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Beijing Is Cracking Down on Corruption — Big Time

President Xi Jinping’s anticorruption campaign is hampering business in China and raising risks for foreign investors.

The son of a retired People’s Liberation Army general, P.J. Chen was so familiar with the halls of power in Beijing that he knew exactly which doors to knock on to gain access for himself and his clients.

Not long ago Chen frequently “shared benefits,” as he puts it, with powerful figures — benefits that ranged from imported luxury products to overseas education for their children to financial “incentives” in the form of thick wads of cash, swanky apartments or even equity stakes in companies he owned. In return, these officials helped Chen win deals that ran the gamut from lucrative oil and gas exploration rights to multibillion-yuan mandates to help state-owned enterprises seek foreign acquisitions.

“In the past there were key people who you had to go to open doors for specific sectors,” says Chen, who worked on Wall Street in the 1990s and now owns a Beijing-based private equity firm that controls dozen of Chinese companies and several oil and gas fields in Xinjiang, in western China. “If you knew which gatekeepers to go to, who to pay off in terms of kickbacks, you were set for guaranteed profits,” says Chen, who agreed to speak under a pseudonym to protect himself from potential prosecution by authorities. “Now, however, those people are no longer there, or if they are there, they are no longer taking kickbacks. They’re afraid, and that’s because the tectonic plates of doing business in China have completely changed since the anticorruption campaign began.”

When President Xi Jinping took office in November 2012, he launched a vigorous campaign against official corruption, calling it a matter of life or death for the Chinese Communist Party and the nation. The unprecedented crackdown has gone after everyone from powerful senior party officials, whom Xi calls tigers, to lower-level officials he terms flies. In the most dramatic case so far, a court in June sentenced Zhou Yongkang, a top party official who oversaw the government’s security services, to life in prison for bribery, abuse of power and the intentional disclosure of state secrets.

“We must make sure officials dare not be corrupt, cannot be corrupt and do not want to be corrupt,” Xi told the party’s Central Committee at a June 27 meeting.

Corruption has plagued humankind ever since societies created positions of authority and people have had the money or goods to influence decisions. As Mark Twain famously wrote, “It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress.”

China offers particularly fertile conditions for corrupt practices: an all-powerful ruling party and a burgeoning capitalist economy that has created more wealth more quickly than any society in history. Some economists estimate that just 1 percent of the population — a group that includes many key government officials — controls 50 percent of the nation’s wealth. In 2012, Bloomberg News reported that Xi’s extended family had amassed company stakes and real estate properties worth tens of millions of dollars, and the New York Times reported that relatives of former premier Wen Jiabao had piled up more than $1 billion in assets. The Chinese government swiftly denied the allegations, temporarily blocked the two organizations’ websites in China and threatened to deny visas for their journalists.

Public anger over corruption was so intense toward the end of the presidency of Xi’s predecessor, Hu Jintao, that top party officials feared it could provoke an uprising, says Guan Anping, a Beijing-based lawyer who advises several government agencies on financial market reforms. Xi had no choice but to launch the campaign to appease that anger, he contends. “Corruption was so excessive within the party a few years ago that it made the average Chinese man and woman furious,” Guan says.

The Communist Party initiated more than 53,000 graft-related investigations in 2014 and disciplined more than 70,000 officials. Under Hu the party initiated only a few thousand cases a year, on average. Penalties have ranged from firing officials and kicking them out of the party to putting them in jail or even executing them. In February the state put to death billionaire Liu Han, who reportedly had close ties to Zhou, for running a criminal organization based on bribery and extortion.

The campaign extends beyond China’s borders. Earlier this year Wang Qishan, a former economic policy chieftain who is leading the anticorruption campaign as head of the party’s Central Commission for Discipline Inspection, released a blacklist of more than 150 former senior cadres who were believed to have fled abroad — mostly to the U.S., Canada and Australia — and asked foreign authorities to help hunt them down. Last year Wang and his team worked with foreign governments to repatriate more than 500 fugitives and facilitate the return of more than 3 billion yuan ($483 million) obtained through illegal means. That may be just the tip of the iceberg. An estimated $1 trillion to $4 trillion may have been laundered out of China since 2000 and is now hiding in some 22,000 offshore accounts, according to a 2014 report by the International Consortium of Investigative Journalists.

Xi’s anticorruption campaign is the most intense political movement in the country since the Cultural Revolution of 1966–’76, say veteran China experts, and that comparison worries many observers. Party investigators often resort to extralegal measures to investigate and punish accused party members. Once arrested on grounds of violating party rules, officials virtually disappear behind closed doors in party-­controlled correctional centers, undergoing months of interrogation before they are formally charged, expelled from the party and handed over to the civilian judicial system for prosecution. Dozens of arrested officials have died in the custody of investigators, prompting human rights groups in the West to decry the campaign for its brutality.

Many China experts are skeptical about Xi’s motives. They believe the campaign is being used to purge political rivals as much as to fight corruption, and they note that Xi has quickly amassed more power than any Chinese leader since Deng Xiaoping in the 1980s. Unless the campaign is put in a strong institutional framework with transparency and due process for those accused of wrongdoing, it can easily be abused for political ends without rooting out actual corruption, they contend.

Belgian Finance Minister Johan Van Overtveldt believes the crackdown has done little to attack the underlying problem. “The Chinese government is replacing one set of corrupt officials with a new set who are doing more or less the same thing,” he says.

Xi’s campaign is constrained by its ultimate goal: preserving the monopoly on power exercised by the world’s longest-lasting Communist regime. “Xi Jinping has little interest in true institutional reforms because they would require political reform, which he is not willing to do,” says Willy Lam, a political scientist at the Chinese University of Hong Kong and author of the newly published book Chinese Politics in the Era of Xi Jinping: Renaissance, Reform, or Retrogression? “His aim is to perpetuate the CCP’s status as ‘perennial ruling Party.’” That means cleansing the party to maintain popular support and increase governmental efficiency but not liberalizing the political system.

EXPERTS AGREE THAT CORRUPTION in China is a serious problem. According to a 2005 study by the Korea Institute of Public Finance, about 15 percent of the country’s gross domestic product — which was worth $2.2 trillion then and currently stands at $10 trillion — was in the underground economy, including everything from unreported and untaxed activities to kickbacks paid to officials to obtain licenses and approvals. Some economists estimate that the underground economy today is about 20 percent of GDP, not unusual for an emerging market but massive in size given the scale of China’s economy.

“Xi Jinping said a few years ago that this was not about saving the party,” says Paul Schulte, an independent economist and former global head of financial strategy at CCB International (Holdings), the offshore investment banking arm of China Construction Bank Corp. “It was about saving China. He saw out-of-control corruption as destabilizing the entire country and concluded a harsh crackdown was necessary in order to pull China back from the brink of kleptocratic anarchy.”

Xi’s attitudes toward corruption reflect the influence of his father, former vice premier Xi Zhongxun, according to Sidney Rittenberg. An American journalist, scholar and Chinese linguist, Rittenberg lived in China from 1944 to 1979, joining the Communist Party and serving as translator to chairman Mao Zedong. He returned to China in the 1990s as an adviser to multinationals including Intel Corp., Levi Strauss & Co. and Microsoft Corp., and got to know Xi personally when the aspiring political star was the party chief of Zhejiang province.

The elder Xi was famous for initiating reforms, chief among them the 1980 launch of the Shenzhen Special Economic Zone, which kick-started China’s economic liberalization. He also openly defied former paramount leader Deng to oppose the suppression of the 1989 student uprising at Tiananmen Square. “Xi Zhongxun was, as a result, frequently in trouble or suffering punishment,” Rittenberg explains. “The son, Jinping, has been agonizing for many years at the frightful corruption pervading all areas of life in China, and at the deterioration of public morality. That is why the top leading circles, faced with what they saw as the possibility of the collapse of party rule, placed Xi and his team in charge.”

Wang, who leads the anticorruption campaign as head of the Discipline Commission, is regarded by many analysts as the second-­most-powerful political figure in China and may see his term extended beyond 2017, when he will turn 68 — well past the mandatory retirement age of 65 for senior officials. Of China’s leaders, Wang enjoys the highest credibility among global investors. Once the vice premier overseeing finance, he is on a first-name basis with former U.S. Treasury secretaries Henry Paulson Jr. and Timothy Geithner. Wang helped former premier Zhu Rongji implement major reforms of state-owned enterprises in the 1990s. He became governor of China Construction Bank and was founding chairman of China’s first offshore investment bank, China International Capital Corp. As mayor of Beijing in the mid-2000s, he oversaw the building of more than $50 billion of infrastructure for the 2008 Summer Olympics.

In his new role as Discipline Commission chief, Wang is due to head to Washington later this year to seek the Obama administration’s cooperation in repatriating corrupt officials who have escaped to the U.S. The U.S. State Department said in March that China had sent a list of 150 suspects it wants the U.S. to deport for prosecution in China. “We continue to encourage China to provide strong evidence and intelligence to ensure that our law enforcement agencies can properly investigate and prosecute cases related to the alleged corruption,” State Department spokeswoman Jen Psaki says.

“Wang Qishan is someone the U.S. trusts and can work with,” says Laurence Brahm, a Beijing-based American lawyer who worked with Wang on state-owned-enterprise reforms in the 1990s. “Wang is a straight shooter, and Americans like that.”

XI’S CAMPAIGN GOES HAND IN hand with reform measures aimed at increasing the role of the private sector in China and shifting the economy from an export- and investment-oriented powerhouse into one driven more by domestic consumption and services. By beating back a kleptocratic public sector, the president hopes to widen the path for private sector development and increase the buying power of China’s middle class, says Beijing lawyer Guan.

The stakes are high. Analysts say success in the campaign could strengthen Xi’s power and cement his legacy as the leader who transformed modern China and gave fresh legitimacy to the Communist Party, which abandoned ideology 30 years ago in favor of economic reform. Failure would be personally devastating for Xi, raising the risk that rival factions could turn the tables and purge him, and would threaten to undermine the government’s economic reform program.

Despite rumors of resistance to the anticorruption campaign from Xi’s rivals within the party, the president has the upper hand — at least for now. The conviction of Zhou, who appeared bowed and broken at his sentencing, underscored the campaign’s reach. Zhou, a member of the Politburo Standing Committee, the party’s highest body, headed China’s police and intelligence agencies for almost a decade. He was the most senior party member to fall since former party chief Zhao Ziyang was purged after the Tiananmen Square uprising for taking a soft line against the pro-democracy movement. The other big victim of the crackdown is Bo Xilai, who was the party chief of Chongqing and an erstwhile rival of Xi’s: Two years ago he received a life sentence for taking bribes — a sensational case that emerged after his wife was accused and later found guilty of murdering a British businessman, Neil Heywood.

Both Zhou and Bo had openly challenged Xi during the early days of his administration, and their prosecution was no accident, contends Jonathan Fenby, former editor-in-chief of the South China Morning Post in Hong Kong and the author of several books on Chinese history and politics. But the corruption crackdown is more than a political campaign, he asserts; it is a broad-based initiative that Xi is using to drive through reforms to break up factions within the party and centralize power at the top. “The thesis I have put forward for more than a year is that beyond using the campaign against political foes, Xi and Wang Qishan see it as a way of improving the efficiency of the Chinese political and economic systems,” says Fenby, co-founder of Trusted Sources, a London-­based research firm that specializes in emerging markets.

The campaign has been effective in reducing corruption not only within the bureaucracy but also among state-owned companies. The official Xinhua News Agency reports that 3,670 cadres at state-owned enterprises were penalized for corruption and extravagance last year — twice as many as in 2013. Since the beginning of 2014, anticorruption investigators have ousted 115 C-suite executives from major state groups, including such global giants as PetroChina Co.; China Petroleum & Chemical Corp., or Sinopec; China Southern Airlines Co.; China Enterprise (Holdings) Co.; and automaker FAW Group Corp. The sacked executives were party members and disciplined for a wide range of offenses, including taking kickbacks and routing business through their own, privately held corporate entities.

Schulte, who is chief executive of Hong Kong–based Schulte Research International, believes the anticorruption campaign has been a positive factor behind the strong rally in Chinese stocks over the past year, which has seen the benchmark Shanghai Shenzhen CSI 300 Index nearly double in the past 12 months, notwithstanding the sharp correction starting in early June. “I think one of the main reasons the equity market began to move was because law and order was being restored,” Schulte says. “This is a vital starting point for a market. Fraud and misrepresentation must be eliminated for a market to work. Xi Jinping has done this.”

Michael Taylor, Hong Kong–based chief credit officer for Asia at Moody’s Investors Service, says Xi’s initiative helps China pursue its broader economic restructuring goals and is good for its Aa3 credit rating. “The anticorruption measures support the government’s goals of economic reform and rebalancing, macroeconomic stability and legal system reform, which we view as credit-­positive,” Taylor says.

However, the campaign has had a negative impact on the economy in the short run. With officials looking over their shoulders, worried about becoming targets of the investigation, the campaign has contributed to delays and even cancellations of public sector investment projects, according to an April 20 report by Moody’s. The rating agency says investments in major projects fell 50 percent short of the government’s target last year. The supply of land for construction purposes dropped by 16.5 percent, and the utilization ratio of supplied land came in at only 50 percent despite the launch of major development and social welfare projects by the State Council, the government’s top executive body, last October. That’s hardly surprising given that land conversions have traditionally offered the richest opportunities for kickbacks, with urban-­planning officials often extracting substantial sums from developers in exchange for the right to build. “On balance, however, we believe that the campaign’s impact on investment decisions will be relatively modest compared with the much greater effect exerted by the reform and rebalancing of the economy,” says Moody’s Taylor.

Xi’s campaign has also caused a sharp slowdown in the sale of luxury goods, which were often used to bribe officials: The sale of luxury goods fell 1 percent last year, to about 100 billion yuan, according to a study by consulting firm Bain & Co. It was the first decline in a market that has experienced double-­digit annual growth rates since the 1990s. Yet luxury goods represent only about 0.5 percent of overall retail sales, which totaled 26.4 trillion yuan in 2014, so the fallout on the wider economy will be minimal, Taylor says.

The biggest economic shock waves from the crackdown are being felt in Macau, the special administrative region adjacent to Hong Kong that is the world’s biggest gambling venue. Gaming revenue fell by 36.2 percent in June from a year earlier, to 17.4 billion patacas ($2.18 billion), the lowest level since November 2010, the Macau government reported. It was the 12th successive monthly decline and left revenue for the first half of the year down 37 percent. Gaming revenue in Macau dipped 2.6 percent, to $44 billion, in 2014, the first annual decline on record. Alex Bumazhny, Fitch Ratings’ New York–based director of gaming, lodging and leisure, estimates that gaming revenue will continue to fall this year, dropping 2.4 percent.

According to sources who study Macau’s gaming sector, Beijing has begun to restrict visas for many of the Chinese high rollers — wealthy businessmen and government officials — who dominate the action at Macau’s tables, in a bid to crack down on capital flight.

Although China maintains strict capital and exchange controls, it has always been lax toward Macau, which returned to Chinese rule in 1999 after more than 300 years as a Portuguese colony. For years Beijing supported Macau’s gaming industry by allowing wealthy Chinese gamblers unrestricted access to their bank accounts on the mainland. Many of these players buy far more chips than they gamble with, then cash out and remit the funds to secret accounts in Hong Kong or elsewhere offshore. Macau, in essence, has been providing corrupt Chinese officials with a convenient channel for laundering their ill-gotten gains abroad, says Steve Vickers, who runs his own, Hong Kong–based corporate intelligence, security and risk mitigation consulting firm, Steve Vickers & Associates.

Macau remains the world’s casino capital. Last year’s gaming revenue of $44 billion was more than seven times larger than Las Vegas’s $6 billion, according to Fitch. And although Macau’s revenue will continue to fall for some time to come, experts say, that doesn’t mean capital flight will stop. “China’s financial system is oiled by corruption,” says Andrew Collier, a former president of Bank of China International in the U.S. who now runs a boutique firm, Orient Capital Research, in Hong Kong. “As the leadership focuses on stolen funds, many officials are finding themselves under the spotlight. They would rather take their money out of the country than wait for what could be a dramatic confrontation with Beijing’s anticorruption teams.”

Collier says companies and individuals “are increasingly using false overseas service payments to move money offshore.” He says the service deficit could double, to $400 billion, in 2015 from $198 billion in 2014. “There are other routes that also may be available to the wealthy,” Collier adds.

THE ANTICORRUPTION CAMPAIGN has touched foreign companies operating in China. In September 2014, British pharmaceuticals giant GlaxoSmithKline agreed to pay a 3 billion-yuan fine to end a 15-month investigation into the bribing of doctors, which allegedly took place as part of a national marketing campaign to boost sales. Mark Reilly, GSK’s former top executive in China, pleaded guilty to bribery-related charges and was deported to the U.K. after receiving a suspended three-year prison sentence. The U.S. government has been looking into allegations that JPMorgan Chase & Co. hired the children of senior officials to gain favorable access to the Chinese market.

Foreign investors in China need to protect their interests by assessing their exposure to various patronage networks, which can stretch further than expected, Vickers says. Foreign companies can suffer a serious hit to their businesses if their “political sponsors” are imprisoned or no longer able to help, he says. A climate of uncertainty created by the crackdown is dampening decision making by government officials and Chinese businesses, he adds.

“The campaign is without precedent in recent Chinese history and presents real risks to foreign businesses, as it is rooting out long-standing patronage networks, altering accepted working practices and dampening sentiment in key markets,” Vickers says. “The campaign is changing the business environment, turning previously acceptable forms of behavior into major liabilities.”

The risks to companies can extend to their home markets, as accusations in China can prompt mirror investigations under the U.S. Foreign Corrupt Practices Act or the U.K.’s Bribery Act. In December, Avon Products paid $135 million in fines to end a six-year U.S. investigation after admitting that its Chinese subsidiary bribed officials with Gucci handbags, foreign travel and cash to obtain licenses to sell directly to Chinese consumers.

“Many multinationals today are caught between commercial challenges in emerging markets and aggressive regulators back home who are incentivized to initiate investigations that allow them to extract large financial penalties,” says William McGovern, a Hong Kong–based partner at Kobre & Kim, an international law firm headquartered in New York.

The risks for global investors are amplified by a lack of transparency in the anticorruption campaign. The Communist Party’s Discipline Commission can detain any of the party’s 80 million members for six months before deciding whether to expel them from the party. If it does, only then are the suspected criminals handed over to the civil legal system for trial. “The commission’s verdict forms the basis for the prosecutor’s charges, and since the conviction rate is 99 percent, it is clear that the secretive and unaccountable body decides the accused’s fate,” says Trusted Sources’ Fenby.

The plight of Taiwanese conglomerate Core Pacific Group highlights the risks facing foreign companies in China. The company is building a $120 million shopping mall in Yangzhou, in Jiangsu province, and Discipline Commission investigators are holding it liable for $40 million in back payments related to the acquisition of land for the project. Executives at Taipei-based Core Pacific argue that the liability should be covered by the city of Yangzhou under the contract they signed with the local government. But Discipline Commission officials say the contract is null and void because it was signed by a former Yangzhou mayor, Ji Jianye, who was found guilty of corruption for taking 20 million yuan in bribes from the developers of various projects. On April 15, Ji was kicked out of the party and sentenced to 15 years in prison.

Company executives are frustrated by the dispute, saying they have been unable to contact Discipline Commission officials directly. “Whenever we tried contacting them, they refused to take our calls or even call us back,” says a senior executive, who asked not to be identified by name for fear of retribution. “They would deal with us through local Yangzhou city officers, who confidentially tell us they disagree with the Discipline Commission’s tactics but must follow orders from Beijing. Dealing with the Discipline Commission is like dealing with a powerful force you can’t see or even approach.”

During the party’s investigation of Ji, all the developers who received approval from him over the years were called in for interrogation. Elliott Sheen, the 37-year-old son of Core Pacific chairman Tony Sheen, who oversaw the Yangzhou project, was not allowed to leave China and return to Taipei even for holidays for much of 2014, during the investigation into Ji. Tony Sheen is a former member of the Central Standing Committee of Taiwan’s ruling party, the Kuomintang, and has met former Chinese president Hu Jintao as part of official delegations from Taiwan. Sheen and his son declined to comment on the case. People close to the company say they believe the Sheens have not been singled out for political reasons but regard their predicament as symptomatic of the heavy-handed approach the Chinese Communist Party is taking with the crackdown.

Despite rising skepticism about the campaign among foreign investors, some China experts say Xi is undertaking broader reforms as part of the government’s anticorruption efforts. Administrative reforms have reduced the number of government approvals and procedures, cutting potential “rent seeking” opportunities for government officials, says Wang Tao, Hong Kong–based head of China economic research at UBS. Reforms in the utility and energy sector have reduced the government’s control of pricing, trimming another potential avenue for corruption, she adds.

“The anticorruption drive has been deeply popular at the grassroot level,” Wang says. “We also think it is long-term beneficial to the economy, as it helps to reduce waste and misallocation of resources, reduce the cost of doing business in China. This will make growth more sustainable.”

Victor Shih, an associate professor of political science at the University of California, San Diego, says it is too early to judge the anticorruption campaign. “I have not seen any survey data, but anecdotally people seem to have a little bit more confidence in the government,” he says. “Officials no longer dare to outright ask for bribes. On the other hand, I don’t think this means the government will become very efficient, because bureaucrats still have incentives to drag their feet and to produce red tape. In fact, lower-­level officials now have no incentive to take any kind of risk to approve anything experimental, which can be bad.”

Although the anticorruption campaign’s chief enforcer, Politburo Standing Committee member Wang Qishan, has stated that the campaign will go on “forever,” China experts expect it to wind down in a few years’ time. “We believe the anticorruption campaign will continue as an instrument of governance at least until the next Communist Party Congress, in 2017, but it may stifle initiative and risk taking, not least owing to Xi Jinping’s political drive for ideological conformity,” says Trusted Sources’ Fenby. •

Follow Allen Cheng on Twitter at @acheng87.

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