Download Seven Troubling Trends Table of Contents Preface: Then and Now

Seven Troubling Trends
Table of Contents
Preface: Then and Now
Introduction: China’s Lost Chances and its “Unthinkable” Future
China’s Amazing Growth Story
China’s Elite Are Worried- Should You Be?
Storm Clouds are Gathering
The Seven Domino Trends Confronting China’s Leadership
Domino Trend #1: Investment Returns Are Falling While Economy
Slows
Domino Trend #2: Property Bubble is Popping
Domino Trend #3: Wages and Cost Soaring=Low Margin Exports &
Manufacturing are Losing Edge
Domino Trend #4: China Calculus of European & American
Multinationals Changing Fast
Domino Trend #5: China’s Primitive & Complicated Financial System
is Leaking Oil
Domino Trend #6: Hopes of Consumer Boom Are Fading
Domino Trend #7: Endemic High Level Corruption is Sparking Mass
Protests
The Endgame: China’s Bicycle Economy Running into a Storm of
Slower Growth and Rising Corruption and Protests
Risk Management & Recommendations
China in Charts
Preface: Then and Now
More than two years ago, I wrote the first draft of the “China
Skeptic” report which provided an overview of seven troubling trends
in China that I thought could lead to the collapse of the Chinese
communist regime.
I remember sending the draft to a very respected and influential
publisher. His first words to me when we later met were:
“Carl, you make a very compelling case here but no one will believe
that China could collapse.”
That was then. Now as I look back three years later, the seven
troubling trends outlined in the “China Skeptic” have deepened
beyond even my expectations.
China auto sales fell 3.4% on a year over year basis through June.
Electricity production fell 2.0%, merchandise exports 8.3% and retail
sales 10.5% year-over-year through July.
Industrial activity is weakening. In February, industrial production
growth came in at just 6.8% year-over-year according to March
report from China’s Bureau of Statistics. This is down from a
February 2007 pre-global recession growth rate of 18.5%.
In the U.S., factories are running at roughly 80% of their capacity,
while in China, it stands at 70% according to a Federal Reserve
report from March 18, 2015.
Capital continues to flow out of China at a rate of $35 billion per
week as the elite look for escape hatches.
Debt, both consumer and government, quadrupled since 2007 to
reach $28 trillion. Last month, McKinsey & Company released a
report on global debt levels and noted China’s debt-to-GDP ratio
stands at 282%, higher than America or Germany. These debt
calculations not only include government balances, but also those of
households and non-financial corporations.
Property prices continue to struggle. The latest home prices report
for China’s largest cities shows that 61 out of the 70 major city
centers experienced price declines. The housing market in China
makes up about 25% of the economy.
The pace of foreign direct investment into China is declining as
foreign multinationals pull back and Chinese economic growth slows.
In fact, direct investment by corporations in China in 2014 was less
than that invested in Southeast Asia.
The much-anticipated Chinese consumer economic boom has not
materialized. In the first quarter of 2015, new auto sales in China
actually declined year over year.
China continues to pursue a confrontational foreign policy with its
neighbors, even going to the extent of building artificial islands with
military capabilities in international waters.
The real estate and stock markets continue to be volatile and
manipulated. The latest sharp pullback in the Shanghai index – 30%
in three weeks have rattled investors and the Chinese mandarins
alike.
The Chinese government has responded in typical fashion; banning
short sales and shutting down trading in more than half of stocks
trading on the exchange. China’s own government tried to force
prices higher by purchasing shares in large companies.
While I have gone back to each section and made updates to each
section of this report, I have decided to stand behind my early thesis.
I encourage you to read on and decide for yourself about the future.
“This could be the early stage of a very serious situation,”
Larry Summers, former US Treasury Secretary
Be Very Afraid of The China Bubble
Time Magazine
Introduction:
China’s Lost Chances and its “Unthinkable” Future
I remember the meeting of the Asian Development Bank’s board of
directors in the spring of 1992 very well. Representing the U.S.
during a review of a Chinese finance sector loan, I asked what I
thought was a straightforward question; “Wasn’t it time for China to
begin privatizing state-owned banks and companies?”
After a pregnant pause, the attack from the other board members
began. “Why was America always so impatient?”….. “These things
have to be done slowly and carefully”, and “The Chinese will develop
a privatization plan that suits their needs and culture”.
Well, here we are twenty years later and China remains a semimarket state capitalism model.
One half of Chinese work for the Chinese government or for stateowned or controlled companies. One quarter of state-owned
companies are unprofitable and state-owned companies grab 90% of
bank lending. The top five state-owned banks control 80% of total
bank lending.
China has had so many lost chances.
China had the choice to set itself on a path to sustainable growth but
instead chose a strategy of overdependence on investment and
exports.
China had the choice of balancing growth with protecting the
environment but instead chose growth at all costs.
China had the choice of using trade surpluses to provide a safety net
so that rural Chinese could avoid saving 30% of their household
incomes but instead chose to let reserves grow to $3 trillion.
China had the choice to put in place basic institutions such as an
independent judiciary, a transparent process to transfer power, a
free press and bankruptcy laws to support growth but instead
avoided any reforms that might weaken the authority of party
leaders.
China had the choice to, like Singapore, take a hard line on political
corruption but instead looked the other way as business and politics
became one and the same.
China had the choice to open its markets and become a champion of
free trade but instead chose a policy of state mercantilism welcoming
foreign capital and know-how but protecting access to markets.
I could go on but the point is that all these choices by China have
important consequences. The Chinese like to portray themselves as
patient strategic thinkers looking ahead centuries as others look at
years but the facts dispute this view.
To be blunt, China is now unfortunately set on a path to deep
disappointment, great uncertainty and perhaps upheaval.
This is the inconvenient truth about China that you will likely find
unthinkable.
You have likely seen hundreds of newspaper headlines about the
scary euro debt crisis and predictions of a coming American debt and
dollar crisis. And article after article about how the China juggernaut
will eclipse America and rule the world or at least dominate Asia.
Meanwhile, I have long been a China skeptic.
While giving the Chinese people enormous credit for their shared
success, I question further progress without significant economic and
political reform.
And while I have been deeply involved in Asian financial markets for
thirty years, the first key to my understanding of China’s dim future
is that I am not a China expert.
My introduction to Asia was through Japan in the 1980s where I was
a student at Sophia and Keio University and then worked as an
investment banker. This was a time that everyone, and I mean
everyone, thought that Japan would dominate the world economy
forever.
David Halberstam included in his book The Next Century the
following passage from a speech he gave in early 1989 before the
fifty governors of the United States:
“If there were any purely economic model for the future, it was the
Japanese.”
Later that year, Japan’s stock market hit its peak and then both stock
and property markets fell apart. The Japanese stock market is
trading today at only 1/3 its peak and its GDP is back where it was in
1996.
I saw the flaws in Japan’s investment and export economic model, its
property bubble, and its old boy banking system. This prompted me
to move out of the market before its bubble economy fell apart at the
seams.
The great majority of investors and the financial media elite missed
the signs of the Japan bubble because it was unthinkable.
But it happened.
Remember the high-flying Asian Tigers of Southeast Asia? I was also
fortunate to avoid the 1997 Asian financial crisis when currencies
crashed and Southeast Asian markets like Thailand and Indonesia
collapsed 65% as debt levels spun out of control. Capital flew out of
these countries at a speed that seemed unthinkable to investors.
But it happened.
In 2010, the “Warren Buffet of London”, Anthony Bolton, was lured
out of retirement by Fidelity to launch a China special situations fund
from Hong Kong. Over his 27-year history of managing money in the
UK, Bolton had delivered to his investors an impressive compounded
annual return of 19.5%.
Bolton came to conquer China with strategy to capture the country’s
rising middle class by focusing on smaller consumer-oriented
companies. Given his stock-picking reputation and China’s doubledigit economic growth, it was unthinkable to investors that his new
fund would be anything but a success.
But after three years of investing, Bolton’s Fidelity China Special
Situation Fund’s net asset value is down 17%.
The financial media and corporate elite are completely missing the
coming China crisis because it seems unthinkable.
This is why more “experts” are not putting together all the signs that
China is encountering considerable turbulence.
It's part ignorance, part politics but maybe it’s just that China may
well be sliding into a crisis too unbelievable to even think about.
These financial and political challenges in China will have a far
greater impact than what happened in Japan or Southeast Asia. This
is because China is far larger and far poorer.
After all, it was Japan’s huge stockpile of savings that allowed it to
survive a zero growth economy for two decades. Japan’s culture also
kept it together as it weathered tough economic times.
In addition, the increasing complexity of the Chinese economy makes
it more vulnerable to shocks. One crack at the wrong time and place
can lead to an earthquake of radical change.
This is how Joshua Cooper Ramo puts it in his book “The Age of the
Unthinkable”:
“Change in complex systems, whether they are ecosystems or stock
markets, often takes place not in smooth progression but as
sequence of fast catastrophic events.”
The second key to my seeing the China red flags is that while I have
lived and traveled throughout Asia during my career – for the past
decade I have lived in independent-thinking Colorado.
This is a long way from Wall Street, Boston and Washington not to
mention London, Hong Kong, Sydney, Tokyo, and Singapore where
everybody thinks the same and China is viewed as an unstoppable
juggernaut.
The irony is that I have lived and worked in all these places.
So recognizing what is happening in China required me to challenge
conventional wisdom and my background in a dramatic way.
This is story well worth following because any significant changes in
the trajectory of China’s economy or political system will shake the
foundation of the world economy and have a big impact on global
financial and trading markets. The key is to recognize and monitor
seven important trends that will shape China’s future. In many cases,
these trends touch and overlap each other like dominoes.
But they do not have to fall.
There is time to make the required changes though I am skeptical
that China has the unselfish leadership and political will to make
these changes.
And even in the wake of a worst-case scenario for China, like in any
financial crisis, there will be many big losers and few big winners.
If you want to be one of the winners, you need to understand what is
happening and get your portfolio ready for the financial earthquake
before it happens.
Before I begin to explain why the China story is taking a bad turn, I
have to warn you.
The data backing these seven China trends affecting a country that
many believe is the engine of global growth is disturbing. It is also
very much related how China’s leadership responded to the financial
crisis of 2008-2009.
I know what you are probably thinking. You've got to be kidding me
– the China locomotive running off the tracks?
Yes, this is a very big story that you need to stay on top of.
Before we discuss these troubling seven trends, we need to begin
with what fueled China’s incredible growth story over the past three
decades.
This is because the drivers of China’s success have become the seeds
of its current troubles.
The Amazing Chinese Growth Story
China has had 30 years of tremendous growth.
Just think, when China began to open up to the world in 1978,
exports for the full year were equal to one day of exports in 2010
In 1980, China’s economy was the size of the Netherlands, in 2013,
it added an amount equal to the size of the Dutch economy.
In 1990, China’s economy was the same size as Taiwan – now it is
more than 10X bigger
China’s success is not magic – it has been built on a tested and
straightforward formula:
1) Rapid manufacturing export growth fueled by cheap labor, cheap
land and foreign investment
2) Huge investments in infrastructure, property and factories driven
by cheap capital and foreign investment.
Hundreds of millions of Chinese have been pulled out of poverty and
some have been able to accumulate great wealth. This is a great
success story. Unfortunately, the recipe for China’s success to date is
also the source of its current troubles.
China’s Elite Are Worried – Should You Be?
You would think that with all this economic progress and momentum,
wealthy Chinese would be brimming with confidence regarding their
country’s future.
The Financial Times, in an article “Chinese doubt the road ahead”,
cites a Chinese banker with close ties to a number of wealthy and
powerful political families:
“There is a sense that we are approaching an inevitable breaking
point, when the pressures in society will boil over and consume the
rulers.”
“Almost all the elements are in place for an uprising like we saw in
1989. Corruption is worse today that it was then, people feel they
can’t get ahead without political connections, the wealth gap is much
bigger and growing, and there has been virtually no political reform
at all. The only missing ingredient now is a domestic economic
crisis.”
The signs of a nervous elite are clearly out there.
A survey co-sponsored by the Bank of China showed that 60% of
those with $1.6 million or more of personal wealth have begun the
process of emigrating or considering starting the process. My banker
friends say that Chinese companies raising capital offshore are
keeping it there – as far away from Chinese authorities as possible.
A study by Bain & Co. shows that these emigration numbers are
“rising dramatically”. The wealthy Chinese are snapping up offshore
real estate and other investments to protect their wealth. In the
Financial Times, Hung Huang, a publishing and fashion mogul says:
“You can feel the anxiety of the ultra-wealthy and even of the
political elite. They feel there’s no security for their wealth or
possessions, and that their assets could be taken away at any time.”
China is burning through foreign reserves at a blistering pace to
stabilize the yuan and offset capital flight estimated at $35bn a week.
This is automatically tightening monetary policy, squeezing liquidity,
and risks holding back the very recovery in China needed to quell
doubts.
The Recent Devaluation of the Yuan by China’s Central Bank
The decision in late August 2015 to modestly devalue and loosen the
tie between the yuan and the greenback was probably done for a
blend of three reasons according to renowned China expert Michael
Pettis.
“Improve trade. While China’s current account surplus has been very
high, this is mainly because imports have done worse than exports.
Both have fared poorly. The numbers were especially bad in July,
when imports were down 8.1% year on year while exports were
down 8.3%. Because of its peg to the appreciating dollar, the
renminbi has been very strong on a trade-weighted basis. The new
currency regime may be aimed at reversing this.
Qualify for SDR. There may have been concern that the large and
persistent gap between the fix and actual trading in both the onshore
and the offshore markets would prevent the RMB from qualifying for
inclusion in the SDR basket. What is more, by including a RMB
pegged to the dollar, the already overly dominant weight of the dollar
in the SDR would be substantially increased, something the IMF
clearly does not want.
Beijing may be eager for the RMB to become part of the SDR basket
because it believes this will result in significant foreign inflows that
will help reverse China’s very large and potentially destabilizing
capital account deficit.
Its strategy may be working. On Wednesday the IMF described the
new pricing mechanism as “a welcome step as it should allow market
forces to have a greater role in determining the exchange rate”. It
followed by noting, a little obviously, that the “exact impact will
depend on how the new mechanism is implemented in practice”.
Monetary freedom. The well-known “impossible trinity” makes it
impossible for a central bank to control both domestic interest rates
and the exchange rate if its capital account is open. Although
technically not open, China’s capital account is porous enough for all
practical purposes.
This means that as long as the PBoC intervenes in the currency, it
cannot provide debt relief to struggling borrowers, and to the
economy overall, by lowering interest rates without setting off
potentially destabilizing capital outflows. This constraint would be
even tighter if the Fed began to raise interest rates. Reform of the
exchange rate mechanism restores interest rate flexibility.
Storm Clouds are Gathering
It’s not just the wealthy that are nervous. Even China’s Premier
admits the economy is:
“Unbalanced, uncoordinated and unsustainable”.
What is going on?
This brings me to a recently completed investment tour through
Southeast Asia ending in Singapore where wealth assets have surged
1,120% since 2000.
There I had fascinating meetings with tycoons, bankers and
ambassadors but the best meeting - bar none - was with the CEO of
a leading private banking firm with a minimum of $20 million to open
a relationship. Here new tycoon clients are whisked into opulent
conference rooms graced with stunning modern art. Coffee is served
in gleaming Selangor silver and poured into the most delicate
porcelain china.
What was my mission? To find out what is really happening in China?
Why did I go to Southeast Asia to find out what is happening in
China? Because for centuries these countries have been China’s
competitors, suppliers, investors and borrowers all rolled into one.
They have to know what is happening behind the scenes in China
because their very survival depends on it.
First, let’s start with some facts and then sort out what this means
for China’s future.
China’s economy is slowing as the two drivers of past growth investment in manufacturing/industry and exports pull back for
different reasons. China’s real estate bubble is unwinding, industrial
manufacturing capacity is way beyond current needs and the
country’s once powerful labor cost advantage has evaporated as
countries such as Vietnam, Indonesia, Bangladesh and even Mexico
now have lower labor costs than China.
To put things in perspective, manufacturing wages in China have
risen tenfold in the last decade.
This decline in competitiveness has hit export growth hard and lately
it has actually gone into reverse with an 8% fall year over year
recorded last month. Consumption is also spotty at best with
domestic auto sales last month actually declining for the first time.
Weaker exports and manufacturing has led to factories closing, bad
loans, and unpaid wages piling up. This, in turn, has sparked protests
– more than 200 protests have occurred already this year according
to an independent watchdog group. This sort of activity is watched
closely by the government, which, above all else, fears unrest.
All of this is a big headache for the mandarins in Beijing who have to
figure out a way to produce 20 million new jobs every month.
So you can’t blame them for trying anything and everything to
stimulate growth. They promoted the stock market early this year
leading to a 60% rise through June before turbulence and even panic
over the government’s clumsy and heavy-handed interference in
markets cut this year-to-date return down to 23% in less than a
month. From there Chinese markets have continued to decline
sharply.
The China Securities Depository and Clearing Co. says there are
more than 90 million individual investors in that country. Compare
that to 87.8 million members of the Communist Party. But I think
that number is understated. If you total the number of people with
access to a brokerage account in Hong Kong and the mainland, it's
about 200 million people.
Now, let's add in the fact that most Chinese are new investors. BNP
Paribas estimated that about 170,000 new stock trading accounts
were being opened each business day in China at one point this year,
more than 10 times the average for 2014. In fact, 3.3 million Chinese
opened brokerage accounts in just one week in April.
But the real explosion has been in China financial sector since 2008.
China’s stock valuations have more than doubled to approach $4
trillion and its money supply has also doubled to reach $12.5 trillion
– roughly equal to America’s monetary stock. Total debt has
quadrupled.
Next on the menu is “adjusting” how the value of the Yuan is
determined.
The official, conventional line is that China is moving to more flexible
exchange rates driven more by markets. The reality is that the
Yuan, which has been largely pegged to the US dollar since 2004,
has made China somewhat uncompetitive as the Japanese yen,
Australian & Canadian dollar, the Euro as well as regional currencies
have significantly cheapened against the greenback. This has put
Chinese exporters at even more of a price disadvantage.
But keep in mind that a policy of weakening the Yuan comes with
significant risk.
The first is that to many in China, advocating a weaker currency is a
loss of face and prestige. The second is that the perception of a
weakening Yuan will accelerate capital flight. This is already a major
problem as tycoons, entrepreneurs and even middle class Chinese
are increasingly moving their wealth overseas to places like San
Francisco, Vancouver, Singapore, London and Sydney.
In addition, China’s 100 million tourists like a strong currency that
makes overseas trips and shopping cheaper. Then there are the 10
million Chinese students who study abroad each year. A weaker Yuan
drives up costs, especially for politically sensitive middle class
families. Then of course, a weaker currency drives up the costs of all
imports.
As China struggles with all these issues, what does this mean for
investors like you? Forget buy and hold, China is a pure trading
market. Follow China’s capital flight of $35 billion each week – it will
point to great opportunities.
Look to China’s competitors especially Asia’s other big dog, Japan, as
it benefits when China falters. Be wary of jumping feet first to try to
catch the bottom of crashing commodities. Remember, just a few
years ago China bought over half of the global supply of many of
these commodities.
Disturbing signs keep appearing about China’s weakening economy
and rising political turbulence.
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economic growth is slowing
the Yuan is weakening
manufacturing is weakening
wages are soaring
competitors are rising
export margins are shrinking
property bubble is popping
trade wars are brewing
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protests are spreading
investment returns are falling
capital flight is increasing
financial system is cracking
political infighting is rising
widespread corruption is being uncovered
consumer inflation is rising and underestimated
China’s seeds of success have turned into millstones. Its success
formula is not working anymore. Its last gasp has been the three
years since the 2008 financial crisis as huge amounts of lending by
state-owned banks allowed a spurt of investment to grow the
economy by 30%.
But the following seven domino trends could lead to a perfect storm.
It is coming on fast and will rock global markets.
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Fixed investment is slowing as returns are diminishing
China’s property bubble is popping
Wages & costs are soaring - low-margin exports are sliding
Trade war with Europe and the US is brewing
Financial shell games heightens vulnerability
Hopes of a consumer boom are fading fast
Corruption at the highest levels and environmental pollution are
spawning an explosion in protests
It is dawning on more and more open-minded thinkers that China
has the wrong economic model and the wrong political model. I will
focus on each of these seven trends more closely but keep these
questions in mind. Does the Chinese Communist leadership have the
flexibility to cope with all these challenging trends? Will the
approaching leadership transition in late 2012 make this even more
difficult?
Are market reformers too few and too weak to do battle with
powerful state-owned giants and the entrenched elite?
All of this is happening at the worst possible time. Soon, the party
will have the most crucial leadership change in a decade.
Let me begin by outlining the big picture of a China’s “worst case
scenario”.
Then I will explain more fully step by step the seven China troubling
trends before getting to possible endgames.
China’s Worst Case Domino Scenario
Stage 1: Economic Crisis
investment declines & exports slide
property bubble pops
economic growth slows
stock market wobbles
capital flight accelerates
trade war with US & Europe escalates
bad loans rise dramatically
lenders look to Beijing for payment
food inflation takes off
foreign exchange reserves decline
Stage 2: Social Breakdown
unemployment skyrockets
230 million migrant workers rebel
high level corruption uncovered
food & essentials hoarded
savings rates go through the roof
elites flee country with wealth
bailout of state banks sparks violence
Stage 3: Political Crisis
authorities crackdown on protests
widespread detention & arrests
crackdown on media & Internet
leadership plays nationalist card
political scandals & corruption escalate
protests explode across China
China Domino Trend #1
Investment Returns are Falling and Growth is Slowing
Fixed investment has been the chief driver of growth in China.
But China’s investment led industrial growth, already into its 17th
year, is very long in the tooth. Real fixed investment has increased
at a faster rate than GDP in nine of the past ten years. Furthermore,
research by Pivot Capital Management shows that the longest
previous period of investment led economic growth was nine years
experienced by both Thailand and Singapore.
For China though, the return on every marginal dollar invested in
China (gross fixed capital formation) is decreasing.
For example, in 2000, it took $1.5 of credit to generate a dollar of
GDP but by 2008, it took $7 of new credit to generate a dollar
increase in GDP.
In 1990, investment was 25% of GDP and the Chinese economy grew
at 10%.
In 2010, investment was 50% of GDP and the economy grew by less
than 10%.
You get the picture – an economy more dependent on investment for
growth but with rapidly diminishing returns.
This has become much clearer since the global financial crisis in
2008-2009. When Chinese exports fell off a cliff, the government
panicked and pushed state-owned banks and local governments to
open the spigots. This led to the biggest stimulus program ($900
billion equal to 20% of GDP) in history relative to the size of China’s
economy.
Stephen Roach in his book, The Next Asia, puts it this way.
“There are worrisome signs that China just doesn’t get it, that it is
clinging to antiquated policy and economic growth strategies that
presuppose a classic snapback in global demand.”
He cites as evidence the make-up of the two-year stimulus package
that, he says, is biased towards old-fashioned infrastructure projects
and not promoting consumption.
In some ways it worked. Chinese economic growth and its stock
market rebounded. But what was the price - vast overcapacity in
many industries such as steel, shopping centers and office towers as
well as mountains of bad debt.
Many infrastructure projects seem to be performing well below
expectations. The 1,000 kilometer high speed line running between
Wuhan and Guangzhou is running at less than 50% capacity. The
China Aviation Authority reports that 135 of the largest 175 airports
in China are losing money.
Meanwhile, bank credit is still expanding at 30%-40% annual clip. In
2011, total fixed investment grew 24.9% year over year. Fitch
estimated that total credit expansion for 2011 came in at 38% of
GDP.
How long can this continue?
Hedge fund king Jim Chanos, who made a bundle challenging Enron
fake accounting, has this to say about China: “They’re on a treadmill
to hell, and they can’t get off of it”
Michael Pettis, professor at Peking University's Guanghua School of
Management, where he specializes in Chinese financial markets sums
up the problem this way:
“China’s problem now is that the authorities can continue to get rapid
growth only at the expense of ever-riskier increases in debt.
Eventually either they will choose sharply to curtail investment, or
excessive debt will force them to do so. Either way we should expect
many years of growth well below even the most pessimistic current
forecasts.”
And let’s be frank, the numbers that have been coming out of China
are suspect. In what other country do the economic growth number
hit the targets year after year?
China’s own statistics bureau admitted in early 2012 that local
governments were pressuring local businesses to report “seriously
untrue” data and that GDP data based on local government figures
was 8.8% higher than the national figure put together by the
statistics bureau. There are anecdotal reports that tax agencies are
telling companies to inflate sales and profit. Interest rates on loans to
private businesses are also creeping upwards just as cash flows get
tighter for private companies.
Also keep in mind that much of China’s exports and foreign
investment is highly concentrated geographically. About 70% of
investment and exports have been in and from Guangdong and the
Yangzi River Delta.
No less than Nouriel Roubini believes that exploding capital spending
can't possibly keep going to useful projects.
When he visited China, he saw newly built airports and bullet trains
that were empty, ghost towns, and highways leading to nowhere.
Commercial real estate projects and luxury residential buildings have
been overbuilt, and automobile capacity has outrun demand.
"The problem, of course, is that no country can be productive enough
to reinvest 50% of GDP in new capital stock without eventually facing
immense overcapacity," he wrote in a 2011 article for Project
Syndicate.
Mr. Roubini also refers to the 1997-1998 Asian financial crisis as an
example of what happens when countries over-invest and underconsume. It wasn’t pretty.
Trade data is an excellent indicator of economic growth for an
economy like China.
Imports were flat in April 2012 (year over year) while they were
projected to be up 11%. Imports for consumption (as opposed to
imported parts for assembly/exports) were up only 2.1%. Exports
were up only 4.9% in April, up about half as much as projected.
At the recent Canton trade fair, orders booked by China’s exporters
were down 2.2% over last year’s event, the first decline since the
2008-2009 global financial crisis. Some companies stated that export
sales to North America and Europe were off 20% over last year.
“What we’re seeing here is a continued loss of (China’s)
competitiveness,” in combination with clear weakness in demand
from export markets, particularly Europe, said Frederic Neumann,
the co-head of Asian economic research at HSBC.
Stanley Lau, the deputy chairman of the Hong Kong Federation of
Industries said that the number of factories in export-oriented areas
like Guangdong is steadily declining as costs escalate. “We are
looking at an inflection point in terms of China’s growth rate, which
should slow gradually over the next decade after the pulsating
growth of the last decade,” says Robert Lind, chief economist at
Anglo-American.
"We thought imports would surprise quite a bit on the downside and
generally the implication is negative. Domestic demand is slowing
down very quickly," Zhang Zhiwei, chief China economist at Nomura
in Hong Kong, told Reuters.
The trade figures also show a slowing of machinery imports from
Japan. This is a clear sign of weaker industrial and construction
activity.
Even Caterpillar (CAT), many investors choice of a great China play
on industrial growth, is now expecting demand for construction
equipment in China to decline. The company’s nine plants under
construction in China now seem to be on the aggressive side.
Demand in China is so low for its construction equipment that
inventories are piling up and the company is exporting to other
countries.
We are waiting for April electricity consumption numbers but
electricity production was up just 0.7% compared to April 2011. Rail
cargo volumes in the first quarter grew at half the pace of the first
quarter in 2011. The People’s Bank also highlighted weak growth in
bank lending. New loans were down 46% in April compared with
March.
In addition, the National Bureau of Statistics recently released data
that showed industrial production (weakest in the last three years),
fixed-asset investment and retail sales all increasing more slowly
than expected in April. Of particular interest, commodity imports
slowed and industrial machinery imports fell in April compared with a
year earlier.
In response, the People’s Bank of China, which is controlled by party
leaders, announced on May 11th its third reduction in the reserve
ratio over the past six months. This means that major banks will be
required to hold reserves equal to 20% of deposits instead of 20.5%.
The central bank is reluctant to move more aggressively to stimulate
growth because food inflation is still a serious problem.
The IMF again reduced its growth forecast for China in to a range of
5-6% while inflation is still rising. Could this be the Chinese version
of stagflation?
And despite the clear danger of over reliance on bank lending and
investment to keep growth rates high: “state-owned banks lent two
trillion yuan in the first two months of 2012. This represents almost
twice what was lent in the last quarter or 2011 and two thirds of the
entire lending for 2008” according to William Gamble.
China is also ramping up government spending on infrastructure in
an attempt to keep growth moving ahead. This may help short-term
but ignores that infrastructure is already overbuilt at lower returns
and projects are oftentimes tied to corruption.
Zhang Hanya, the head of China's investment association, a think
tank affiliated with China's economic planning agency, was quoted as
saying that boosting investment is the only choice for Beijing to
bolster growth. "China has to rely on infrastructure investment to
manage economic slowdown," Zhang was quoted as saying.
But some analysts question whether the Ministry of Railways can
continue servicing the more than 2 trillion yuan in debt that it
borrowed before the high speed rail accident last year.
China Domino Trend #2
Property Bubble Popping
Cheap land has been at the heart of the Chinese growth story.
Investment has been the most important driver of Chinese economic
growth and property has been about 20% of total investment.
Property investment represents 15% of Chinese GDP and speculative
fever has led to a doubling of prices over the past four years. There
were $500 billion of land sales in 2010 – double the amount in 2009.
All land in China belongs to the state and local governments offer,
“land use rights” up to 70 years. Local governments have grown
addicted to property sales as a principal source of revenue - some
estimates put property sales as representing 70% of government
total revenue. William Gamble reports that the Guangzhou
government’s land sales program has seized up - decreasing province
revenues by 70%.
You can easily see why China’s mandarins want to keep property
prices to keep going up but the days of cheap land are well over.
A key metric of housing prices is the price of property relative to
income. At the peak of the U.S. housing bubble, property prices were
more than 5 times income. In China today, they have reached 10
times income and in Beijing and Shanghai they are around 30 times
income.
Keith Bradsher reported that a 1,000-square-foot apartment in
central Guangzhou costs nearly fifty times the starting annual salary
of a new college graduate and this is despite price dropping 20%
over the last year according to two Guangzhou real estate brokers.
Property prices have gone up 700% since 2000.
Below is a chart showing how Chinese property prices stack up
against much more developed markets.
But there are signs that over building, a weaker economy and skyhigh prices are leading to the bubble are already popping. Property
sales volume and prices are declining.
“Worries Grow as China Land Sales Slump”
Financial Times, 1/6/2012
Data provider, Soufun, reported on May 5, 2012 that residential land
sales in the country’s 20 largest cities had fallen 92% from the
previous week.
Transactions are down 40% to 50% year over year in the tier 1
through tier 3 cities. Prices are down. In some cases, we've seen
riots in sales offices, where people are amazed that prices could
actually go down.
There are lots of indicators on the side. There's a growing sense that
the Chinese government will ease. We point out that credit this year
will grow between 30% and 40% of Chinese GDP. If that’s tight, I'd
hate to see it ease."
Some condo developers have cut prices 40% to move unsold
inventory. To put things in perspective, at the peak of the U.S.
housing bubble, there were 2 million housing starts in a country with
¼ of China’s population and much higher incomes.
China’s pipeline of housing starts for 2012-2013 is 20 million even
though new property starts fell by almost 20% year on year in 2011.
Simon Rabinovich, Beijing representative of the Financial Times,
notes that 900 land auctions failed in 2011, three times more in
2010. Government revenues from land sales fell 13% across 130 big
cities.
Home prices in China fell in February for the sixth straight month,
according to a private survey, as two years of government measures
to curb property speculation hit home.
This is a far cry from 2010 when prices jumped 70%.
The Chinese Academy of Social Science believes there are 64.5
million empty apartment units based on no electricity usage for 30
consecutive days.
The sharp drop in land sales revenue to local governments comes at
the worst possible time – just as big debt comes due.
Andy Lee of UBS comments that 80% of Chinese construction firms
say property developers are behind in their payments.
A Standard & Poor’s report released a report entitled "The Worst Is
Yet To Come For Chinese Developers In Asia's Shaky Property
Sector" warned that more credit downgrades for China’s property
developers are likely.
"Many developers in China may be at increased risk of refinancing
due to weaker property sales, high funding costs, and tightened
liquidity. And that will increase the pressure on ratings," according to
S&P credit analyst Bei Fu.
China Domino Trend #3
Wages & Costs Soaring = Low Margin Exports &
Manufacturing are Losing Edge
When you think of China, you think of an export machine – especially
manufactured exports.
But the vaunted China export machine is leaking oil for two reasons:
 Weaker demand in its two biggest markets – Europe and America
 Rising labor, land and capital costs
The signs are coming in that Chinese exports are in trouble. UBS
believes that Chinese exports to Europe will decline 12%. Exports of
some textile goods like socks headed to Europe were down 30%.
Wages and other costs are also rising. Over the past decade, wages
in eastern manufacturing zones have risen tenfold.
China’s Ministry of Human Resources and Social Security report that
manufacturing wages were up 22% last year. A survey released by
China's statistics agency showed the 159-million-strong migrant
workforce saw an average salary increase of 21.2% from a year
earlier.
Foxcon Technology, one of the biggest manufacturers of products for
Apple, Dell, Hewlett-Packard and other electronics companies,
announced that salaries for many workers would immediately jump
by 16% to 25%.
This wage increase is due to the weak return of migrant workers
following their return to home provinces for New Years celebrations.
Beijing, Shenzhen and Guangzhou are still short hundreds of
thousands of migrant workers. Shandong Province is missing a full
third of its migrant work force, and Hubei Province reports a loss of
more than 600,000 workers.
This is tough to cope with when your profit margins are already quite
thin. Stratfor’s George Friedman estimates that the average profit
margin for a Chinese exporter is, at best, a paper-thin 1.7%.
These exporters are also finding it difficult to obtain financing. The
big state-owned banks favor loans to state-owned enterprises - not
private entrepreneurial exporters.
Competitors are also moving in on China’s turf.
Textile manufacturing is moving to places like Bangladesh and Sri
Lanka where labor costs are much lower. Western multinationals are
also looking at cheaper manufacturing bases like Vietnam and
Indonesia and also are moving some production back to America to
be closer to markets.
Kirk Yang, Managing Director of Barclays Capital comments that:
“The so-called cheap labor model has created a lot of problems and is
not working anymore.”
Peter Chen, sales manager at Hua Hai Toys stated that for the first
time, buyers are asking for the right to return unsold products.
A recent survey by New York consulting company Panjiva, found that
more than half of American importers interview were interested in
new suppliers and in particular, those from India, Thailand and
Vietnam.
China’s attractiveness as a low cost base for global manufacturing is
also less compelling given all the logistical issues that go along with
supply lines spanning the Pacific.
Alix Partners studied five manufacturing segments over a five-year
period and found that China’s pricing advantage for exports arriving
in Long Beach, California relative to domestic prices have declined
from a 22% advantage to just 5%.
In March 2014, the HSBC/Markit Flash Purchasing Manager’s Index
hit a four-month low signaling a contraction in activity. Manufacturing
hiring is also at two-year lows.
Taking everything under consideration, Mexico is now a better
manufacturing hub than China for companies selling into North and
South American markets. And Bangladesh and Vietnam offer
manufacturing wages 30-50% of Shenzhen China.
Chrysler is now exporting cars from its plant in Mexico to China. A JP
Morgan study shows Mexican manufacturing wages, 237% higher
than China in 2002, are now 14% lower. Higher fuel and
transportation costs are helping as well as Mexico’s 44 free trade
agreements.
And lately, manufacturing has been a bright spot in a rather sluggish
U.S. economy.
The U.S. Labor Department reported that manufacturing companies
have added jobs in two consecutive years. Until last year, there had
not been a single year when manufacturing employment rose since
1997.
Another favorable trend is that companies are beginning to move
some offshore manufacturing back home. This is driven by higher
labor costs in countries like China, plus the desire to protect
intellectual property and bring production closer to end markets.
No wonder that a recent PriceWaterhouseCoopers quarterly survey of
American manufacturing executives found almost 63% were
optimistic about growth prospects in the next 12 months.
U.S. manufacturing workers are standout performers with
productivity rates five times that of Chinese workers.
This “onshoring” trend was highlighted by a story told by Ed Crooks
of the Financial Times about a North Carolina family furniture
business run by Bruce Cochrane. In 1996, he was forced to sell his
business and the new owners moved production to Asia.
In early 2011, he announced he was getting back to manufacturing
furniture in North Carolina saying, “I’m convinced our timing is
exceptionally good.”
Cochrane notes that as recently as 2000, the average manufacturing
wage in China was 50 cents an hour. Now it is $4.50 an hour.
China Domino Trend #4
The China Calculus of European and American Multinationals
is Changing Fast – Raising Probability of Trade War
Until recently, the partnership between China and Western
multinationals worked fairly well. China would provide a low cost
base for manufacturing and assembly by western multinationals.
In turn, these giant companies made significant investments in China
while tolerating intellectual theft and very limited access to local
consumer markets. Meanwhile, America and Europe largely ignored
an undervalued Chinese currency, and weathered political pressure
not to move jobs to China.
The U.S.-China Business Council tracks direct investment by
American corporations in China. It has grown from $43 billion in
2000 to a peak of $95.3 billion in 2008.
In return, China held out the carrot of much greater access to
Chinese consumer markets and recycled export dollars to invest in
primarily U.S. Treasury bonds.
Now the business and political calculus has changed dramatically.
Protecting intellectual capital is now more important than savings on
manufacturing costs since there has been an alarming increase in
Chinese cyber attacks against western businesses.
FBI Director Robert S. Mueller recently testified before Congress that
cyber attacks would soon replace terrorism as the agency’s number
one concern. General Keith Alexander, head of the U.S. military’s
Cyber Command called rampant cyber theft “the greatest transfer of
wealth in history”.
In addition, rather than opening up, China is taking steps to further
protect markets from foreign competition.
So Western multinationals are incrementally moving manufacturing
home or to other markets and are increasingly frustrated with getting
meaningful and profitable business in China.
A General Motors executive, a company oftentimes described in the
media as a “China success story”, told me that its average profit per
vehicle sold in China was only 20% of a vehicle built and sold in
America.
In an unguarded moment at a private dinner in Italy, General Electric
CEO Jeffrey Immelt commented: “I really worry about China… I am
not sure that in the end they want any of us to win, or any of us to
be successful.”
The pressure on multinationals to bring jobs home is intensifying in
light of high unemployment and a weaker economy.
This sentiment will grow during 2012 as the presidential and
congressional campaigns take off. Nationalistic sentiment is also a
tool that China’s leaders use from time to time to shore up political
support.
These issues taken together blend a dangerous cocktail and the
points of disagreement are endless.
Trade tensions between America and China reached a new height in
late 2011 when China announced higher taxes on U.S. made car
imports. This decision came after China lost a two-year battle at the
World Trade Organization over Chinese tire exports to the US.
The taxes will affect models from General Motors, Chrysler, and the
U.S. arms of Honda Motor Co., Mercedes Benz and BMW. The
ministry claimed that autos are being dumped on the Chinese market
causing damage to its domestic industry.
This sort of disputes will go back and forth increasing tension and
misunderstandings.
And then there is the long simmering accusation that China is
manipulating its currency to boost exports and build surpluses. In
October 2011, by a vote of 63-35, the U.S. Senate passed a bill that
aims to punish China for “manipulating” the Yuan.
This legislation, would lower the bar for action since instead of citing
countries that ‘intentionally’ manipulate their currencies,” the
Treasury would only have to “determine whether any foreign
currencies are in fundamental misalignment, and propose ways to
correct the imbalance with countries that are named.”
This “action” would likely be higher tariffs and duties on Chinese
imports.
The tempo of trade disputes moved to another level as the U.S., the
European Union, and for the first time Japan, joined forces to file a
complaint against China at the WTO regarding China’s restrictions on
rare earth exports.
The currency issue is also coming to a boil as China’s yuan has fallen
in 2012 against the U.S. dollar as China seeks to boost its exports.
On May 17, 2012, America imposed antidumping tariffs of more than
31 percent on solar panels from China. This action by the Commerce
Department, infuriated Chinese officials since it is the world’s largest
exporter. The United States imported $3.1 billion worth of Chinese
solar cells last year, representing more than half the American
market for the devices.
One week later, China launched a complaint at the World Trade
Organization against U.S. import duties on 22 Chinese products that
the United States says are unfairly priced or subsidized, including
solar panels and steel products.
A coincidence? Beijing launched the action the same day that a WTO
panel issued a confidential ruling (to made public in two weeks) in a
closely watched case aimed at prying open China's huge electronic
payments market for U.S. firms like Visa, MasterCard and American
Express.
Three other trade issues are also heating up.
Auto Parts: About 150 members of Congress have sent a letter to
President Obama asking him to investigate whether China has
violated American trade laws by helping its auto parts manufacturers
become big suppliers to the United States market.
Cars: After promising late last year not to discriminate against
foreign products in government procurement, China released a
“China only” list of automobiles that officials may buy.
Subsidies: Congress has just passed a law that would retroactively
revise some American trade laws to 2006.
China-EU trade disputes are also approaching a boiling point. While
the EU has courted Chinese capital it has demurred as Japan has
been a big buyer of euro bonds and has pledged $60 billion of new
capital to the IMF.
The EU has brought forward a huge case to the WTO charging that
Beijing illegally subsidized telecom equipment companies like ZTE
and Huawei Technologies.
One think tank believes the Chinese see this action as a “declaration
of war”.
The EU-China trade deficit has tripled in size from 2000 to 2010. In
the seeming blink of an eye, China has gone from a partner to a
dangerous competitor. China feels it is being used as a scapegoat for
the EU’s financial challenges. Europe feels cheated by China’s trade
restrictions and subsidies increasingly aimed at high value industries.
China’s more assertive foreign policy
China’s more assertive policy in the South China Sea is also raising
risks of conflict. The 2012 annual Pentagon report to Congress stated
that:
“China’s actions in 2011 with respect to ongoing land and maritime
territorial disputes with neighbors,” the report said, “reflected a mix
of contentment with the status quo, renewed efforts to reassure wary
neighbors, and continued willingness (particularly through the use of
paramilitary maritime law enforcement assets) to assert Chinese
claims.”
In 2012, tensions with the Philippines are rising significantly due to
conflicting claims about Scarborough Shoal just west of Manila.
Chinese fishing boats attempted to detain several Chinese fishing
boats but were thwarted by Chinese marine surveillance ships.
This will be an ongoing risk since China claims virtually the entire
South China Sea. These exaggerated claims are unacceptable to
Vietnam, the Philippines and the United States.
Aaron Friedberg of Princeton’s Woodrow Wilson School, author of A
Contest for Supremacy, describes one of China’s three foreign policy
axioms as “advance incrementally”.
In addition, my view is that the weakening economy has greatly
increased pressure on China’s leadership to take a more aggressive
stance in foreign policy to divert attention and cater to nationalistic
pressures.
Highlighting this increasingly aggressive foreign policy is the decision
in early May for China’s largest offshore state-owned oil producer
CNOOC to begin its first deep-sea drilling project in the South China
Sea, a move analysts see as a response to domestic pressure on
Beijing to be more assertive in claiming disputed areas. The deep-sea
drilling platform is located in disputed waters between the Paracel
Islands claimed by China and Taiwan.
China Domino Trend #5
China’s Primitive & Complicated Financial System is Leaking
Oil
Fraser Howie, a managing director at CLSA Asia-Pacific Markets, who
is based in Singapore and is a co-author of “Red Capitalism: The
Fragile Financial Foundation of China’s Extraordinary Rise” sums up
the nonsense of China’s financial shell games.
“There’s an awful lot of money just going round and round from one
pocket to another, giving the appearance of strength when it’s really
not there.”
China’s financial system is both complicated and primitive.
This is why it is much more fragile than many believe.
At its heart are four huge state-owned banks that serve as “cash
machines” for companies owned or controlled by the government and
the Communist Party.
Senior management of state-owned and favored privately managed
companies are completely dependent on party friends and allies. The
end goal is money and political power.
It is not an overstatement to describe the Chinese economy as a
family business. This is the experienced view of Carl Walter and
Fraser Howie, authors of Red Capitalism: The Fragile Financial
Foundation of China’s Extraordinary Rise.
Jim Chanos, who made a fortune figuring out the accounting
shenanigans at Enron, strongly believes that “China’s banking system
is built on quicksand”. Chanos not only believes that China’s banking
system is extremely fragile, he expects massive loan write-offs
requiring huge amounts of capital.
Some of you may be thinking, what about China’s $3 trillion in
foreign exchange reserves? Can’t these reserves be used to deal with
any problems that come up? No question this stockpile is an asset
but China’s liabilities are also quite significant though hidden by shell
games.
Victor Shih of Northwestern University has done quite a bit of
research in this area. The central government has implicitly
guaranteed huge amount of loans issued to state-owned companies
by China’s four leading state-owned banks.
The central bank has already issued liabilities worth about $3 trillion
– equal to all of its foreign exchange reserves. In addition, China’s
central bank reported that foreign exchange reserves fell by $20.6
billion in the fourth quarter of 2011.
This is the first time in a decade that the reserves have dropped.
In late March of 2012, China Business News reported that the central
bank admitted that $1.4 trillion had been loaned to local government
by the central government. This represents 25% of China’s GDP and
about 1/3 of these loans are due during the next three years. The
plan is to roll over many of these loans to buy time.
State-owned companies are also increasingly lending to each other
as well as issuing bonds. Provincial and local governments are also
active backers of government companies.
This off-balance-sheet lending is the result of China trying to crack
down on traditional banking excesses forcing financing underground
in “grey” areas. Hong Kong-based GaveKal researcher, Joyce Poon,
estimates that outstanding off-balance-sheet lending doubled from
2009 to 2011.
There is also a great deal of “political lending” to enterprises that are
not profitable. Rather than write down non-performing loans, the
debt is rolled over and sometimes the maturity is lengthened as well.
When these bad loans get to be too much of a problem, they are
moved to a new “investment company” so they are off the books of
the bank but are sometimes accounted for at full value.
The lending spree following the 2008 global financial crisis has led to
a sharp increase in non-performing loans. To put things in
perspective, Morgan Stanley believes Chinese banks loaned more
than $4.1 trillion in the two years following the end of 2008.
Estimates of total lending during this period from all sources rose to
$5.7 trillion. This is larger than China’s entire gross domestic
product!
Fitch, the rating agency, estimates non-performing (overdue for 90
days or more) loans at $2 trillion.
China’s steel industry alone has $400 billion of debt and profit
margins have slid to just 2.9%.
"Certainly a good number of loans made in the last three years will
go bad," said David Madden, a managing partner at DAC Financial
Management, a $425 million private equity firm in Hong Kong
focused on trading Chinese bad debt.
"They weren't necessarily made with the highest levels of credit
analysis."
China's cumulative loan growth is the second fastest in the world's
emerging economies at around 55%, after Belarus, and a third faster
than India's 40%, Fitch Ratings said in early 2012.
And while China’s big state-owned banks have raised huge amounts
of capital over the past few years they are short of cash. “For the
first time, a large number of Chinese banks are beginning to face
cash pressures,” according to Charlene Chu, a banking analyst at
Fitch Ratings.
“It is because of this cash constraint that the forthcoming wave of
asset quality issues has the potential to become uglier and more
destabilizing than in previous episodes of loan portfolio
deterioration.”
Then there is borrowing and lending by provincial and local
governments to deal with. Stratfor comments that; “At least 4.6
trillion yuan ($729 billion) out of a government-estimated local debt
of 10.7 trillion yuan is set to mature within two years, and Beijing
expects 2.5 trillion to 3 trillion yuan of the total risk to turn sour.”
Mr. Shih estimates that there are $9.6 trillion of government
contingent liabilities in China’s financial sector.
If interest rates rise, this could be a disaster.
But rather than consolidate debt, bank lending is actually still
increasing. Chinese banks extended 640.5 billion yuan ($101.51
billion) in new loans in December 2011, up from 562.2 billion yuan in
November, according to data released from the People's Bank of
China.
Edward Chancellor of global asset manager GMO commented in early
2012:
“I would argue that China has had a credit bubble the last three or
four years,” Mr. Chancellor said, noting that debt levels, as a
proportion of economic growth, have risen substantially”
He goes on to add:
“I think China’s problems will continue to be a source of concern,” he
warned. “It’s quite questionable whether China can be an engine of
global growth going forward, and that has large repercussions for the
region.”
Chinese Corporate Bonds Under Growing Scrutiny
In April 2015, a Chinese power-transformer maker became the
country’s first state-owned company to default on an onshore bond,
signaling the government’s willingness to let market forces decide an
enterprise’s fate.
Baoding Tianwei Group Co., the unit of central government-owned
China South Industries Group Corp., said it will fail to pay 85.5
million yuan ($13.8 million) of bond interest due Tuesday. Kaisa
Group Holdings Ltd. became the first Chinese developer to default on
its U.S. currency debt.
Until now, only private-sector companies have defaulted in China’s
domestic bond market even as state-owned enterprises have sold the
vast majority of debt. Tianwei’s default highlights a shifting attitude
toward financial risk, underscored by Premier Li Keqiang’s pledge to
open a cooling economy to market forces and strip power from the
government.
“It’s probably a start of more defaults in China,” said Qu Qing, a
bond analyst at Huachuang Securities Co. in Beijing. “The economic
slowdown has given a huge blow to some industries.”
In 2012, the first-ever triple A rated China bond slid into default
status.
The issue was quickly addressed and creditors repaid in full
but this default may signal more are on the way.
Wang Jing, head of fixed-income research with Jinyuan Securities
commented that: “Defaults will become increasingly frequent
because so much was borrowed over the past few years that has to
be paid back now.”
Gabriel Wildau and Lawrence White of Reuters recently completed a
study of how non-Chinese bondholders are looking very differently at
Chinese blue chip companies such as China Shansui Cement or
Fosun.
For example, the yuan notes issued by China Shansui in October
2010 yield about 5.29% but U.S. dollar notes issued by the same
company in May 2011 are yielding 9.71%.
This immense gap reflects the perception that onshore yuan bonds
are considered investment grade by domestic investors certain that
the government would step in to prevent default but treated as risky,
high-yield plays by more skeptical offshore investors.
And the appetite by foreign investors in Chinese corporate bonds is
waning. New dollar-bond issuance by mainland firms totaled $39
billion in 2010 and 2011, according to Thomson Reuters data. But
issuance slowed late 2011, as wariness grew about Chinese
corporate governance and the slowing of the Chinese economy
reduced investor appetite for new bonds. Only three Chinese
companies have tapped the offshore bond market so far in 2012, in
deals totaling $1.3 billion.
Another reason for the huge gap in yields between onshore and
offshore corporate bonds is that China's onshore bond market is
effectively closed to foreign investors and investing overseas is
greatly restricted by China’s mandarins.
One of the major worries of offshore investors about Chinese bond
issuers is the ability to recover assets in the event of a default. In
addition, while Chinese credit agencies rate almost all Chinese
corporate issuers AA or AAA, overseas rating agencies like Fitch are
tougher. For example, Fitch rated a recent offering by Fosun as Ba2
while a Chinese rating agency rated it investment grade AA.
Overall, Fitch classifies China among "jurisdictions not supportive of
creditors rights, and/or where significant volatility in the application
of law and enforceability of any claim materially limits the practical
chances of recovery," according to a Fitch presentation at a recent
Asian bond forum in Shanghai.
Henry Wong, a fund manager at BEA Union in Hong Kong comments
that: "The higher yields being offered (for offshore bonds) are to
compensate investors for the risks of being an offshore structure,
which means less claim on the underlying asset"
Finally, Chinese corporate bonds are also often issued via offshore
subsidiaries in Hong Kong or tax havens and the offshore issuing
entity often has few assets beyond shares of company stock, which
would be worthless in the event of default.
China’s Bankruptcy Law Highlights Confusion and Favoritism
State-owned Shandong Helon, a rayon manufacturer, needed local
Weifang government authorities to step in to repay $60 million in
unsecured commercial paper that matured last month. This
backroom deal will do little to assure private creditors concerned
about the lack of a clear and transparent bankruptcy process in
China. The company still has substantial overdue secured bank loans
on its books. Helon has reported net losses for two consecutive
years and has 8,700 employees.
The Weifang government, which owns 16% of Helon through its
investment arm, remains its biggest shareholder.
The trend of preferential treatment of state over private firms will
only make lenders and investors tilt to the state sector.
"You've got basically 10 times the amount of credit going to the state
sector as to the private sector to produce the same amount of
output," said Fraser Howie, chief executive of brokerage CLSA in
Singapore.
The World Bank estimates that more than one in four of China's state
firms lose money. If the government steps back from these firms,
many of them will fail leading to not only loss of capital but higher
unemployment.
Capital Flight and Stock Market Woes
If capital flight accelerates, the financial system could also be
vulnerable as bank deposits (assets) shrink and liabilities stay the
same or increase. A recent Wall Street Journal article reported that
$24 billion in capital is being withdrawn annually from China.
How long before a trickle turns into a torrent?
Mr. Shih estimates that the top 1% of Chinese households controls
$2 trillion to $5 trillion in assets. When $500 billion or more leaves
the country, it will trigger a panic.
And let’s not forget China’s troubled stock market.
During 2010-2015, the Shanghai index fell 10.2% badly lagging
global equity markets.
China’s Shanghai market is trading at the same valuations as
Argentina which is reeling from the nationalization of a Spanish
equity stake in a leading domestic energy firm.
Of the 600 new stocks launched on the Shenzhen stock market over
the last two years or so, 85% are now trading below the offering
price. No wonder the 72 million individual investors that account for
75% of trading in this market are so frustrated and skeptical.
In the United States, the many Chinese companies that went public
on the Nasdaq stock exchange through backdoor reverse merger
IPOs have also led to numerous scandals of false financial reporting.
China Domino Trend #6
Hopes of China Consumer Boom Are Fading
The media is sending this comforting message to investors: don’t
worry about China’s unsustainable dependence on investment and
exports for growth, a consumption boom will become the main driver
of economic growth going forward.
This optimistic thinking has a couple of problems. First, as the above
and below charts highlight, the data does not support this widely held
belief. Consumer spending as a percentage of GDP is decreasing –
not increasing. In 1998 consumption was 45% of GDP, in 2010,
consumption declined to 35% of GDP. In 2014, it was 32% of GDP.
Second, China is still a relatively poor country. Overall, the Chinese
people have very limited spending power and also tend to be big
savers.
Stratfor estimates that 600 million Chinese live on $3 a day and an
additional 300 million on $3-$6 a day. Only 60 million have incomes
of more than $20,000 a year.
Even in urban centers like Shanghai or Beijing, the average annual
household income is below $8,000 and this doesn’t go very far since
basic housing and food prices are soaring.
Of course there are about 4-5 million wealthy Chinese elite with
considerable spending power but this is not enough fuel for a
sustained and broad based change in China’s growth engine.
The bottom line is that consumer spending in America during 2011
was more than six times larger than China even though it has only
20% of China’s population.
As China’s economic growth slows, it makes sense that consumer
spending would drop as Chinese consumers become even more
cautious. China's savings rate is already high because the country's
social safety net is almost zero and most Chinese must pay for health
care and pensions out of their own pockets.
Mark Williams of Capital Economics comments that:
“Just at a time when the government in China and a lot of people
elsewhere are hoping to see Chinese consumers step up to the plate,
actually they’ve been staying away from shops …………the trend over
the past couple of years has been relentlessly downward.”
This is confirmed by a McKinsey Chinese consumer study. Just 37%
of those surveyed, for example, agreed or strongly agreed with the
statement "I feel confident about my financial future."
The respondents also confirmed that they saved a quarter of their
family income—vastly more than people in Europe and the United
States save. China’s banking system is also highly dependent on low
interest rate deposits from Chinese workers. The government
certainly will not encourage a flow from saving to consumption – a
move that would weaken state banks.
Auto sales are a good barometer of consumer confidence. In 2010,
car sales were up 32%. In early 2012, they are increasing at only a
4.5% rate. In June 2015, year over year comparisons went negative.
In addition, the head of Samsung in China highlighted soft consumer
markets in China and the Goldman Sachs called Chinese economic
activity “exceedingly weak”. The CEO of Haier stated that the sale of
home appliances fell 13% in the first quarter of 2015 year over year.
To make matters worse, saving deposit interest rates are negative
after taking account of inflation punishing Chinese savings and
favoring Chinese banks and state-owned enterprises.
Carl E. Walter, a former J. P. Morgan executive who is co-author of
Red Capitalism: The Fragile Financial Foundation of China’s
Extraordinary Rise puts it this way:
“The banks make loans to who the Communist Party tells them to, so
they punish the household savers in favor of the state-owned
companies.”
In addition, China’s weak currency helps sustain its export economy
by lowering the global price of Chinese goods. But it also makes
consumer imports unaffordable for many Chinese people. The New
York Times puts it this way in a recent article on weak Chinese
consumer spending: “Raising consumption ………will require a radical
overhaul of the Chinese economy……… a significant dismantling of the
state capitalism that has enabled China to come so far so fast. “To
get consumption to surge,” said Mr. Pettis, the Peking University
lecturer; “you need to stop taking money from the household sector.”
In other words, Chinese consumer spending will only take off when
the China economic model as we know it ends.
China Domino Trend #7
Endemic High Level Corruption and Pollution is Sparking
Protests
In a speech last year on the 90th anniversary of the founding of the
Communist Party, President Hu Jintao urged the party to fight
corruption and create what he described as a clean government. He
warned that acts of corruption by party members who hold political
office could cause the public to lose trust.
This is a vast understatement. Corruption in China is a cancer that is
eating away at the trust of the people in their local and national
leaders.
A report by China’s central bank found that thousands of Chinese
government officials have smuggled billions out of the country and
fled, mainly to the U.S., highlighting "the corruption within a corrupt
system".
The report quoted statistics based on research by the Chinese
Academy of Social Sciences. Since 1990, the number of Communist
Party and government officials, public security members, judicial
cadres, agents of State institutions, and senior management figures
of state-owned enterprises fleeing China has reached nearly 18,000.
Also missing is an estimated 800 billion Yuan (more than $120
billion).
Robert Klitgaard has described the formula for corruption as
monopoly plus discretion minus accountability.
This sure sounds like China to me.
Beneath the veneer of a modern capitalist economy lies a statecontrolled protected business model to serve and boost the wealth of
“friends & family” of the Chinese Communist Party.
William Gamble, author of Investing in Emerging Markets: Rules of
the Game describes how the Chinese Communist party uses as
system known as paoguan, an expression that translates to “run
around for titles”.
In short, at promotion time members of the party make kowtow
visits to higher-level officials. The change of leadership later this year
means that offices in 31 provinces and province-level municipalities,
361 cities, 2,811 counties and 34,171 townships will be reshuffled
among 80 million members of the party. Many of these offices have
considerable decision-making power and therefore can lead to money
and perks.
Professor Michael Johnston of Colgate University, who has done
research on Chinese corruption for the World Bank, puts it this way
in a report: Corruption in China: Old Ways, New Realities and a
Troubled Future.
Here are a few key passages in this report that highlight the culture
of corruption.
“… In China's case a politically unchallenged regime creates
opportunities for its officials to control and exploit rapidly growing
economic opportunities. The economic incentives to corruption grow,
while countervailing political forces are absent.”
“But corruption is nothing new in China, and the post-reform surge of
corrupt practices and its growing significance as a political issue have
deep roots. Reforms and growth have created new opportunities, and
much higher incentives, for illicit connections between wealth and
power.”
“Today, corruption threatens the vitality and international credibility
of the nation's emerging new economy, and is a major issue for
critics of the regime, as shown on Tiananmen Square in 1989 and
more recently in the petitions of dissident groups”.
“The danger, however, is not just that corruption will continue to
distort economic policies and development, or that it is becoming a
focus for political discontents for which there are, as yet, few
legitimate outlets. It is that corruption itself may spiral out of control,
with consequences that are difficult to predict.”
The consequences seem pretty clear to me - the growing lack of trust
in their government by the people of China.
From time to time, you may read in the newspaper about protests in
China but they are much more common than you might think.
Tsinghua University estimates that there were 180,000 protest
incidents in China during 2010. Oftentimes these protests are about
higher food prices, corruption by public officials or land seizures. So
far in 1015, there have been more that 200 protests, often about
corruption or factories closing with a tycoon taking off to Hong Kong
before paying back wages.
The provincial or central government normally moves in quickly to
quell protests by reaching some sort of compromise but recently
some of these protests have gone on for months.
In particular, protests in the village of Wukan in Guangdong province
over a land grab corruption issue, has created solidarity amongst the
villages 20,000 residents. The entire village was cordoned off as
protests continued for more than two months before a deal led to a
cooling of tensions.
The Growing Public Outcry over Pollution
Another huge and growing problem is pollution in China. As growth
became the overall priority, the environment has suffered greatly.
China expert at the Council on Foreign Relations, Elizabeth C.
Economy, does a great job of explaining the environmental disaster
unfolding in her book: The River Turns Black.
One example is the Huai River Valley in eastern China. This fertile
valley, the size of England, is home to 150 million Chinese. But as
tens of thousands of small factories dumped their waste into the
river, it literally turned black, sickening many and killing 26 million
fish.
The following statistics capture only the tip of the dismal situation.
China is home to 16 of the world’s 20 most polluted cities. About 500
million Chinese do not have access to safe drinking water. Only 1%
of China’s 560 million city residents breathe air considered safe by
European Union Standards. The World Bank estimates that 750,000
Chinese die prematurely each year, primarily from air pollution in big
cities.
In many ways, pollution and corruption are two sides of a coin.
The Seven Troubling Trends Endgame:
China’s Bicycle Economy Faces Storm of Slower Growth and
Rising Political Corruption and Protests
The president of the highly respected Council on Foreign Relations,
Richard Hass, published a column in the Financial Times on January
29, 2012 entitled:
“Why a tremulous China’s greatest threat is internal”
Here is the first paragraph.
“I have been traveling to China for more than three decades, but
never have I encountered a Chinese leadership so uncertain of the
country’s future. It is little exaggeration to say the world’s most
populous nation is on its heels”
The biggest challenge for the leaders of China’s Communist Party is
to keep growth and employment high. Its economy is oftentimes
compared to riding a bicycle. It has to keep moving forward or it will
fall over.
How long before it becomes clear that Chinese authorities have lost
control of the credit and investment locomotive? How fast does the
Chinese economy need to go before it gets wobbly?
The Financial Times reported that Yu Yongding, an advisor to the
government, said that 7-8% GDP growth would be acceptable but
growth below 7% would signal an economic crisis, or even a political
crisis.
Maintaining a 7-8% year-on-year increase in GDP is the bare
minimum acceptable to Beijing mandarins. In the minds of the
central authorities anything lower risks the civil unrest that has so
often in China’s history shaken the hold of the central government.
This growth rate is quite a high hurdle and explains why China’s
leaders panicked in 2008 pumping an extraordinary $900 billion
(equal to 20% of China’s economy) of stimulus spending through its
banking and government system.
But the growth boom following this injection is fading and the
following perfect storm scenario for China during 2012-2015 is not
only possible – it is likely.
 Property prices decline sharply
 New private investment (50% of China’s economy) slows
 Export growth falls as U.S. and Europe economies continue to
struggle
 Lenders look to central government to cover state-owned banks and
company’s liabilities
 China’s banking system faces huge write offs and reorganization
 Trade and political conflicts escalate
All of the above could slow economic growth in China to 5% or less
for 2015. While the US or Europe would welcome a 5% growth rate,
it poses a disaster for China.
Internal migration of rural agricultural workers to the cities is already
adding uncounted millions more job seekers to the unemployment
roles of the new industrial China.
These workers will have to be sent home. Will they go or will they
rebel?
The Privileged Elite vs. Struggling Middle Class
Then there is a sharply growing sense of frustration that middle class
mobility is waning while the power and privilege of the politically
well-connected Chinese is growing.
I refer to this as “Moneybags Communism”
In a Foreign Policy article by Christina Larson, “The End of the
Chinese Dream”, Tsinghau University professor Patrick Chovanec
describes this emotion well:
"When Jack Ma makes a billion dollars for starting a successful
company, that's OK. It's inequality of privilege. It's how people make
their money. There's now a whole class of people getting wealthy
because of who they are, not what they do -- and they follow a
different set of rules."
………the Government has great power in determining winners and
losers, so who you are and who you know does more than anything
else to determine success…Privilege begets money, and money
begets privilege."
Chovanec goes on to say, "If you perceive that you're losing buying
power -- or have rising but unmet expectations -- that's when people
get upset. And this country, for a country growing at over 9% a year,
is in a foul mood."
Meanwhile, the politically connected elite in China, the so-called
“princelings”, is becoming more and more wealthy and powerful.
They are China’s “guilded” class.
“Business tends to be associated with the elitist faction,” says Cheng
Li, a senior fellow of the Brookings Institution. “But if their approach
is not balanced, politics might unfold in a way that shocks the nation
and the world. If China were to become chaotic, it would be a
disaster.”
The examples of party officials and their families carving up the
Chinese economic pie are endless. Jiang Mianheng, the son of former
party leader and still potent kingmaker Jiang Zemin, has done
lucrative deals with Microsoft and Nokia and recently signed a deal
with Dreamworks. , Wen Yunsong, the son of Prime Minister Wen
Jiabao, heads a state-owned satellite company, President Hu Jintao’s
son, Hu Haifeng, earlier ran a state-controlled firm that held a
monopoly on security scanners.
As Harvard China hand Roderick MacFarquar puts it , “They don’t
want to bring this into the open” because “It would be a tsunami.”
A young reporter in China sadly sums up the reality in China:
“People no longer believe you can win by working hard and honestly
in China."
A new book, Why Nations Fail by MIT professor Daron Acemoglu and
Harvard professor James A. Robinson highlight the theme that
institutions determine the fate of nations. The authors state that
enduring success comes when political and economic institutions are
“inclusive” creating incentives for everyone to invest in the future.
China is anything but an inclusive country. Its leaders extract wealth
through controlling the leading heights of the economy. The
overriding goal is to maintain and strengthen the power and wealth
of the leadership of the Communist Party.
One telling and powerful example in the book was the arrest and
sentencing of Dai Guofang in 2003. What was his crime? Mr. Dai
founded a low-cost steel company to compete with Party sponsored
steel companies.
Slower growth, like a tide going out on a beach, is shining the
spotlight on these stark realities.
Protests could explode all across China.
Remember, all of this is happening while the Communist Party
anoints its “fifth generation” of leaders in the fall of 2012. This
causes great uncertainty and could lead to chaotic decisions by
China’s mandarins at exactly the wrong time.
After all, the Communist Party always had only two cards to play in
order to maintain control and power.
The first is to deliver high levels of economic growth and the second
is stirring up nationalistic sentiment. There are no other durable
institutions or ideals holding the government in place.
Ian Bremmer, president of the Eurasia Group, describes the situation
in a recent column in the Financial Times:
“Beijing’s values represent no greater ideal. They appeal only to
those who dream of maintaining power and manipulating markets for
political or personal gain.”
“Occupy Wukan” is Just One Ticking Time Bomb
Corruption at local levels in China is often tied to corrupt land grabs.
This is what happened in the fishing village of Wukan in Guangdong
province in late 2012. After a series of corrupt land deals, protests
were organized.
Leaders of the protest claim that the village committee sold off or
granted long-term leases to nearly 60% of the village’s 11 square
miles over an 18-year period beginning in 1993. The sales were said
to include roughly four-fifths of the village’s farmland and much of its
forests.
No one seems to know where the revenue from these land sales
went. In addition, the New York Times reports that the village’s
Communist Party secretary, Xue Chang, had held office since 1970
before being replaced amid Wukan citizen protests in September.
Among others, a local leader, Xue Jinbo, was taken into custody. Xue
Jinbo died of a heart attack while in police custody. Nobody is buying
this explanation and officials refuse to turn over his body to relatives
for proper burial.
As you might expect, tensions escalated and village officials and
police fled as an armed security cordon tightening around the village.
Roads into the village and the harbor were blockaded straining food
and water supplies and robbing fisherman of their livelihood.
The village became self-governing with villagers making primitive
spears while calling for justice and free elections.
Wukan is hardly an isolated case. It’s all across the country,” said Liu
Yawei, an expert on local administration who is the director of the
China program at the Carter Center in Atlanta. Incidentally, there are
625,000 locally run villages in China. China’s government seems
uncertain what to do about this unrest and discontent is spreading.
In late December 2011, about 100 kilometers up the coast in the
town of Haimen, thousands residents confronted police armed with
teargas.
According to the Financial Times, the main reason for the protests
were the arrests of villagers who complained to authorities about
environmental pollution.
The Purge of a Princeling
A riveting drama unfolded in the global media that rocked party
leadership and exposed corruption at the highest levels.
Son of a revolutionary hero and comrade of Chairman Mao, Bo Xilai
was a man on the move. He was a member of the elite 25-man
Politburo and party chief of Chungking - an area with a population of
32 million the size of Austria.
More importantly, Mr. Bo was practically a shoe in for a slot in
China’s all-powerful nine-man Politburo Standing Committee later
this year. Think of it as a cabinet including the president and vicepresident.
But the maverick, populist Bo seems to have overreached. He built a
power base around his personality and symbolic links to the Mao era.
As his enemies in the party watched closely, his business dealings
came under scrutiny. His campaign of inquisition including thousands
of businessmen and officials and allegations of seizure of assets were
at best controversial.
Party leaders took action on March 15th, stripping Mr. Bo of his party
chief role. Then the story took an incredible turn. Mr. Bo’s wife, Gu
Kailai was taken into custody under suspicion for the death of British
businessman Neil Heywood, who was found in a hotel room in
November 2011. The daughter of a top military general, she and her
son had business dealings with Mr. Heywood. Apparently, they had a
falling out over “economic interests”.
Next, after Chungking’s police chief and top deputy to Mr. Bo, Wang
Lijun was dismissed, he went to the U.S. consulate in Chengdu to
seek asylum. After being turned away, he was taken under custody.
On April 10th, Mr. Bo was removed from the Politburo.
The Bo Military Connection Exposes Corruption
Perhaps even more troubling than political corruption is that the Bo
Xilai spectacle shines a light on longstanding corruption in the armed
services of China. The People’s Liberation Army (PLA) is extremely
active in the Chinese business community.
As previously mentioned, Mr. Bo’s wife is the daughter of a highranking general, Gu Jingsheng, former head of a paramilitary force
that was used to control the country’s northwestern region. Mr. Bo
has also aggressively courted the political support of senior officers in
the PLA to as part of his political strategy to gain and expand his
power base.
Mr. Bo reportedly also has close personal ties with the current head
of the Navy as well as other key military decision makers that sit on
the Central Military Commission.
One of them, General Liu Yuan, head of General Logistics
Department (GLD), earlier this year commented on the “dangerous
level” of corruption in the military. Corruption investigations are
oftentimes used not only to expose wrongdoing but as a tool to
silence critics and opposition within the military.
Kathrin Hille of the Financial Times reported in February 2012 the
recent detention of Lieutenant General Gu Junshan, deputy head of
the GLD of the People’s Liberation Army.
PLA has seen many high-profile corruption cases in the past, and the
GLD responsible for much of the military’s real estate and other
valuable assets and projects, is well known for offering opportunities
to get rich by skimming off deals.
All these ties are probably why rumors of an attempted coup
following the removal of Mr. Bo as party chief of Chungking were
widely reported on the Internet.
China watcher John Garnaut writing in Foreign Policy describes a
military leadership corrupt to the core. The buying and selling of
official posts is commonplace and open. Garnaut writes that “the web
of military cliques, factions and internal knots of organized crimes
sounds more like the workings of warlord armies before the
communist revolution than the rapidly modernizing forces now
rattling China’s neighbors.”
A senior official sums up the sad situation by commenting that
“corruption is the glue that keeps the whole thing together….”
Is Bo Xilai the Tip of an Iceberg?
Some call this Bo Xilai scandal the biggest crisis in China since
Tiananmen. I think it is the tip of the iceberg.
The circumstances surrounding Mr. Bo’s collapse may indeed be
sensational but the mixing of business and politics by high and low
level party officials is not the least bit unusual.
I believe this case will unleash a torrent of corruption scandals that
will undercut the legitimacy of the party.
It also highlights that the carefully cultivated appearance of a unified
Communist Party is far from reality. Clashing factions and ferocious
infighting is the truth.
There are growing rumors that military leaders are at odds with more
cautious members. Reformers who wish to open up markets and trim
the power of state-owned enterprises are clashing with those who
want to exert even more control over the economy.
Gridlock is the most likely best-case scenario. It is hard to imagine
that those advocating a path to political and economic reform will
triumph over hardliners.
The Economist underlines the clash by citing two popular media
outlets. The Utopia website called on the army to take a stand
against the “treacherous running dogs” while the Caixin Media, a
Beijing media publisher said it was time for “gradual but firm”
political reform.
History shows us how difficult comprehensive reform in China can be
since Chinese traditionally see politics as a zero sum game.
In 1898, Emperor Guangxu announced comprehensive changes to
education, the economy, the military and the bureaucracy aimed at
modernizing China. In response, Empress Dowager Cixi organized a
coup, reformist advisers were executed and Guangxu was placed
under house arrest.
The Qing dynasty fell only 13 years later.
A Migrant Movement – 230 Million Strong
A group of workers in Guangdong rioted for three days in mid-June
2011 after security guards pushed around a married pair of street
peddlers while ejecting them from the front of a supermarket. The
South China Morning Post said the guards first demanded a bribe and
then delivered the beatings when the couple offered too little money.
Protests escalated and an estimated 10,000 protesters took part in
the riot on the third night, with People's Liberation Army troops
joining to control the chaos.
This is but one example of a growing number of recent cases where
so-called migrant workers have rebelled against their second-class
social status. In the same province just four days before, "clashes
between migrants and police broke out after a worker in a ceramics
factory was stabbed, allegedly on the orders of his boss when he
went to ask for unpaid wages," according to the Financial Times.
Workers whose families come from some other province receive low
pay and are denied social benefits--such as public education, health
care and unemployment insurance--that local residents are entitled
to.
Residential registration, known as “hukou”, is hereditary, so a longterm urban worker may remain classified for life as a "migrant
farmer" lacking the rights of full citizens. There is also urban
prejudice against Chinese of peasant origin.
According to official figures, China has more than 230 million
"migrants," whose cheap labor formed the backbone for its
construction and manufacturing booms.
China's overall level of class struggle has climbed steadily since the
mid-1990s. From 1994 to 2004, mass incidents rose sevenfold, from
10,000 to 72,000. By 2008, the number grew to 127,000.
According to the Los Angeles Times, "a sociologist at Beijing's
Tsinghua University reported this year that China has had 180,000
mass incidents in 2010, double the number in 2006."
The best evidence that the Chinese authorities are scared of protests
getting out of hand is the extremely harsh sentences for even talking
about problems.
The New York Times recently reported that Chen Xi, a liberal Chinese
writer, has been sentenced to 10 years in prison on a charge of
“inciting subversion” of the state. This harsh sentence, imposed by a
court in the city of Guiyang, the provincial capital of Guizhou
Province, was for 36 essays that Mr. Chen had written and posted
online.
The Chinese government has launched a broad attack on liberal
writers in an attempt to stamp out any seeds of dissent. Another
author, Chen Wei, was sentenced by a court in Suining, Sichuan
Province, to nine years in prison on the same charge after four of his
essays were posted online.
Communist Party Leadership Changes Heighten Uncertainty
The once-in-a-decade leadership change of the Chinese Communist
Party and the government is expected in late 2012.
The Politburo has 25 members but the key is the Politburo Standing
Committee that currently has nine members. Think of this as China’s
ruling cabinet. The new Cabinet will only take over at the National
People’s Congress in March 2013.
The Party reshuffle is the one to watch. The government hierarchy
shadows the Party at the highest levels. The head of the Party is also
the country’s president; those on the next rungs down in the Party
act as head of the National People’s Congress (the parliament) and
prime minister. As a result, the new senior figures in the new
government should be settled on after the Party Congress.
At lower levels, the handover of power is already beginning – new
heads for the banking, securities and insurance regulators were put
in place late last year. However, the identity of some ministers and
agency heads may not be known until the spring of next year.
The key Party appointments are those to the Politburo Standing
Committee, China’s top decision-making body. Of its current nine
members, seven are at retirement age and expected to step down
this year. The other two, Xi Jinping and Li Keqiang, are the only
members of their younger group currently on the Standing
Committee.
All these leadership changes come at a time of extreme tension
within the country and the Communist Party. The reformers will most
likely take a backseat to the hardliners lest they look weak and
vulnerable.
This will put any meaningful policy reforms on the back burner.
Candidates vying within the party for important posts will also want a
strong and stable economy. This will lead to significant expansion of
monetary and fiscal policy – just when the country needs to go in the
other direction. Most importantly, the uncertainty regarding
leadership will be a huge handicap in making decisions on how to
deal with an economic slowdown and explosion of protests.
The Challenges Facing the Communist Party
The legitimacy and credibility of the Chinese Communist Party, like
any authoritarian government, is based on its ability to generate high
economic growth and portray a leadership that represents the
national interest.
Both of these are now very much in question. The economy is
slowing but more importantly it is seen as unfair and wildly uneven.
Corruption within the leadership down through the ranks of the party
is seen as common rather than rare.
While Jing Huang, a scholar of Chinese politics at National University
of Singapore believes the leadership is trying to make Mr. Bo the
“poster child of corruption and crime”, the Chinese people know that
the system itself is corrupt. In short, there are two sets of rules, one
for the connected privileged elite and one for everyone else.
The high command is doing everything possible to fight this growing
perception. In the last few weeks it has closed 42 websites and
censored 210,000 online comments. Unfortunately, it is becoming
clear that the system is rotting from the top.
A new book, Why Nations Fail by Daron Acemoglu and James A.
Robinson does an excellent job getting to the core of why China’s
present system and course is not sustainable.
Based on fifteen years of research, the author’s contend that nations
such as China that lack inclusive and open political and economic
institutions are not sustainable. Economic growth can be achieved by
“extracting” profits for some time but eventually radical reform is
necessary to achieve long-term success.
The problem is that the privileged classes that benefit from these
closed systems do not want to give up their positions and fight
reform to the death. A society must have an accountable and
responsive government to the great masses of citizens plus
incentives that reward innovation, hard work and risk taking.
Is China Ripe for Radical Change?
This was the question posed by a February 12th, 2012 New York Times’
article by Stephen Platt of the University of Massachusetts, Amherst.
His first sentence caught my attention.
“ONE HUNDRED years ago, on Feb. 12, 1912, the 6-year-old child
emperor of the Qing Dynasty abdicated, ending more than 2,000 years
of imperial rule in China.”
Mr. Platt then goes on to explain that the current situation in China
more closely resembles the violent Taiping Rebellion that took place 50
years earlier.
He describes the challenge faced by the Chinese Communist Party as:
“…..enormous, inchoate rural unrest. The dark side of China’s
economic rise has been a shocking widening of the gulf between the
prosperous coast and the poverty-stricken interior, a flourishing of
corruption among local officials and, by such data as we can gather,
widespread anger and discontent.”
The Taiping Rebellion was eventually quashed but its beginning is what
must send chills down the spine of current leaders.
“What was so remarkable, and so troubling, about the Taiping
Rebellion was that it spread with such swiftness and spontaneity.
Finally, Senator John McCain recently warned China’s Vice Foreign
Minister that “the Arab Spring is coming to China,” pointing to the
wave of Tibetans setting themselves on fire in China.
We have covered a lot of ground together. Let’s pull things together
and with what you can do to protect your capital.
Coming Full Circle to Japan
In the introduction, I described the lessons learned from my
experience with Japan’s boom and bust. Japan’s fall from grace just a
few years after it being lauded by many as the best economic model
on the block is telling.
This is important since China has largely followed Japan’s blueprint
for success. This includes heavy investment in industry, focus on
exports, high levels of savings, top-down management by the
bureaucracy and a cozy financial system.
This worked well for roughly three decades before the implosion in
2009 due to a financial and property meltdown. The bottom line is
that Japan was unable to cope because it was not really a flexible
market economy. Market prices and interest rates did not direct
capital.
Who would have thought that over the last two decades Japan’s
economy would have flat lined and its stock market would be trading
at 25% of its peak?
And consider the advantages that 1990 Japan had over the China of
2012.
Japan was a wealthy country with a stable and broad middle class.
Japan was a close ally of America and ran a deft low-key, nonconfrontational foreign policy. Japan also had the advantages of a
democratic, stable government and a homogeneous society.
Most importantly, while Japan certainly had corruption and the
government’s role in the economy was significant, China has much
bigger challenges with both of these important issues.
For example, it may surprise you to learn that 50% of China’s
workers are employed directly by the government or by state-owned
companies.
Could China now embark on a far-reaching period of market reform?
I see no signs of it and the forces arrayed against reform are
formidable indeed. And time is running out as a "China 2030" report,
recently released by the World Bank points out that:
"China could postpone reforms and risk the possibility of an economic
crisis in the future -- or it could implement reforms proactively.
Clearly, the latter approach is preferable,"
The Chinese Stock Market:
Casino for Investors -ATM for Government and Elite
I have purposely said little about China’s stock markets since its
performance is not tied to the economy but is rather a pure
momentum and liquidity play.
For example, from 2000 to 2011, China’s economy increased almost
500% while the Shanghai composite index rose only 46% - reflecting
negative real returns after taking inflation into account.
There are several reasons for this poor performance.
First, initial public offerings in China are almost always significantly
overpriced helping companies and inside shareholders but leading to
losses for ordinary investors.
Second, state-owned companies retained a high level of share
ownership after going public and have from time to time sold these
shares into the market to raise cash but dilute ordinary investors.
Third, insider trading is rampant. A study by Dow Jones showed that
over a decade the majority of gains could be attributed to 10 days of
unusually sharp gains.
In addition, I have another suspicion about the relatively poor
performance of China’s stock markets. Perhaps the market is working
as a forward-looking mechanism implying that the quality of
economic growth and earnings is poor and overstated.
Observations from a Yankee China Hand
An American businessman who has been visited Shanghai every
quarter for the past decade made these astute observations on
Michael Pettis’s blog.
“First – The size of China’s economy is beginning to hit the
mathematical limits of compounding. A perpetual 10% increase of a
larger and larger GDP is a mathematical impossibility.
Second – Going forward, Central Planning will prove to be more of a
hindrance than a benefit. It will be very difficult for a centrally
planned economy to effectively micro manage the huge number of
market decisions required to redirect growth from investment to
consumption.
The majority of decisions made by the Central Committee over the
last 15 years have been beneficial to economic growth. However
many of the decisions were easy choices; build an infrastructure,
develop energy and basic manufacturing industries etc. Picking the
low hanging fruit so to speak. On my quarterly visits since
2010/2011, it has become increasingly obvious that new
infrastructure investments have a much lower marginal value.
Members of the Central Committee have become enormously rich
over this period on infrastructure projects and GSE’s. It seems
somewhat doubtful that these same influential party members are
going to take away the punch bowl until debt burdens imposed by
reckless investments result in some sort of economic crises.
Third – Chinese products are no longer inexpensive. Lower end
products are being out-sourced to Indochina and manufacturing for
higher end products are beginning to be repatriated closer to the end
market. In our case, we have opened a second contract
manufacturing facility in Mexico and costs are fairly equal. A large
increase in demand for Chinese goods in the West is unlikely.
Fourth – Expect some political instability from the interior regions of
China. When the promised increased living standards experienced in
the coastal regions do not materialize in the interior, there will be
political repercussions.
Fifth – China’s overall economic policy appears to be patterned after
the mercantilist policies adapted by the US in the first half of the
20th century, Japan in the 80’s, and currently Germany in the EU.
The eventual unwinding this policy will likely result in much slower
economic growth rates going forward. I think 3-4% economic growth
prediction is spot on.”
China Landmines Are Everywhere
Looking forward, the blowback from China’s financial and political
turbulence will be far reaching for the world and your investments.
And nobody will really benefit from a China collapse.
Why?
The consequences of a Chinese collapse, however, would be severe
for the United States and for the world. There could be no major
Chinese contraction without a concomitant contraction in the United
States.
That would mean sharply curtailed Chinese purchases of U.S.
Treasury bonds, far less revenue for companies like General Motors,
Nike, KFC and Apple that have robust business in China (Apple made
$6.83 billion in the fourth quarter of 2012, up from $4.08 billion a
year prior), and far fewer Chinese imports of high-end goods from
American and Asian companies.
It would also mean a collapse of Chinese imports of materials such as
copper, which would in turn harm economic growth in emerging
countries that continue to be a prime market for American, Asian and
European goods.
Even if you do not own any Chinese stocks, your portfolio will be
affected because China’s economic tentacles reach into many
companies, commodities and countries.
For example, take a company in Brazil.
Brazil’s second largest company and the largest iron ore miner in the
world is Vale (NYSE:VALE).
A shocking 40% of Vale’s sales are to one country: China.
But this is nothing compared to what will happen to this stock if
China’s economic growth falls below 7%.
Hong Kong is another market to avoid since main land China stocks
now represent for 55% of the listings on the Hong Kong stock
exchange, and about half of the city’s trade is with the mainland.
While China takes only 7.5% of US total exports it is the buyer of
more than 20% of exports from Japan, Australia, Taiwan and South
Korea.
Many commodity prices will also be a big loser from the fall of China.
Already in the first quarter 2012, while global stocks are up 11%, a
widely used commodity index is flat.
From an investment perspective, the China economic slowdown
means the end or at least the interruption of the commodity boom.
Many industrial metal prices are already down roughly 50% or more
from 52-week highs.
The FTSE All-World mining index has already dropped 61.8% from its
peak in April 2011 while the mining sector accounts for 1/8 of the
value of London’s FTSE 100 index.
China accounts for up to 75% of forecasted consumption growth of
iron ore, copper and coal. This has huge implications for share prices
of companies such as Brazil’s Vale, which sells about 40% of its iron
ore to China. Vale accounts for 20% of the Brazil’s stock markets
value so its direction has a significant impact on the market.
Australia and Indonesia’s mining companies also need to be
evaluated carefully.
“We believe that the tail wind of ever-higher commodity prices, which
has been the principal driver of share prices, is now over,” says
Heath Jansen, head of metals and mining research at Citigroup, in a
report entitled “Super-Cycle Sunset”.
Mining costs were also up 10-15% in 2014 according to a study by
Deutsche Bank and running at about the same pace so far this year.
Naturally, this is squeezing margins and trimming profitability.
Significantly, the Financial Times reports that Australia’s global
mining giant BHP announced last week that it was slowing the
development of several high profile mining projects.
Consider decreasing allocations to industrial metal miners and cut out
the highest cost producers, low dividend payers, and firms heavily
dependent on China market.
The Chinese economy is a key market for commodities producing
countries like Australia. Noted Societe Generale strategist Albert
Edwards puts Australia risk in the following stark terms:
“Australia, at its simplest, is a credit bubble built upon a commodity
boom dependent for its sustenance on an even greater credit bubble
in China.”
Australia’s economy has been on quite a run avoiding any negative
growth since 1991. The country has also experienced a tremendous
housing boom with house prices up 300% since 2000, 100% more
than in the US at its peak. In addition, Australia is very vulnerable to
a China slowdown sending 25% of its overall exports to China.
BHP Billiton reports that China‘s share of global demand for coking
coal and iron ore is over 50%. For aluminum it is 42%, copper is at
37%, and potash is about 18%.
Deferrals and defaults: Chinese consumers of thermal coal and iron
ore are asking traders to push back cargos and in some cases
defaulting on contracts according to traders in London and
Singapore. One senior trader commented that, “China is hand to
mouth at the moment”. Soybeans and cotton markets have also
experienced deferrals and defaults.
So what should you do to protect yourself and profit from any China
chaos and the collateral damage that might spread across the world?
Here are just a few of the questions you need to address.
What commodities will be hit hardest?
What will be the best safe haven currencies?
What multinational companies and country stock markets are most
closely linked to the Chinese economy?
Are their some stock markets that will move opposite Chinese
markets?
What will likely happen to prices of precious metals? Which ones will
likely outperform?
What companies and markets could potentially benefit from a China
crash?
How should investors time their re-entry into Chinese stocks?
Here’s what I recommend...
Sell Teucrium Soybean Fund (SOYB)
The investment thesis here is fairly straightforward: China is the
biggest buyer of soybeans in the world.
Sell or Buy Put OptionMarket Vectors Rare Earth/Strategic Metals ETF
(REMX)
China produces 90% and exports 97% as the leading miner of rare
earth and strategic metals. This ETF holds approximately 30
companies from around the world that are engaged in
mining, refining, and manufacturing of rare/earth strategic metals
though Chinese stocks account for only one-tenth of total assets.
Sell or Put Option on South Korea Index Fund (EWY)
South Korea is a preferred trading partner of China especially with its
giant conglomerates that dominate this top heavy ETF.
Sell or Put Option on iShares MSCI Chile Index Fund (ECH)
Chile, South America’s most prosperous nation is one of China’s
biggest trading partners. About a quarter of its total exports go to
China and copper is at the top of the list.
Buy ProShares UltraShort FTSE China 50 (FXP).
This ETF targets twice the inverse (-2X) of the daily performance of
the FTSE China 50 Index. To be sure, this ETF is speculative and it
definitely would not be suitable for the faint of heart. Although its
price quickly doubled during the market sell-off of 2008, its price has
plummeted 64% during the last two years.
Buy iShares Japan (EWJ)
My view is that Japan would be a bit of a safe haven if China really
went south. The yen would strengthen, Japan would greatly benefit
from lower commodity prices, and Japanese manufacturing
companies would see margins increase as competition from China
lessened.
Capture the Value – Manage the Risk
While reading this book, your first instinct is probably to call your
broker and sell all of your China related holdings.
I strongly suggest a different approach for a number of reasons.
First, the direction and/or pace of these seven China domino trends
are not set in stone. I am skeptical that the Chinese system is
flexible enough to cope or adjust to these enormous challenges but
they will certainly try.
And China has powerful monetary tools such as cutting its reserve
requirement. Unlike the monetary policies in the developed
countries, a China RRR cut is very stimulative, acting like a tax cut
and a regulatory green light for lending.
All of these trends need to be monitored carefully to see how they
develop.
Second, Chinese stock markets are usually driven by liquidity and
momentum rather than fundamentals. There were many years during
the 1990s when the Chinese economy was growing at 10% plus rates
and the stock markets did nothing.
As 2012 opened, the Shanghai market came off a two-year period of
weakness – down 37%. And as 2015 opened, many stocks, and
especially the banks, were trading at attractive valuations. This
doesn’t mean the market will go up but it makes it more likely.
The kindling was there for a run up in the Shanghai market, which
reached more than 60% in July, but since then, markets have given
back more than 40% of this gain.
On the liquidity issue, some of the domino trends might boost the
market short term. As Chinese property markets slide, investors may
very well move this wall of liquidity to stock markets. After all, what
other choices do they have?
The state banking system has set interest rates so low that they are
negative after adjusting for inflation. No wonder those Chinese that
are able are moving capital offshore.
The bottom line is to know how much China related exposure you
have and then execute a strategy to capture growth while managing
risk.
From Growth to Value - From Macro to Micro
In conclusion, despite all the risks, there will be some investors that
will be able to make money in China with the right strategies.
Here are two observations that may be helpful to you.
First, China is moving from a growth story to a value story. Be very
wary of buying into a momentum story. Unless you are lucky, it will
not end well.
Be mindful of value and this more conservative approach will lower
risk and offer you maximum upside.
Howard Marks of Oaktree Capital puts price and value at the center
of his book, The Most Important Thing:
“For a value investor, price has to be the starting point. It has been
demonstrated time and time again that no asset is so good that it
can't become a bad investment if bought at too high a price.
And there are few assets so bad that they can't be a good investment
when bought cheap enough.”
Second, China is moving from a macro story to a micro story. This
means the broad-based ETFs are out and more targeted ETFs, stock
picking, and trend following are in.
This means you need to do some serious research and, even better,
visit China yourself to learn firsthand of the risks and the
opportunities.
This is why I have become involved with Global Frontiers, which has
been organizing and executing institutional research trips to China
and other emerging and frontier markets for over 17 years.
Best wishes for profitable investing in China and throuout Asia.
China in Charts
Overcapacity in Key Industries
Total Debt as % of GDP