At the end of October the New York Times published an article concerning the “hidden wealth” of China’s prime minister Wen Jiabao’s family. The story provides an excellent example of how business is done in China specifically and in emerging markets in general

At the end of October the New York Times caused a small sensation in an article it published concerning the “hidden wealth” of China’s prime minister Wen Jiabao’s family.  The article alleged that Wen’s family had amassed a fortune of over $2.7 billion. Two Hong Kong lawyers purporting to represent the family denied the existence of any such wealth and threatened to sue the Times. The Wen story is interesting, but why should investors care? For the simple reason that the story provides an excellent example of how business is done in China specifically and in emerging markets in general.

The first point to understand about the Wen story is the fact that elite power in emerging markets has been institutionalized. Certainly developed countries have their own aristocracies which are often based around the best educational institutions, but they are nowhere near as extensive or pervasive. In China the elites are based on relationships within the Chinese Communist Party. The party favours its own, especially the descendants of the founders of the People’s Republic of China. These individuals are known as taizidang ("princelings"). They include not only children, but often members of the extended family including wives, siblings, uncles and even in-laws. In fact the disgraced Bo Xilai’s father, Bo Yibo—one of the “Eight Immortals”, supported a process where only one member of each powerful clan could enter politics, leaving the other relatives free to make money.

Family connections in China are especially important and not only for cultural reasons. In countries where law might be given lip service, the only way to enforce bargains is to do business with people you trust. The people you trust are those with whom you have the strongest relationships—often family members, but could include members of the party, members of the same religion, sect or caste. What makes the process particularly prevalent in China is the extent to which the government controls the country’s economy. More unrestricted government power provides more opportunities to amass riches. So club membership goes way beyond connections to get in an elite school or a good job. It allows members to control entire industries.

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Wen’s wife, Zhang Beili, provides an excellent example. Zhang Beili’s specialty was jewellery and gemstones. So with her husband’s power and connections, she was able to create two powerful state entities create the National Gemstone Testing Center in Beijing, and the Shanghai Diamond Exchange. Both of these institutions were the official gate-keepers. They formulated rules that required any diamond seller to buy certificates of authenticity for any diamond sold in China, from their government-run testing centre.

Under these rules, if you wanted to get into the jewellery or diamond business in China, you had to deal with Ms Zhang. So Ms Zhang became quite popular with the likes of Cartier or De Beers, who would happily work with the family to have the privilege of entering a growing market.

Maintaining control over the rules also allowed princelings to take advantage of bits of state property as they were privatized. It was a tremendous advantage to know which companies would be privatized so that the relatives could get in early and often purchase dominant positions. Once the privatization had gone through, the new private owners could be sure that competition would be limited.

The most important competitive advantage for the well-placed in China was and is access to capital. State-owned banks do not lend to just any qualified borrower, but only to the largest and best connected. Listing on exchanges is also restricted.

But why is this a problem? Certainly connections help in every market. The reason is has to do with certainty and transparency. Any investment is a bet on the future. If the legal and regulatory process is dependent upon connections it can easily change. Rich businessmen and foreign companies try to outdo one another to curry the favour of the connected. But the connected as rent seekers are always looking for more. For example several princelings including George and Jeffrey Li, Wilson Feng, Jeffrey Zeng, and Li Tong have all left their foreign banking employers and set up their own investment houses. If you have the power, why share?

The other problem is that without legal protections, property rights and power can disappear. When Deng Xiaoping died in February 1997, his son and son-in-law became subject of an investigation. When Hu Jintao became president in 2003, took revenge on his predecessor, Jiang Zemin’s cronies in Shanghai.

But the real problem is transparency. If scare resources are allocated according to connections and the relationships are unclear, the allocations cannot be efficient. So the fact that a lot of wealth ended up with Wen’s family means that much of that same wealth was diverted from the Chinese people or more importantly, investors.

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(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected].)