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Our last post touched on warnings of market volatility, uttered prior to the sell-off, by high-ranking officials with authority and credibility among Chinese financial policy-makers. To what extent was the sell-off at 3000, immediately upon the return from the Lunar holidays, triggered by official movement? And the evidence for such a claim? None but rumor on the Chinese bulletin boards. And yet, given pervasive Chinese state involvement in all facets of big money, I do not believe it can be discounted.

Just think of the timing -- massive amounts of non-tradable state shares have come on the market over the past two years. [Read prior posts on this subject here and here.] Shouldn't this have dampened share prices across the board in an already weakened market? Instead, shares have rocketed. Now that the process of making those shares marketable has more or less completed, officialdom proclaims to throw the burden of loss upon the "irrational exuberance" of the hair-dresser cum day trader -- just before a major correction. And when shares finally stabilize, the converted shares will retain apparent value so greatly above what the market may have commanded without the general market rise. Oh, gee whiz, I should be ashamed of myself, shouldn't I... Is that a conspiracy theory or what?

Stephen Green, about as accurate and knowledgeable a reader of the Chinese financial tea leaves as one finds, on the rumors of state involvement in price stabilization after the sell-off:

"There were some reports of state buying -- I don't know how reliable those are. But it's also possible people may have decided 9 percent in one day was too much and they are still bullish on stocks," said Stephen Green, senior economist at Standard Chartered Bank in Shanghai. "I don't think anyone really knows where we go from here."

Down, perhaps? As low as 2300? [In Chinese.] How low is this thing "supposed" to go?

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Prepared Remarks by Treasury Secretary Henry M. Paulson, Jr. on the Growth and Future of China's Financial Markets [Here's one take on it.]

Shanghai, China – Thank you very much. I am very happy to be here in Shanghai, and I appreciate your warm welcome. In December, I was in Beijing for the first meeting of the U.S.-China Strategic Economic Dialogue. After that meeting, I decided that I should return to Shanghai to speak about the growth and the future of China's financial markets.

In my travels here over the last 15 years, I have seen this city grow to be a cosmopolitan center of finance and culture. Shanghai has in many ways come to symbolize the economic dynamism of China. It is an example of China's emergence as an important participant in the global economy. So it is only fitting that I am making this visit against the backdrop of a global economy, which over the last several years has been as strong as any I have seen during my business lifetime – an economy that has been characterized by strong growth, low inflation, and high levels of liquidity.

As China has grown, the relationship between the United States and China has become more important than ever before. We welcome China's growth and integration into the world economy – it benefits the Chinese people, and the people of the world. Today, China is transitioning from a planned economy to a market-driven economy and there is no doubt that this process will continue for a number of years. But because of its size and its role in world markets, China is already a global economic leader and deserves to be recognized as a leader. And with leadership comes responsibility. Decisions about the pace and shape of your economic reforms, as well as policies relating to energy and the environment, affect nations around the world.

Since the economic relationship between our two countries is an important part of the overall relationship, I have focused intensely on China from the day I became Treasury Secretary. To manage the economic relationship between our two nations on a long-term basis, President Bush and President Hu established the Strategic Economic Dialogue. We were very pleased with our first meeting in Beijing in December, and will meet again in Washington in May. Because the U.S. and China share many strategic economic interests, I am confident the SED will help us make progress on fundamental long-term structural economic issues, as well as on very pressing short-term issues.

The economic relations between our two nations are vital to the future of the global economy. And I believe we share many of the same goals – the policies of openness and market principles that the United States advocates are similar to those that China's leaders have embraced to bring balanced, harmonious growth to your nation. As I have said many times, our policy disagreements are not about the direction of change, but about the pace of change. It is worth noting that over the last five years, the U.S. and China accounted for over 50 percent of global growth. Make no mistake about it, China's continued economic success is not only vitally important to the people of China, but also to the rest of the world.

China ups the pressure on star quarterback Hank Paulson by showing him he shouldn't count on the Chinese putting most of their eggs in the U.S. treasuries basket.

Finance Minister Jin Renqing:

''We can achieve more profit from the investments,'' Jin said at a news conference. ''We are now preparing the organization of this new corporation.''

A fine bit of statecraft, if nothing else, as the sale of any great amount of China's holdings of US treasuries -- a tremendous sum -- would very likely lead to its massive devaluation. Of course, Paulson understands that the Chinese are handcuffed as well. But how tightly? [In Chinese.]

UPDATE (March 16, 2007):

Wen Jia-bao in yesterday's press conference stated:

“I can assure you that by instituting such a foreign exchange reserve investment company, it will not have any adverse impact on US dollar-denominated assets,”

One hand (Jin) slaps the face, while the other (Wen) caresses it.

This is a characteristically Chinese technique of controlling an adversary at close quarters. I have observed that, in business, it does not issue from a perception of strength. Instead, one who perceives himself to be weaker attempts to keep the threatening party off balance with a display of contradictory ideas, showing both the ability to harm the stronger and the inclination to assist him.

Executives jockeying for territory and promotion use it against each other, as will a more than usually insecure manager with his staff. The statements made and actions taken by the weaker party in his own defense are themselves of little value.

[Editor's Note: We are grateful to Paul Jones for today's post on China's new franchise regulation, in which he delineates the differences between it and previous franchise regulations. Mr. Jones is a franchise and intellectual property lawyer in Toronto, Canada, and a Chinese speaker. The international law program at John Hopkins University currently uses his paper on the interpretation of the previous Commercial Franchise Measures to illustrate the differences between common law and civil law. He may be contacted at this address.]

China has just released a new franchise Regulation (商业特许经营管理条例) to come into effect on May 1, 2007. It replaces the existing Commercial Franchise Measures (商业特许经营管理办法) that came into effect on February 1, 2005. [In Chinese.] The new regulation (hereinafter, "Regulation") is significantly different from previous Measures that had caused considerable concern amongst international franchisors and led to intervention by the U.S. Trade Representative.

The Regulation tries to balance a variety of international and domestic concerns and there is some question as to whether it manages to satisfy the needs within China for intervention to prevent fraud and abuse, and the international desire for easier access to the China market. The new Regulation has clarified that it will apply to all franchises operations in China equally. The Measures had a separate chapter (第七章外商投资企业的特别规定) that had requirements for Foreign Invested Enterprises (FIE), but it was not clear from the text what triggered the requirement to set up an FIE, and some questioned whether these separate requirements were in line with China’s WTO commitments. The Regulation has eliminated this issue by eliminating separate requirements for FIEs.

Another international concern was the requirement for a franchisor to have owned and operated two locations in China for at least one year. The requirement to have owned and operated two locations has been retained in the Regulation, but the requirement that they be in China has been removed. Foreign franchisors that have met this requirement in their home market will now be eligible to franchise in China.

But there are also restrictions to try to curb the rampant fraud in the domestic market for franchises. The State Council’s Legislative Affairs Office and the Ministry of Commerce (国务院法制办、商务部) also released a set of questions and answers on the new Regulation. [In Chinese.] They describe the Regulation as having five aspects that are designed to deal with problems in the franchise market.

Firstly, only corporations and other legal entities can be a franchisor. Individuals may not be franchisors. Franchisors must have a mature business model and have the resources to provide support.

Secondly, franchisors must disclose sufficient information for the franchisee to make a suitable investment decision. This information must be accurate, complete and not omit related information. Previously, U.S. franchise lawyers had complained strongly about the vagueness of the unfamiliar civil law drafting in this section. The wording has been changed, but the obligation to disclose all material facts may still arise out of Article 42 of the Contract Law (合同法). Article 42 requires that parties negotiate a contract in good faith and not conceal “key” or “material” facts (重要事实). It is based on similar provisions now codified in Germany’s Bürgerliches Gesetzbuch. German courts have relied on the equivalent law to impose an obligation of pre-contractual disclosure on franchisors in several cases. The questions and answers clearly indicate that the General Principles of the Civil Law (中华人民共和国民法通则) and the Contract Law continue to govern franchising.

Thirdly, franchisors must now register within 15 days of signing their first franchise agreement in China. The Regulation specifies certain documents that must be submitted for registration, such as a marketing plan, but does not specify the fees, if any.

Fourthly, the Regulation stipulates a number of items that must be in a standard form franchise agreement, including an unspecified cooling-off period.

And finally, the Regulation sets certain standards for the relationship, such as requiring the franchisor’s approval for the transfer of locations and requiring the franchisee to protect the franchisor’s commercial secrets.

The Regulation will make it easier for foreign firms to enter the China market, but the greater concern will continue to be not the laws and the courts, but the lack of more developed “rule of law” culture, or as the State Council calls it, the “chaotic market conditions” (市场秩序较为混乱).

Americans must be working from a script because yet another fellow is auditioning for the same part:

Chairman Guy Halgren of Sheppard, Mullin, Richter & Hampton on plans for a China office:

"It's a giant legal market and we're getting in the middle of it," said Chairman Guy Halgren, who announced last week that the firm had opened a Shanghai office as expected.

A giant legal market? China will never become a giant legal market. China means some additional business for American firms whose clients do business there, but, unlike shoe manufacturing, law will not grow to American-like proportions over time just because an impoverished population has finally made productive use of its human capital.

Chinese businesses -- the market law firms would hope to target -- are unreachable, given the prohibition against legal practice by foreigners. One must also doubt whether Chinese would consider a foreigner competent, as compared to a native-born and educated Chinese, to represent them in China. But even more significantly, Chinese businessmen consider law to be of little importance: it is an afterthought to be avoided always, unless it is impossible to do so. Ask a Chinese businessman to be proactive about legal matters and you will get a laugh.

And besides, Chinese do not and never will pay American rates. American companies in China generally do. (And I've heard more than one rumor of large discounts given by law firms to American clients in China because of the heated competition.) They, the Americans, appear to be Sheppard's target, just as they are everyone else's.

Tell me again how many American firms have offices in China now? 60? 90? (Ever increasing, it seems.) And selling legal services to a few thousand American multi-nationals with sufficient business. Just how many apples can you fit into one pie?

We represent almost every major film studio in the country, and studios are making major investments in China," Halgren said. The firm will ideally work on intellectual property issues related to distribution in Asia, particularly China, he said.

Okay, IP in China is a big deal for Americans. But it's not for Chinese. Is there a market for IP work for anyone but Americans? And lest we forget, the American clients a firm goes over with may jump ship, stranding attorneys with an office, little business and little idea how to market. Attorneys in China who read this know what I mean. So, then, quo vadis, Sheppard?

It appears as if the ex-Coudert people who landed at Sheppard have managed to convince the firm to open an office, perhaps simply to retain current clients. Given the Coudert contacts in Chinese government (if they still have them), perhaps Sheppard may even capture one or two large Chinese clients whose American business interests they might represent. But it doesn't shake up to be the giant legal market pie in the sky. Of course, I hope otherwise for the firm.

Mr. Holmgren stated:

We're going to establish ourselves and show we have the best product. Let the best person win.

To this curious expression of loyalty to market forces (whatever that may mean) where non-market forces reign (government influence, personal networks, a belief in fortune), one can only wish the best.

Just a quickie today -- this superb article on Vinson & Elkins, its Chinese government clients and the argument to change the Commerce Department's countervailing duty policy. [Site registration required - here.]

More American critics of Chinese intransigence here and here. More experts are mustered to plead a case believed persuasive, but not resulting in hoped-for change. And none should be expected, as I've argued many times on this blog, unless Chinese decision makers find change to be absolutely necessary and directly advantageous to them. Constant reports (for years) of what top level Americans are unable to accomplish has become a mainstay of traditional financial news, valuable to historical researchers 50 years from now and to a few policy makers in marbled halls. But otherwise of little value.

Lest we not forget the baby's rhyme, remember, please, that the wolf never could blow down the brick house of the last little pig. It was too strongly built to fall to the hot air with which the wolf blew down weaker structures. Why didn't the wolf offer the pig a bucket of slops to induce him out into the open? The pig was too smart. Why didn't he use a bulldozer? Because wolfie wanted to eat the piggy alive. Somewhere in the middle of these extremes lies a method involving a strong arm, but one must be willing to use it.

Quite a few years ago, I was interviewed for a position in Beijing representing a large Western industrial organization, which, it turned out, hoped to significantly influence Chinese government policy. I suggested it was not possible to move Chinese policy as far as the organization wished. (I hope, however, their choice for the position has done what I didn't think quite possible.) During our talks, I asked what the organization believed it could offer to benefit Chinese policy makers and, as well, what strength it possessed that would allow it to put substantial pressure on them, forcing change. As you have likely guessed by now, the latter is an essential part of achieving a goal in China when contrary individuals possess as much or greater authority than you. It appeared to me that the organization had not even considered these fundamentals of the equation. Needless to say, we were not a match.

Benefits are easy for Americans to think up. We really do like to help out. But this is different. Where is the stick and who is going to wield it?

[UPDATE: Has the administration decided to up the ante?]

Teddy Roosevelt advised that it was useful to talk softly and carry a big stick. But people have to believe you'll use it.

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