Transparency may make it difficult for investors to acquire a block without moving the price, exacerbating the Grossman and Hart (1980) free-rider problem (Kyle and Vila (1991)).
    • Transparency may hinder insider trading, in turn encouraging outsiders to gather information (Fishman and Hagerty (1992), Bushman, Piotoski, and Smith (2005)). It would make impossible backdating of option awards or any other financial transactions.
  • Greater Liquidity. Securities trades can be executed and settled much faster and more cheaply. Currently in the US, settlement takes three days and involves many parties.
    • Liquidity can enhance governance through voice (see the models of Maug (1998) and Kahn and Winton (1998) and evidence of Norli, Ostergaard, and Schindele (2015)) and exit (see the models of Admati and Pfleiderer (2009) and Edmans (2009) and evidence of Edmans, Fang, and Zur (2013), and Roosenboom, Schlingemann, and Vasconcelos (2014))
    • This can benefit ordinary people, not just activist shareholders. Currently, sending money from Zurich to New York costs 7% and takes 3 days.
  • Voting. Blockchains can be used to record votes in corporate elections. This should improve accuracy and address the concern that most close votes are won by management, perhaps due to manipulation. It will also make empty voting (modelled by Brav and Mathews (2011), studied empirically by Hu and Black (2006) and Christoffersen, Geczy, Musto, and Reed (2007)) harder since stock lending will be transparent.
  • Real-Time Accounting. A firm could post all of its business transactions on a blockchain, allowing anyone to aggregate them into an income statement and balance sheet at any time. This may significantly reduce the need for of auditors, deter accruals earnings management, and deter related party transactions.
  • Smart Contracts. A smart contract is an automatic way to execute a contract: for example, a self-driving car could drive to the bank if the borrower defaults on a car loan. The blockchain can implement smart contracts cheaply, for example changing the title of collateral upon a default, substantially reducing enforcement costs. Finance professors might not be able to write papers in the future about difficulties in seizing collateral!

Is This Just A Pipedream?

Many revolutionary technologies end up falling flat, but others end up being transformative. Will blockchain live up to his promise? Three prominent events in 2016 suggest that it may:

  • The Australian Securities Exchange announced its intention to redesign its clearing and settlement systems using blockchain technology, and a number of other major stock markets launched exploratory projects.
  • The NASDAQ Estonia Stock Exchange announced a pilot program for blockchain voting in shareholder meetings. Broadridge, a private company that handles vote-counting in most U.S. elections, began a significant research effort into using blockchains in American corporate voting.
  • A US public company,, in November issued equity over a blockchain, registering the shares with the regulatory authorities but bypassing the traditional stock exchanges.

The returns to investing in grass-roots sport and the distraction of Olympic medals

Unless we look more creatively about how we engage everyone in physical activity, we may win medals but we will be bottom of the league table on health and wellbeing” – Paralympian Baroness Tanni Grey-Thompson

Britain really has got sport upside down. Why spend billions on an Olympics when few kids in the country have the facilities to play judo, fencing, or equestrianism anywhere near their homes?” – Simon Kuper, co-author of Soccernomics and FT columnist

On 27 February I went to a fascinating debate, “Has Britain Got Sport Upside Down?”, hosted by Pro Bono Economics, (a charity established in 2009 by Bank of England Chief Economist Andy Haldane and Tomorrow’s People CEO Martin Brookes) at the Royal Institution, sponsored by Nomura and Weil. The 2012 London Olympics was a tremendous success for the UK, in terms of its performance both in hosting the Games successfully and in the events themselves. The 2016 Rio Olympics saw a record haul of 130 medals, with heroes such as Adam Peaty restoring national pride and apparently inspiring a nation to take up sport themselves.  So, it seems a no brainer for UK Sport to invest £345m to win more medals – to take us on “the journey to the Tokyo 2020 Olympics and beyond”.

Not so fast. This debate provided a range of viewpoints – from Simon, Tanni, Mark Gregory (EY UK & Ireland Chief Economist who has quantified the economic and social impact of sport), and Will Watt (founder of Jump and an expert in policy evaluation) – on whether UK Sport should instead invest its limited funds on grass-roots sport. I attempt to summarise the main points here; these views are the panellists’, rather than my own, and not shared by every panelist. To inform the debate, YouGov conducted a survey, which provides some of the data here.

Does the Olympics Inspire Participation?

Kids have posters of their sporting heroes on their walls, and dream of becoming the next Wayne Rooney or Andy Murray. Olympic stories are arguably even more inspiring, with many of them having to juggle training with a job or studies. So, it seems obvious that Olympic success should inspire Britons to take up sport.

But, only 7% of respondents were “inspired to take up a particular sport as a result of any Olympic games” (emphasis added). Of those who said no, the reasons were the following:


Alternative Investment Strategies

65% of respondents cited the cost, busyness, no close facilities, low-quality facilities, or low confidence. So, perhaps a better strategy would be to invest in making participation opportunities high-quality, affordable, accessible, and non-intimidating? Indeed, only 4% of respondents argued that “gold medal wins in Tokyo 2020” should be the UK’s main priority, with most respondents suggesting that funding should benefit the general public:


So, the public would rather us divert our limited funds to investing in grass-roots sport, rather than chasing gold medals. Uncannily, this echoes Prime Minister May’s industrial strategy to make business work for “all, not just the privileged few” and calls to focus on the “99%” rather than the “1%”. Gold medals can inspire, but without the opportunity to participate, even the inspired may not take up sport – which may be why only 7% actually do so.

The Problem and the Opportunity

The panelists provided some fascinating anecdotes, arguments, and statistics to highlight the crisis in UK grass roots sport, and the potentially substantial returns from investing in it. (Note: the statistics come from the panelists, not me):

  • In the UK, you ask “which football team do you support?” In Holland, you ask “which football team do you play for?” There’s a massive amateur league structure for both genders. It doesn’t matter if you play for the 7th team – what’s most important is that you’re playing.
  • Iceland beating England in Euro 2016 was a massive shock. But, it’s perhaps not too shocking when you consider the countries’ different approaches to grass-roots sport. The UK sold off school playing fields to a large scale during the Thatcher/Major years. In contrast, in the 1990s, Iceland invested in all-weather pitches. They also had an integrated strategy across all sports. For example, many of their goals and goal attempts came from long throws, which in turn resulted from their investment in handball.
  • There is widespread agreement that the UK should invest substantially in the National Health Service. But, sports is the National Preventative Health Service.
  • Yet, health is only 10% of the return to investment in sport. Most is social interaction, enjoyment, confidence, and discipline. For example:
    • The discipline of training for a competition instills discipline into work and study habits.
    • Sporting success, even at a grass-roots amateur level, can instill confidence into other areas of life
    • Sporting participation requires focus, determination and quick thinking, firing synapses in the brain. If a child learns to catch a ball at age 2, their Maths and English end up being better. (Note, this is only a correlation, not a causal statement).
  • We should think open-mindedly about what counts as sport. Skateboarding has negative connotations, but it will be an Olympic sport in 2020, and teaches risk-taking.
  • Physical activity among children falls over the summer, despite the weather being conducive to more activity, which one panellist called a “national disgrace”. This is because children have limited opportunities or encouragement to participate outside school.
  • It’s companies’ responsibility to encourage employees to participate, e.g. through being intentional about promoting company sports teams, physical activity interest groups, and gyms.
  • We give PE teachers far less respect than Maths teachers. Maths is seen as a serious subject and an investment in a child’s future, but sports are just as much an investment. It’s a no-brainer that a Maths teacher needs a Maths degree, but we invest far less in training PE teachers. In some schools, the PE teachers primarily focus on other subjects and just teach PE on the side.

Applying Insights from Economics

(This section contains my own views).

What can economic principles teach us about the optimal funding strategy? They highlight the problems with non-linear schemes, where there’s a sudden jump above a particular threshold. For example, a CEO incentive scheme that pays out if earnings per share exceed £1 provides little incentive to increase earnings from 50p to 99p, but large incentives to increase earnings from 99p to £1, even though the former is a bigger improvement.

Similarly, a strategy to maximise Olympic medals provides little return to Team GB finishing 4th in a sport in which they never even qualified for the finals previously, but a substantial return to converting 4th place finishes into a medal. While there’s clearly some direct benefit of medals (national pride and inspiration), most of the benefit is indirect. Olympic finishes are a by-product of general investment in sport, rather than the goal in itself. When there is active grass-roots sport, this feeds through into developing future Olympians – just like purposeful companies do not chase profit directly, but become profitable as a by-product of being purposeful. So, moving from non-finalists to a 4th place position would likely be an outcome of significant increases in general participation – with substantial social benefit – but not be rewarded in medal tables. And, the law of diminishing returns suggests that the investment required to move up from 4th to 3rd is likely substantial, compared to moving up from 10th to 4th.

Back to CEOs, an earnings per share target may cause CEOs to ignore other dimensions – e.g. cut R&D to boost earnings. Similarly, a strategy to maximise the number of medals may cause sporting authorities to ignore certain sports simply because the UK has little chance of winning a medal – including mass participation sports such as basketball, which require very little equipment to play. If the ultimate goal is mass participation (and Olympic inspiration is one of many ways to achieve this), shouldn’t the UK invest more in basketball rather than rowing (where participation require a nearby river, the ability to pay for expensive boats, and a job/lifestyle that allows early-morning training)? (Note: I’m terrible at basketball, but have rowed ever since university and love the sport, so any personal bias should be to the latter).

A Holistic Strategy?

The idea of redirecting funding to grassroots sport and away from Olympic medals was not shared by all panellists. Some emphasise the substantial pride that results from Olympic success. This spills over into the inspiration to take up far more than just sport. For example, the stories of how a gold medallist worked hard training in their sport may inspire people to work hard and train in a non-sporting context. Separately, in a 2016 marked by a divisive Brexit campaign, the success in Rio helped unite the country again.

Thus, many panelists argued that it should not be an “either-or” strategy. We should invest in the Olympics to generate the inspiration, but also in grass roots to allow the public to act on this inspiration. A skeptical panelist said “nice idea in theory, but in practice, there’s not the money to fund both.” But, we can think of innovative funding strategies. For example, Premier League footballers pay £891m in income tax. We could earmark a small percentage of that to invest in grass-roots football.

Perhaps one of the best ways to invest is to help the many volunteers who help encourage sports participation for free. For example, Happy Bootcamps runs bootcamps all across the UK, and in 7 other countries, which provide free high-intensity interval training sessions (that fitness companies would charge £15-30 for). All coaches in all locations (including the founder, a former professional rugby player whose goal is to get 1m people active within 5 years) work for free, yet there are barriers to even voluntary activity. For example, to run a session in London’s Royal Parks requires buying a permit, and developing a website to advertise these sessions is also costly. Giving these permits for free, or the government supporting (either financially, or through its own advertising) voluntary activities could potentially give a substantial return for little investment.

Davos in a Nutshell (Non-Economics Sessions)

Perhaps the most illuminating sessions in Davos were ones unrelated to economics, and thus gave me insights into topics that I would not normally get the chance to learn about. Here is a short summary.

While these sessions were on quite different topics, one common theme to many was the “neuroplasticity” of the brain. The brain is not fully formed after childhood, but you can keep developing it, e.g. through meditation, mindfulness (paying attention rather than being distracted).


A Buddhist monk led a session on “compassionate” meditation, which is quite different from standard meditation:

  • Picture a loved one in suffering, and being relieved of this suffering. Then, move to acquaintances, strangers, enemies, and dictators. This simple practice helps us show compassion in our everyday life
  • A little bit of meditation every day is better than 8 hours once a week. You water plants every day rather than throwing a bucket once a week.

Exploring Our Limits: Workshop on Creativity

  • Jeremy Balkin (Karma Capital, Give While You Live, 5x marathon runner)
    • Modern society tells kids to conform, to color within the lines, but we need risk
    • For each of us, there’s one thing we haven’t done because we’re scared. Think what this is, and do it
    • We’re all born as naked vulnerable beings, and we’ll all die as naked vulnerable beings. What matters is what we do in between. And we don’t know at what point death will come
    • We’re told that running 26 miles is physiologically dangerous. But, humans used to run to get food. And technology is evolving (e.g. better shoes) to help us. The world has changed a lot in the past 5 years, even in the past year. There’s almost nothing we can’t do
  • Lewis Pugh (first person to swim across the North Pole)
    • Jeremy Clarkson doesn’t get his ideas for Top Gear by sitting in the BBC studio, but going to the pub, having a few beers and allow his imagination to get wild
    • Lewis himself decided to swim the North Pole and Everest in creative moments, on a whim
    • Creativity and imagination never takes place in the office, but with friends. You don’t make a wild decision based on an economic cost-benefit analysis, but on a whim
    • Use the “4am test”. If a crazy idea makes sense to you at 4am in the morning, it’s probably a good idea
  • Bobby Ghosh (TIME magazine World Editor)
    • 10 years from now, you’d like to think “I’m proud I did this wild and dangerous thing”, but also “I’m proud I did not do this wild and dangerous thing”. We often extol the virtues of being wild and crazy, but judgement is also required. Sometimes not doing something wild is the boldest decision
    • Ask yourself: “When is the last time you did something for the first time?” Hopefully, the answer is “recently”
  • Celine Cousteau (granddaughter of Jacques Cousteau)
    • You need a team of people to help you – you can’t do it alone. We like to promote the “self-made millionaire”. No-one is self-made. Entrepreneurs have customers, employees
    • Must connect with the hearts and guts with everyone in your team. This principle also guides you on choosing your team-mates: are they in?
    • You need to give yourself space for creativity to happen. We’re obsessed with doing things. Don’t do, just be
  • Tina Seelig (Stanford, moderator)
    • Privilege.  If you’re an MBA student (or professor) at a top business school, you’re privileged, There are others who should be here who aren’t here
    • Platform. We are lucky to have a platform – use it to help those in need
    • Perseverance. Nothing comes for free
    • In baseball, if you hit 0.300, you’re a great hitter. Encourage people to make mistakes when stakes are low: don’t be a perfectionist on small things

Making Better Decisions

This was the session that I served as a discussion leader (on behavioral finance). Sendhil Mullainathan of Harvard was one of the co-facilitators (with Eldar Shafir of Princeton, his coauthor on a book called “Scarcity”). He talked about two topics: bandwidth and scarcity:Bandwidth

  • We talk a lot about time management, but what’s more important is “bandwidth” management. You only have a limited capacity for difficult tasks
  • The biggest predictor of a plane crash is whether the pilot is in a bad relationship
  • Tools to manage bandwidth
    • Delegate unimportant decisions to others
    • Manage expectations. If others know that you may not reply to email instantly, this removes the mental burden of having to constantly check email
    • Don’t pack every item in your schedule. You can’t go from one meeting on a hard topic to another meeting on a hard topic. Your mind will wander and you will lose focus. You need to build in “bandwidth breaks” during a day, else you’ll be ineffective
  • Respect other people’s bandwidth. We think it’s unacceptable to charge kids $100 to apply for a scholarship, but it’s OK to make them fill in a 40-page form
  • Listen to hear the other person, rather than to prepare your reply to the other person. You can’t do both, as you have limited bandwidth
  • If you’re overcommitted, you may think you should drop everything from your schedule so that you have lots of time. But, then you’ll take on unnecessary commitments
  • A woman with lots of debt still keeps spending. She’s a bad debtor of money, spending money she doesn’t have
    • We’re often bad debtors of time, spending time we don’t have
  • The tagline of their book “Scarcity” is “Why having too little means so much”. When we experience scarcity, we focus on the one thing to make ends meet right now
    • Sometimes it works: we can be super-productive when you have a deadline
    • But, long-term consequences: spending money you don’t have involves taking payday loans
    • Thus, there’s an optimum amount of scarcity – not too much, nor too little
Mindfulness (Goldie Hawn)
  • For further color, read the TIME Magazine article “The Mindful Revolution”,
  • The more attentive you are, the more your brain circuits wire together and fire together. Mindfulness has been scientifically proven to change the neuroplasticity of the brain
  • Mindfulness – focusing on one thing – teaches self-control, and ensures that you can control your emotions rather than being reactive
    • Hot cognition: you make decisions based on emotion
    • Cold cognition: you can distance emotion from decisions
  • The “Stanford marshmallow experiment” showed that, whether kids were able to resist eating a marshmallow, was a significant predictor of future success
    • Being distracted (e.g. checking phone during dinner, or doing urgent stuff over important stuff) is like eating a marshmallow or not controlling your hot cognition
  • Psychology used to be about fixing broken things. Nowadays, positive psychology is about building on the good things in people. This involves attentiveness and focus
Mindfulness Dinner
  • Otto Scharmer (MIT): the success of an intervention depends on the internal state of the interviewer
    • For someone to be a good leader or teacher, the people he’s leading or teaching must be mindful
  • Tania Singer (Max Planck Institute): mindfulness isn’t just attention (like being a sniper). It doesn’t just make you more efficient
    • Mindfulness has an ethical dimension. Being present and aware of what it exists, and accepting what exists: compassion for others, self-acceptance for yourself
  • Buddhist monk: mindfulness isn’t just being aware of your thoughts, but also countering bad thoughts
    • People are born with traits. However, by accumulating moods, you scientifically modify your traits by changing the neuroplasticity of the brain.
    • Being a restless monkey all the time is bad. Be deeply aware of what’s going on
  • The founder of Twitter mediates for 10 minutes a day, even though Twitter seems the opposite of mindfulness

Should Drugs Be Legalized?

  • Governor Rick Perry (Texas): I’m the only one on this panel against the legalization of drugs, but I come to this debate with an open mind
  • Kenneth Roth (Human Rights Watch): decriminalize drugs, so that we can regulate them like alcohol, tobacco
    • Treatment is key, but treatment is undermined by criminalization, so victims run away from treatment
  • Kofi Annan: drugs have destroyed many people, but government policies have destroyed many more.
    • The US spends more money on prisons than education
    • We don’t need to legalize drugs, but we should decriminalize them – there’s an important difference. You can decriminalize possession, but still keep supply illegal (as in Colorado)
  • Juan Manuel Santos (President of Columbia): drug policy is currently decided by law enforcement people, but it should be discussed by public health people
    • Criminalization creates drug cartels and the potential for huge profits. This leads to murders – profits are so high that people are literally willing to kill for them
    • Tobacco and alcohol firms make normal profits because these substances are legalized
    • The Surgeon-General of the US said 8 million deaths have been prevented by the legalization of tobacco
  • Roth: decriminalization doesn’t mean throwing your hands up and giving carte blanche. Use education, drug substitutes
  • Perry: I won’t jump in front of the parade just because this is the way public opinion is going. Instead, science should lead us
    • In the 5 years since decriminalization of drugs in Portugal, the murder rate has risen 40%
    • Marijuana today is much more potent than in the past – it’s genetically modified
    • The fact that Texas is stricter than other states doesn’t mean that Texas is too strict, or that the other states are too lax. The 10th Amendment was to give states authority to set laws, and then people can choose where to live. We shouldn’t have the “one-size-fits-all” mentality that seems to come out of DC.
  • Perry: something must certainly be done, but there are other steps we can take besides criminalization
    • Go after the money. Crack down on banks who allow money laundering
    • Science can create drug substitutes. Decriminalization dissuades drug users from moving off drugs onto substitutes.
  • Annan: decriminalize consumers, stay harsh on suppliers
  • Audience question: does it apply to all drugs?
    • Santos: we need a different approach for each different drug, since each drug is different
    • Perry: the others on this panel have used economic arguments for legalizing drugs – that legalization will remove cartels. But, if so, the economic argument would apply to all drugs. This exposes the fallacy of a purely economic argument. Instead, we should look at the science of each drug. We should also think about the medical cost of sending the message that it’s OK to smoke marijuana
    • Roth: but we’re not sending the message that tobacco is OK. Packets say “smoking kills”
    • Perry: but that used to be the message. Films, celebrities portrayed the image of smoking being cool. We haven’t spent enough since then to reverse this image.

Closing Address

  • Pope Francis: humanity should be served by wealth, not ruled by it
  • Jim Wallis: Hope is believing in spite of the evidence, and then seeing the evidence change
  • When we return home, we will be confronted by the tyranny of the urgent – but we need to be mindful of what’s morally urgent
  • Think about: what’s the one thing I will commit to right now to help support the World Economic Forum’s mission to improve the state of the world?

Eradicating World Poverty: Inspiring a New Generation to Act

This is a summary of a Davos session on “The Post-2015 Goals: Inspiring a New Generation to Act” on the eradication of world poverty and the millennium development goals. It featured, among others, David Cameron, Bono, and Ngozi Okonjo-Iweala (the Nigerian Finance Minister and the most impressive person I heard at Davos):
  • David Cameron: tackling poverty is a holistic issue. We can’t tackle poverty without tackling climate change, governance, corruption, justice, democracy, gender equality. Many of these reasons are why North Korea is poor but South Korea is rich
    • Growth is insufficient. It must be in areas that create jobs for poor people (e.g. agriculture, housing), and we must create a social safety net
    • People want two things: a job, and a voice. Can’t just focus on the former
  • As a result, the Millennium Development Goals (established following the 2000 Millennium Summit of the United Nations) cover eight different areas:
    • Eradicate extreme poverty and hunger
    • Achieve universal primary education
    • Promote gender equality and empowering women
    • Reduce child mortality
    • Improve maternal health
    • Combat HIV/AIDS, malaria, other diseases
    • Ensure environmental sustainability
    • Develop a global partnership for development
  • Bono: I write lyrics like I write poetry. But, goals must be the opposite: hard and precise.
  • Bono:
    • We should get out of the way of poor people. Ask them what they want, rather than presuming that we know
    • Capitalism can be a great creative force, but also a great destructive force. Even if it’s not immoral, it’s amoral
  • Bono: to me, transparency is even more important than debt cancelation
    • If a firm is registered on the NYSE, it must publish what it pays executives. But, declared and actual pay is different.
    • Companies always lobby against transparency. The American Petroleum Institute lobbied against the Extractive Industries Transparency Initiative, which requires oil, gas, and mining companies to disclose the payments they make to governments for extractive projects
    • The government must also be open. The question shouldn’t be “are we open for business?” but “are we open”?
  • Ngozi Okonjo-Iweala (Nigerian Finance Minister):
    • Nigeria is forward-thinking compared to the rest of Africa, but shouldn’t try to be an oasis in a desert, because the desert always wins
    • Africa needs to move beyond extracting resources and use them to create wealth and equality
    • Nigeria’s policies are targeted. Use conditional cash transfers to encourage kids to attend school. Don’t just receive aid, but use it to leverage private sector resources better
    • We write off whole countries when there’s a bit of sectarian conflict. But, even in such countries, we can try to get kids into school. As peace is being brokered, the next generation can get an education
  • Cameron:
    • I reallocated the aid budget from India and China to other countries. India and China have resources to help themselves
    • Some of the fastest-growing countries in the world are in Africa. But, there’s lots of red tape hindering trade between African countries. Thus, lots of infrastructure has been build to export goods out of Africa, rather than trade within Africa
  • Ngozi: gender inequality isn’t limited to developing countries. Only 15% of Davos is female. But, because Nigeria is poorer, we can least afford it. I have to take the bull by the horns
    • Girls’ literacy is key. With the UK’s Department For International Development, we pioneered conditional cash transfers to get kids into school. Attendance rose 40%
  • Ngozi: everyone agrees we should invest in developing countries
    • But, we typically think of investment being in hard assets – building schools and infrastructure
    • We need to invest in soft skills: training midwives, teaching a mother to give water to a baby with diarrhea
    • An educated woman has 2.1 kids, an uneducated woman 8.9
  • Cameron: the UN must agree on a set of specific, measurable, inspiring goals that apply to everyone. We shouldn’t have separate goals for the rich and poor. Anti-corruption, justice, transparency are goals for all countries
    • Jasmine Whitbread (CEO of Save the Children): goals are universal, but the strategy to achieve them may differ across countries.
  • Tidjane Thiam (CEO of Prudential): we don’t want to talk about Africa changing. Africa is still the same – it’s weather and resources are the same. Instead, we want to talk about Africans changing – a change in people’s attitude
  • Bono: next year will be the 30th year of Live Aid. I hope that Bob Geldof and I are just guests – that we won’t need Live Aid any more

Davos in a Nutshell (Part 2)

Here are key takeaways from additional sessions I attended in Davos. The last blog mainly covered sessions that were statements of fact (e.g. current economic indicators); here I cover sessions on which there was an exchange of opinions – in particular, different viewpoints around the world on what economic policies to adopt.

Economic Policy Around The World
  • Mark Carney became governor of the Bank of England and adopted forward guidance – indicated that he would not raise rates until unemployment fell below 7%. He expected this to take 3 years, but it’s likely to take 6 months – unemployment is currently at 7.1%.
    • Thus, just before Davos he issued a statement saying he wouldn’t automatically raise once unemployment fell below 7%
    • Since then he’s said that he will use the output gap (the difference between actual GDP and potential GDP), rather than unemployment to guide policy
  • Geoff Cutmore (CNBC anchor, moderator of this session): is this back-tracking a sign that monetary policy has failed?
    • George Osborne: no. We’re only discussing this because unemployment has fallen rapidly to 7.1% – because the exceptionally supportive monetary policy has worked
    • 7% was never going to be a trigger for action, merely a threshold – one of many things that the Bank of England would consider when deciding whether to raise rates
    • Moreover, the interest rate isn’t the Bank of England’s only tool. It has tightened the mortgage approval process and used the Funding For Lending scheme. The Bank of England is second to none in having all the relevant tools at its disposal – the interest rate and a variety of macroprudential tools
  • Larry Summers: I’m worried about macroprudential complacency, due to human error
    • Governments missed the 1987 stock market crash, the 2007 financial crisis.
    • Spain’s countercyclical capital requirements didn’t protect it against the real estate bubble
  • Thomas Jordan (governor of Swiss National Bank): we don’t do forward guidance, but this doesn’t mean it’s bad. Different policies are good for different countries.
    • Switzerland targets the exchange rate
    • Also has tried to rein in the property bubble through bank capital regulations, rather than interest rates
  • Cutmore: the UK has seen a fall in the savings rate, and a housing market recovery, but no increase in exports nor productivity: rapid fall in unemployment despite modest rise in GDP suggests productivity hasn’t risen. Growth has been bubbly, not balanced.
    • Osborne: the job is indeed only half-done. But, the progress has been good. The recovery has indeed been generated by the consumer, but income-generated, not debt-generated. Now we must hand over to business investment and exports
  • Haruhiko Kuroda (Governor of the Bank of Japan): Abenomics contains three arrows:
    • Flexible fiscal policy: short-term fiscal stimulus, but the government aims to eliminate the deficit by 2020
    • Supportive monetary policy: Quantitative and Qualitative Easing (QQE)
    • Structural reforms
  • Kuroda: Abenomics has worked so far. It aimed to achieve a 2% inflation target in 2 years. We’re 9 months in, and consumer price inflation is at 1.2% (excluding fresh food)
    • There’s still a way to go; it’s premature to discuss tapering. But, we’re watching how other banks (e.g. Fed) are managing the tapering process
  • The Fed only started tapering the second time around. The first time around, it blinked: in September 2013, Bernanke decided not to taper. In December, it reduced QE by $10bn/month to $75bn, and said it would wind down QE by end of 2014
  • Monetary policy shouldn’t be conducted in isolation. As we taper monetary policy, we can’t do too much fiscal contraction
  • Larry Summers:
    • We are way better off than in 1929 due to good policy, but growth has only kept pace with population growth
    • We have significant structural issues: structural unemployment leads to hysteresis, meaning that US output is way less than potential.
    • We don’t know how to have sustainable growth. The growth in 2003-6 was said to be good because unemployment fell without inflation rising, but this was due to credit expansion and a fall in lending standards.
  • Summers: the good news of the past year allows us to shift focus from the public deficit to other deficits in the economy, such as the public investment deficit
    • Construction unemployment is in double-digits. The US can borrow for 30 years at 3% in a currency that we print ourselves. Why not fix JFK airport?
    • We spend 25% less on life sciences than 5 years ago. That’s a deficit too
    • Deficit isn’t just financial debt, but other debts we bequeath to future generations
  • Jordan: businesses will only invest when the feel confident; the near-death of the Euro made this much harder. Policymakers can’t force a company in a free market to invest, but they can do everything to create conditions that support investment.
  • Cutmore (to Osborne): Why are businesses not investing? What do they fear?
    • That your government won’t be around to follow through on its policies?
    • The U-turn on forward guidance, which creates policy uncertainty?
  • Osborne: we’re building nuclear power stations and investing in fracking, which other governments aren’t. The UK is prepared to take difficult decisions

Rebuilding Banking in Europe

  • A few months ago, probability of Italian default was 40%; the world had stopped funding some European firms. Credit default spreads were high, liquidity and bank capital were low
    • So we’ve come a long way in a short space of time. The ECB took decisive action, and fiscal policy became more credible
  • Tail risks (e.g. fear countries exiting the Euro) have been alleviated. As of January 2014 we now have more members of the Euro (Latvia has joined, so now 18 members) not fewer
  • But, there’s still a long way to go
    • Anshu Jain (Deutsche Bank): 3/4 of credit in Europe comes from banks, not capital markets, so banks are key to the health of the overall economy
  • While the European economy has recovered a little, this hasn’t manifested in greater lending, either to businesses or households. Some people think that one more push (e.g. the Asset Quality Review) will finally get lending going again.
    • But, this is wishful thinking. The problem isn’t insufficient supply of loans (we’ve already had a huge fall in bank funding costs which has increased loan supply), but an insufficient demand for loans.
    • Businesses won’t demand loans for investment while there’s still uncertainty over policy, and uncompetitive labor markets.
  • The European Central Bank will be the single regulator of all banks in the Eurozone from 2014. It will conduct an Asset Quality Review throughout Europe to “stress test” banks’ portfolios, to see if banks are healthy.
    • Are you worried that it will unveil severe problems? Jeroen Dijseelbloem (Dutch Minister of Finance): I hope so! We want to find problems so that we can fix them.
    • Having banks fail will show that the stress tests were done seriously. Europe first did some stress tests in 2010, but they were viewed as not tough enough. National supervisors did them independently, with little coordination. Thus, they had incentives to hide problems. This is why Ireland and Spain didn’t fail more banks
    • However, we must realize that stress tests aren’t a panacea. They can’t tell you definitively the quality of a bank’s loan portfolio – this quality keeps changing. This is why bank capital is necessary, to help prepare for the unpredictable.
    • Interbank lending is low, even with in Europe. The world’s willingness to lend to European banks is also low. A stringent stress test will encourage lending to banks that pass the tests.
  • Lord Adair Turner (former Chairman of the UK Financial Services Authority): the US’s stress tests in 2009 were very successful as they were stringent. Also, it was very clear what would happen if a bank failed: it would be given a certain number of months to raise capital privately; if it failed to do so, there would be a public recapitalization.
    • Dijseelbloem: but EU does have a clear set of next steps if a bank fails the stress test. It will be given time to deal with its problems. If unsuccessful, it must engage in a “bail-in”, where existing bondholders see part of their debt written off (this happened in Cyprus). Only if it’s undertaken a bail-in can it request government funds as a last resort. If the government can’t recapitalize the bank because  it’s too big, it will have to request a loan from the European Stability Mechanism, the eurozone’s government bailout fund.
  • December 2013: EU finance ministers created a Single Resolution Mechanism. It imposes levies on banks to build up national resolution funds, which will be gradually merged over 10 years into one European pot worth €55bn. This will act as a financial backstop
    • When a bank fails, its shareholders and creditors (rather than the taxpayer) should pick up the bill. But, the resolution process may require outside funds, e.g. to recapitalize key parts of a bank before selling it, or provide liquidity. This is what the backstop is for
    • While the resolution funds are being built up, the backstop will be the national government (and thus the ESM if the government has insufficient funds)
  • €55bn pot criticized as being too small. The Spanish bailout cost €40 bn, ant that’s only one country
    • But this fund is only the last line of defense. We have been building up other lines of defense. Bank capital is the first line of defense, and banks have been recapitalizing. We also have national resolution funds
  • Lord Adair Turner : we need to go further than the mutualization of a guarantee scheme
    • We need a single banking union, just like in the US. It’s not the case that New York banks just lend to New York, and New York depositors rely only on New York for deposit insurance
    • We can’t just close down a very large bank that’s failing. We will need to put in public capital. This is why the Resolution Fund (financial backstop) is key. Until the fund is in place, we’re still in danger
    • In the US, there’s a pan-US response if a bank fails. In Europe, it’s a national response
  • Trust is a huge issue in banks at the moment:
    • LIBOR and Forex benchmark manipulation
    • Commission-oriented salespeople sold Payment Protection Insurance that wasn’t needed
    • Banker bonuses despite losses
  • David Rubinstein (Carlyle): not clear that popularity is the relevant criterion. Even in good times, the public never loves banks or PE. Unlike Apple or Starbucks, most people’s relationship with banks involves paying fees
  • Lord Turner: the collapse of the financial system isn’t a problem just for industry, but also for regulators and academic economists
    • Policymakers used to think that more innovation, more efficiency is always better – they overly believed in market efficiency
    • Central bankers thought the financial system unimportant for the real economy
    • Most academic models don’t contain a financial sector
Coperation Between China, Europe, and the US
  • Theme of session: these are the three largest economies. If they can work together, we can guarantee global growth and world peace. But, how can we foster cooperation?
  • Nick Clegg: GATT reflected the old world order. Now, the balance of power has shifted from the west to the east. Thus, trade agreements are bilateral, not global
    • Must ensure regionalism and bilateralism don’t undermine multinatinoal agreements
  • Lloyd Blankfein: trade is always a win-win. Everyone has a stake in everyone else. If oil is discovered anywhere in the world, it’s best for the country that discovered it, but it’s good for other countries too. The same goes for growth: any growth in the world is good for the rest of the world.
    • China will grow, but we have to manage our expectations. This is quite natural – if China would definitely grow and there are no risks involved, the market would be inefficient
  • Angel Gurria (Secretary-General of OECD): it’s OK to build brick-by-brick, as long as bricks fit into a coherent bubble
    • Agreements should be not just on trade, but intellectual property rights and procurement
    • State-owned companies must be on a level playing field with private companies. Common labor and disclosure rules. Need to pay dividends to the Ministry of Finance
  • Joseph Nye: we must include Japan in these discussions, and not let tension between China and Japan get in the way
  • Clegg: any open economy requires China; the UK is one of the most open economies. Chinese investment in the UK in the last 18 months has exceeded the investment in the prior 30 years
    • Thus, UK must stay in the EU to be able to negotiate with clout with countries like China. UK is 60m people, Europe is 500m.
  • Clegg on trade: there’s no future in protectionism, but we need to be true to our values. We can’t ignore human rights.
    • It’s insufficient to sign up to new agreements; we must adhere to them, and have teeth in case countries don’t adhere
    • We’ve gone beyond haggling tariffs; we’re now discussing norms and standards
  • Should China see its future with the BRICs rather than the west, because the west isn’t growing so fast?
    • No, that would be very short-sighted. The US will still be huge. Even though China GDP will soon overtake the US’s, China GDP/capita won’t for a while, and this is a measure of economic effectiveness.
  • Clegg: China should recognize that it’s own future depends on sustainability. It can’t ignore the environment
    • Gurria: China is a big user of coal, which is very bad for the environment.
    • China is so large that any actions that it take have global implications.
Challenges Facing US Competitiveness
  • The World Economic Forum ranks the US #5 in global competitiveness, up from #7
  • There are concerns that the government should stay arm’s length with the private sector
  • Michael Porter:
    • The US faces structural competitiveness challenges. The few jobs they are generating are in areas insulated from international competition, suggesting that the US is losing international competitiveness
    • The problem isn’t that the US doesn’t have strengths (it has science, technology, entrepreneurship, innovation) but that it has allowed weaknesses to crop up: regulatory complexity, poor infrastructure, public education, tax complexity. Complying with regulations costs $17tr, $10k per employee. The tax system is so complex that companies would rather invest overseas
  • Glenn Hutchins (Silver Lake):
    • There will be a global equalization of wage rates as China, former Soviet Union come into competitive markets. This will push US wages down, so wages may not be there to support consumption
    • Employment has to be reformed. Unemployment benefit is not means-tested
  • There’s great opportunities to do trade agreements – no President since FDR has had such ability to negotiate trade, but little has been done.
  • Healthcare costs are out of whack; Obamacare didn’t get at the cost structure.
  • The US will gain 35m workers, of which 43m (> 100%) will come from immigration. China will lose workers due to its 1 child policy
  • Eric Cantor (House Majority Leader): we believe in a global economy as it reduces costs for consumers, but access to the US market requires reciprocity in turn
  • Porter: the US is complacent. We think we’re rich and will be rich foerever, while other countries are fixing regulation, investing more
    • Unfunded Medicare liabilities seriously worsen the deficit
    • Need to transfer from Defined Benefit to Defined Contribution pension plans, but the president won’t go there