China's Money Sleuth

Auditor-general Li Jinhua, known as ‘Iron Face,’ says it will take a generation to stamp out corruption at the country’s banking behemoths

China’s financial watchdog, Auditor-general Li Jinhua, has a mixed message for the foreign investors who’ve spent $74 billion on shares in his country’s banks since 2001. The good news, says the man nicknamed “Iron Face” for his perceived incorruptibility and because he rarely smiles in public, is that his campaign against corruption, embezzlement and waste has helped to improve banking practices in the past seven years. The bad news: It may be a couple of decades more before the banks’ management is acceptable by Western standards.

“It would be naive to think that once these state-owned banks are listed publicly they won’t suffer any operational prob- lems,” says Li, 63, whose position at the head of China’s Nation- al Audit Office gives him cabinet minister rank. “It might take a whole generation to get these banks into reasonable shape.”

After three decades of economic growth averaging 10 percent a year, China’s boom is still precarious, as the 9.2 percent plunge in mainland Chinese shares on Feb. 27, the beginning of a $3.3 trillion global stock selloff, shows. China’s financial institutions hold $161 billion of bad loans, according to the country’s central bank. Since 1999, Li and his 80,000 auditors have uncovered $6.4 billion worth of irregularities at state-owned banks.

While Li is making financial institutions his prior- ity, he’s also scrutinizing the accounts of China’s other big state-owned enterprises. And he and his team are keeping an eye on the $34 billion of spending on next year’s Olympic Games in Beijing; construction projects such as the $22 billion Three Gorges Dam, the world’s biggest hy- droelectric project; government departments; and even the Communist Party itself.

Li doesn’t flinch at taking on China’s biggest state-owned companies. On his to-audit list this year are China Everbright Bank, which is controlled by the Cabinet; state oil company China Petrochemical Corp., or Sinopec; and insurers China Re- insurance Co. and PICC Holding Co. He also plans to view the books of the four asset management companies China set up in 1999 to clean up the big banks’ nonperforming loans and to audit four unidentified heads of government-controlled companies.

“When pressure comes on in China, it’s serious pressure,” says Allen Blewitt, 55, chief executive officer of the London- based Association of Chartered and Certified Accountants. “A lesser person would have crumbled. He’s vigorous, inde- pendent and outspoken.”

Li says one of his most-effective weapons is exposing wrongdoers publicly. “We try to make everything transpar- ent,” he says. “Sunshine cures diseases.” Those sent to trial face more than shame: The country’s courts can impose life prison sentences or even the death penalty for corruption.

The ills are widespread, Li says. The National Audit Office estimates that his auditors have exposed 1.74 trillion yuan ($225 billion) in mis- spent funds over the past 20 years. In 2006 alone, audits of 7,000 state-owned companies uncovered 1 billion yuan worth of abuses, Li said at a meeting of 200 of his top auditors in Beijing in January. “The numbers Li quotes are scary,” says Blewitt, whose group awarded the auditor-general its global prize for achievement last year. “On those figures, governments would fall in a Western system.”

In a two-hour interview conducted in Chinese, Li says his team unearthed finan- cial discrepancies that ultimately led to the downfall of one of China’s leading bankers, Liu Jinbao, and one of the country’s most- powerful politicians, Shanghai Communist Party chief Chen Liangyu, a member of the Politburo, the country’s highest policy-making body. Li’s auditors were also called in to investigate Liu Zhihua, a vice mayor of Beijing in charge of Olympic construction.

Liu Jinbao, 54, former CEO of Bank of China’s publicly listed Hong Kong unit, was given a suspended death sentence in 2005 for embezzling $1.8 million and for being unable to account for almost $2 million in personal assets. Shanghai Party Secretary Chen, 59, who’s accused of misusing pension funds, and Beijing Vice Mayor Liu, who is said by the official news agency, Xinhua, to have taken millions of yuan in bribes, were both fired by the Communist Party Central Committee. Chen and Liu could not be reached for comment.

Li also cited two other top-level bank corruption cases as examples of the type of graft his auditors have to fight. They involved Zhang Enzhao, 60, former CEO of China Construction Bank Corp., who was jailed in November for 15 years for accept- ing 4.9 million yuan in bribes, and Wang Xuebing, 57, who had been president of both Bank of China and China Construction Bank and was sentenced to 12 years in jail in 2003 for taking what Xinhua described as millions of yuan in bribes.

China’s citizens back Li’s efforts to root out corruption. “I think he’s a hero,” says Fu Jie, 40, an office manager in Beijing. “Given the pressure he must be under, he’s shown a lot of courage.” The wealth gap between the boom- ing cities of eastern China and the countryside—where 200 million people still live on less than $1 a day—has widened, according to the World Bank. Last year, there were about 72,000 protests involving more than 100 people, accord- ing to the party’s Central Committee for Public Security.

Still, in a one-party state, it can be hard to differentiate between a genuine corruption drive and a political purge, says May Yan, a Hong Kong–based analyst at Moody’s Investors Service. “Li seems to be one of the objective ones, but the politics are always difficult to see through,” she says.

Graft is so bad it could even destabilize China’s 58-year-old communist regime, says Steve Vickers, CEO of International Risk Ltd., a Hong Kong–based consulting firm. “If corruption continues unchecked, it’s going to bring the roof down on this government,” Vickers says.

Transparency International, a Berlin- based advocacy group, ranks China as second only to India in its annual bribe payers’ index. Almost 100,000 party members were disciplined last year for bribe taking and other rule breaches, the party announced in February.

Looking relaxed in a brown jacket over a gray sports shirt, Li says he’s undeterred by political pressures. “We have experienced resistance from auditees because we have made many government departments’ private interests suffer,” says Li, who’s 5 feet 6 inches (1.7 meters) tall. “I am not scared. The constitution has given me the power to do what I have done.”

Li says his office forwards to China’s courts about 10 percent of the 2,500 corruption cases they deal with each year. Bank employees also could be caught and reported to the police by the China Banking Regulatory Commission, a financial watchdog established in 2003 under the leadership of former Bank

of China Chairman Liu Mingkang. At the auditors’ meeting in Janu- ary, Li said his employees last year had uncovered 37 illegal acts involving 55 people at Bank of China, China Merchants Bank Co. and Shanghai-based Bank of Communications Ltd.—all of which are list- ed on the Hong Kong Stock Exchange. Li’s office declined to disclose further details. The three banks say they haven’t yet been officially notified of the auditor-general’s

findings, so they say they can’t comment.

The misappropriation of vast amounts of money from China’s banks has polarized investors, says Arthur Lau, who helps man- age $1 trillion at JF Asset Management Ltd., a unit of JPMorgan Asset Manage- ment, in Hong Kong. “There are two types of investor,” says Lau, who declined to identify his holdings. “Some will stay away from this sector because of the risk and also the valuation. But others can’t get enough of it. I hope and hope there will be fewer and fewer of these incidents going for- ward, but the accounting system is still not up to par, and you may see some anomalies.”

So far, the risk has paid off for investors prepared to bet on China’s leaky banks. Shares of China’s biggest lender, Beijing-based industrial & Commercial Bank of China Ltd., in which Goldman Sachs Group Inc., Allianz SE and American Express Co. have a combined 10 per- cent stake, soared 38.4 percent to 4.25 Hong Kong dollars on March 7, from HK$3.07 on Oct. 26, when the company sold US$22 billion of shares. Industrial & Commercial Bank is now the world’s 10th-biggest company by market value, according to data compiled by Bloomberg. Since their IPOs, beginning in mid-2005, shares of Bank of China have risen 25 percent; Bank of Communications, 200 percent; and China Construction, 80 percent, as of March 7.

Li has traveled a bumpy road on his journey to cabinet minister and custodian of China’s vulnerable financial assets. He was born in Rudong, a coastal township of 60,000 in Jiangsu province, 100 kilometers (60 miles) north of Shanghai, in 1943, when most of China was under Japanese occupation and much of the rest was controlled by the Nationalist Party government of Chiang Kai-shek.

The son of an impoverished pastry cook, Li says his for- tunes changed when Mao Zedong’s Communist Party came to power in 1949, enabling him to finish his schooling with government support.

In 1963, Li won a place at Beijing’s elite Central Institute of Finance and Economics, later renamed the Central University of Finance and Economics. Among his contempo- raries were Jin Renqing, China’s current finance minister, and Dai Xianglong, former People’s Bank of China governor and now mayor of Tianjin, China’s fourth-largest city.

Even amid such company, Li stood out, says Wang Pei- zhen, 89, who taught finance at the time and still gives tuto- rials at the university. “It wasn’t easy to get into this institute,” she says. “It picked 100 students from among tens of thou- sands. And then, every year, the faculty would pick seven or eight of the most-outstanding students in the graduate class to stay behind as teaching staff. Li was one of those.”

Wang recalls him turning up at the start of school in a gray cotton jacket, which he wore every day. “He was among the most down-to-earth students I had that year,” she says. “He had no political backing—none at all. He gained what he did purely through hard work.”

Wang says that in 1966, as the Cultural Revolution loomed, some students began to turn on her and other teachers. Li, who had joined the party in 1965, never took part, she says.

The Cultural Revolution prevented Li from taking up the teaching post in Beijing, Wang says. After graduating in the fall of 1966 with the highest grade of “excellent” (the others were “good,” “fair” and “fail”), Li was dispatched to the mountainous Shaanxi province, 1,000 kilometers away, to teach at the North-

west Institute of Finance and Economics.

In 1971, with the Cultural Revolution still raging, he became an accountant at aircraft factory number 572 in Shaanxi, where he worked for the next 14 years, rising to become the factory’s director. In 1978, two years after Mao’s death, Deng Xiaoping came to power in China. Deng began introducing a free-market economy, helping spark China’s current economic boom. In 1983, Deng also reintroduced the government audits that Mao had allowed to lapse. Auditing is a Chinese tradition going back 3,000 years to the Western Zhou dynasty.

In 1985, Li became deputy auditor general—a job he says he was given because of his finance training. At the time, he says, he knew little about government auditing. “Now I know this profession much better,” he says.

So much so that in 1998, Premier Zhu Rongji appointed Li head of the National Audit Office. Since then, Li has been raising its public profile. That year, it held a rare press conference. In 1999, Li published parts of his report to the standing committee of the National People’s Congress, China’s parliament. In 2004,

in a China Central Television poll, viewers voted him the country’s economic personality of the year, beating People’s Bank of China Governor Zhou Xiaochuan and Yang Yuanqing, then CEO of Lenovo Group Ltd., the technology company that had just acquired the personal computer business of International Business Machines Corp.

During the live presentation, Li’s iron mask slipped. He wept as he told viewers he didn’t deserve the award because he could have achieved nothing without his 80,000-strong team spread across China. “The television channel showed a film of how difficult some of the auditors’ working conditions were,” Li recalls. “There was one whose mother was dying at home, but the auditor was still working in the field. I was very much moved by that.”

Li, who keeps a miniature, red hammer-and-sickle party flag on his file-stacked desk and who does calligraphy in his spare time, says he’s immune to political pressure. “I am a person who always practices in accord with the law and sticks to principles,” says Li, whose office in Beijing’s Xicheng district is half an hour’s drive from Zhongnanhai, the walled compound adjacent to the Forbidden City where China’s political leaders live. “No one can tell me what to do,” Li says.

Among his targets are other ministries. Since 1999, Li has exposed officials of the National Development and Reform Commission, China’s powerful planning ministry, for diverting funds to buy 9.6 million yuan worth of com- mercial housing. He’s also uncovered evidence that the sports ministry was doing the same thing with funds intended for the Olympics, according to Xinhua. The roads authority, Xinhua says, spent $205 million on bonuses, conferences and other indulgences when the money should have gone to farmers for land requisition. Spokesmen for the sports ministry and the Minis- try of Communications, which oversees roads, declined to comment.

The planning commission didn’t return phone calls seeking comment. Li’s January report said he and his auditors had uncovered 5.4 billion yuan of state budget funds misused by 48 central government departments and their affiliates in 2006. He added that his team had audited 34,000 government and party officials and handed over 116 suspects to judicial departments.

The government knows there would be international repercussions if it were to try to rein in Li, says Blewitt of the accountants’ group. “If someone started sit- ting on the auditor-general, it would destroy investor confidence,” he says. “At the highest level, they have decided that they have got to give this guy his head.”

Even when China’s state-owned enter- prises are listed on the world’s stock ex- changes, Li and his team still conduct audits. That’s because, in most cases, the ‘He’s vigorous, indepen- dent and outspoken,’ a Western accountant says of Li. majority of the shares remain in Chinese government hands, Li says. That’s good news for foreign investors, says Templeton Asset Management Ltd.’s Mark Mobius, who oversees $30 billion in emerging-market shares, including Chinese state-owned stocks. “We feel a little more comfortable with the Chinese state-owned companies since not only do you have independent auditors look- ing at the books, but you also have the government investigative and monitoring agencies looking at them,” says Mobius, who’s based in Singapore. “It is wonderful what they are doing.”

Mobius says he’s not worried by Li’s prediction that it could take a generation to clean up the banks. “We know it will be a continuous battle,” he says.

China’s banks began running up hundreds of billions of dollars of bad loans in the 1980s, in large part because the government forced them to lend money to prop up insolvent state enterprises. Local Communist Party committees approved the appointment of branch managers. Risk management and fraud detection were nonexistent.

In 1998, then President Jiang Zemin and Premier Zhu de- cided to clean up the banks as part of a plan to sell shares and at- tract Western strategic investors. That year, Li says, his audit team examined two of the four biggest banks. They found that of 600 billion yuan of bad loans, only 58 percent could be blamed on inherent business risk. “The remain- ing 42 percent was due to the improper management of the banks,” Li says.

Since then, the government has spent 3.5 trillion yuan bailing out and recapitalizing the banks, according to New York–based rating company Moody’s Investors Service. Starting in 2001, China raised $21.4 billion by selling minority stakes in some banks to international financial institutions such as Bank of America Corp., HSBC Holdings Plc, Royal Bank of Scotland Group Plc, UBS AG and Goldman Sachs, as well as Singapore government–owned investment company Temasek Holdings Pte. Since 2002, Chinese banks have sold $52.4 billion of shares in public offerings.

Wang Zhaowen, Bank of China’s Beijing-based spokesman, says earlier fraud and embezzlement scandals have hurt his bank’s image.

The biggest to come to light so far: embezzlement over a nine-year period from 1992 to 2001 of $482 million from a Bank of China branch in Kaiping, a small town in Guangdong province, about 110 kilometers west of Hong Kong. Three Kaiping managers were arrested in the U.S. in 2002 and 2004. One, Yu Zhendong, 44, pleaded guilty to racketeering and was returned to China, where he was jailed for 12 years, according to Xinhua. The two others, Xu Chaofan and Xu Guojun, remain in jail in Las Vegas, awaiting trial on charges of racketeering, money laun- dering and visa fraud. In a jailhouse interview with Bloomberg News, they denied the charges and claimed they were framed. In January, a Hong Kong couple, Hui Yat-Sing and Wong Suet-Mui, both 48, were convicted by a Hong Kong court of money laundering in connection with the case. The pair, who denied the charges and planned to appeal, were jailed for six and a half years.

Bank of China wrote off the $482 million, according to its share sale prospectus. The 2003 arrest of Liu Jinbao happened after the 2002 listing of Bank of China’s Hong Kong unit, which Liu pre- sided over, but before the sale of shares in the mainland parent.

“It really affected the Bank of China brand,” spokesman Wang, 53, says. “But after our banking reform and restructuring, we have plugged the holes in our system and installed strict accountability, so that should anyone think of committing these crimes, they really have to consider the costs of doing so.”

One of the National Audit Office’s longest-running assignments has been going through the books of the Beijing Organizing Committee for the 2008 Olympic Games and the government bodies and companies that have been building the stadiums and other construction projects that are trans- forming China’s capital.

The Standing Committee of the Beijing Municipal People’s Congress last June fired Liu Zhihua, the Beijing deputy mayor in charge of overseeing major Olympic construction, and stripped him of his party membership for taking millions of yuan in bribes, “depraved behavior” and obtaining project contracts for his mistress, according to Xin- hua. Li says his investigations so far have found that Liu’s alleged crimes had nothing to do with the Games and that Olympic organizers are in the clear. Liu could not be reached for comment.

Li, who turns 65 in July 2008, says he won’t start thinking about retirement until then. That means he could be around to audit the final receipts after the Olympic Games end in August of that year.

Until then, those who cross paths with Li—even old friends had better keep their books in order. Guo Yucheng, head of the finance and economic secretariat at Li’s alma mater, still recalls the day six years ago when Li was invited back to give a speech. After- ward, instead of sending a note of thanks for the invitation, Li sent his auditors in to check the books, as part of a broader nationwide audit of educational institutions. “To everybody’s surprise, the poorest department was the department of accounting,” Li says with one of the broad smiles he never shows in public. For once, the iron-faced auditor didn’t find any wrongdoing.

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