China : The Emperor Wears no Clothes

August 11, 2010


“Once Upon a Time there was an emperor who wore no clothes. For the longest time, no one noticed.”Extraordinary Popular Delusions and the Madness of Crowds

      In many ways, the 2008 Summer Olympics in Beijing captured the essence of the “China Miracle.” The opulence of the opening ceremonies as a demonstration of how far the country has progressed, the patriotism of the crowd in contrast to a long history of disgruntled uprisings and violent government suppression, and, finally, what many view as the inevitable supplanting of the US when China finished atop the Gold medal count.  It turned out, there was more to the story. Allegations surfaced of overspending and under-reporting on cost;  lip-syncing of the opening song;  forced cheering and state monitoring of crowds;  erratic gymnastics judging , and finally, cheating by using underage girls to win the showcase event – women’s gymnastics.  As the story goes, China rose from the ashes over a 30 year period by adopting the governance and economic lessons of the West, finally unleashing the power of 1 billion people  to topple the United States, and is now on the cusp of becoming the next global power. Perhaps, like the Olympics, the real story has not yet been told.

There had been a Chinese tv show called Snail House. It serves as a microcosm of Chinese society today.  The main actors were two sisters who become “fangnu,” or mortgage slaves, with the episodes centering around their quest to meet their monthly payments. Officials brought the show to an abrupt end when one sister slept with a corrupt Communist Party official to in order to make payment ( 1).  Skyrocketing home prices, corrupt party officials, censorship,  and an increasingly confrontational and disgruntled society are all under-reported facets of the China story.

In real life, couples making the equivalent of $40k in the US are buying $700k homes, according to the work by Kynikos Associates, while stories of maids and taxi drivers quitting their jobs to flip pre sales rights to condos are common.   Across China’s 8 major cities, the price to rent ratio has ballooned to 39.4 times versus a peak of 22.8 prior to the US housing crises. Couples are getting divorced in order to purchase two properties, said the head of the leading residential real estate brokerage firm. Loan sharks have been setting up auctions, where people gather to bid for the right to capital so they can turn to the housing market to speculate. Units are sold with no walls, appliances,  and units sit empty and uninhabitable. Prices in many areas exceed those in the US, despite that one merely leases the underlying land from the People’s Republic of China, who in 70 years, retains rights.  Land speculation has pushed prices up a staggering 800% since 2003, according to the NBER. State owned enterprises, from food producers to railroads have purchased 82% of local government land auctions, while paying 27% higher than equivalent prices in the second market.

The government has built 30 billion square feet of office space for 1 billion people, with enough supply to provide the equivalent of a  5 x 5 private office for every man woman and child, said Jim Chanos.  The building continues with another 200 million square meters planned for this year, according to Mark Hart of Corriente Advisors.  Pivot Capital notes that China has built nearly the same number of roads as the United States, despite roughly 1/10 the number of cars, the same number of bridges but 1/7th the number of rivers.     They built a city for 1 million people, which is abandoned, and constructed the largest mall in the world, which is 95% unoccupied. The investment in fixed capital has exceeds 50% of GDP, above levels seen prior to the Japanese peak in the late 80s, and the Asian Tigers in the mid 90s, and subsequent crises. The result is a disproportionate number of single males who have migrated to the cities to seek an inflated numbers of construction jobs. Meanwhile, an estimated million college graduates are homeless on the city outskirts, caught in a government web that needs to keep the construction industry humming to avoid social unrest.

The mania has spread like a virus beyond national borders, with mainlanders driving prices across the world to stratosphere heights.  In Hong  Kong, a 1,476 square foot condo recently sold for $37 million, or $25,000 square foot, magnitudes higher than in New York City at the height of the housing bubble Easy bank credit is the culprit. Mortgage interest rates are less than 1%, many issued with floating rates and some of them financed by Swiss banks.  Chinese students are buying $500,000 beach-front homes in Australia (1) , and up to 50% of the luxury properties in Vancouver, Canada, (1) by some estimates .  The loans are secured with down payments of 30% or more, the saying goes – secured by other inflated property is the reality.

Chinese demand for infrastructure commodities such as steel, copper, cement, etc., has been behind the strength in global mining companies from Brazil to Australia, with up to 65% of steel sales from the three major global steel producers going to China, despite stock piling and idle Chinese mill capacity.  Total excess steel capacity will reach 200 million tons this year, more than the EU’s and Japanese entire production this year. The PBOC has been engaged in the ultimate “Texas Hedge,” enhancing their exposure to the industrial materials sector. China Investment Corp, the sovereign wealth arm of the PBOC, has spent countless billions to purchase stakes in industrial mining companies across the world, while simultaneously negotiating high-risk questionable investments with corrupt countries from Afghanistan, to Congo, the Sierra Leone, and many others.  In all, China and 43 corresponding African nation have set up joint committees that convenes to discuss economic and trade issues, according to the WSJ.

Credit exceeded 140% of GDP in 2009 and was well on its way to the 200% crises levels seen in the US in 2008 and Japan in 1991. This is an ominous sign given that rapid credit growth was the single best predictor of financial crises in a 140 year study of 60 financial crises by the US National Bureau of Economic Research (1). Chinese debt levels are listed at just over 20% of GDP, but if one were to add in local debt,  total debt would closer to 70-80% of GDP, versus the United States’ near 90% of GDP says Victor Shih, professor at Northwestern University. This operates under the grand assumption that the published figures are believable, and with a long history of accounting gimmicks that stem back to the Asian crisis of 1997, corruption rampant, there is the possibility these are conservative figures. The real question what is priced into the market. The US debt situation is well known, while the consensus on the Chinese government’s fiscal health is much different.

Chinese banks’ allegedly conservative lending standards have given way to a credit growth surge climbing at an alarming 20-30% per annum.   Recently, Fitch has uncovered evidence that banks have understated the amount of bank lending, “many banks continued to secretly shift loans off the books, creating a pervasive understatement of credit growth and credit exposure,” says Fitch’s Charlene Shun. Her calculations show credit exposure was understated by 28% in the first half of the year, or 190 billion, as banks reclassified liabilities as investments.  The debt is being hidden in Local Investment Companies, “shell entities which borrow from Chinese banks and invest in fixed assets,” says Corriente Advisors. Much like in US pre-crises, Banks have been undergoing de facto securitization, repacking loans to companies engaged in land speculation into wealth management products, which are then resold to customers. These transactions are then booked as investments rather than liabilities.  China has taken great pride in the pay practices at  State Owned Enterprises, such as banking executives, whose salaries remain in the 200-300k range. But recently, there are questions over whether this practice of systematic underpayment has created a culture of corruption. It’s worth noting that there is little way of deposit guarantees by the PBOC, historically a risk factor in bank runs.

There’s mounting evidence that the dubious Chinese fiscal picture and corruption has spread beyond the government accounting, SOE’s, and banks, and into the company level in non finance companies as well.  ForensicAsia takes a picture of the fiscal health of non financial companies on whole, then uses as a baseline the composite fiscal health of companies prior to past crises, such as Scandinavia in 1990, Mexico in 1993, and Thailand in 1996. “Gearing exceeded 100% of shareholders equity and returns on equity were around 10% or below on the eve of crises,” says ForensicAsia. The composite score also takes into account working capital, quality of earnings, and balance sheet governance.  The threshold is typically 25% of companies showing signs of weak financials.  Chinese companies on whole are showing signs of excess leverage, low returns on equity, and a heavy reliance on equity offerings and debt issuance.   Price signals to companies and entrepreneurs were distorted by the massive government stimulus, with companies responding by gearing up for worldwide growth when much of Europe is in retrenchment and the US mired in slow growth.  So long as the flood of IPOs and credit flows freely, the corporations look healthy.  Like Warren Buffet said “It’s only when the tide goes out that you learn who’s been swimming naked.” Australian companies, which are heavily cyclical and with a large share of mining companies, are also reaching pre-crises levels with stressed fiscal conditions.

Not only are companies showing symptoms of questionable balance sheets, fraud is beginning to surface. There are stories of former company employees now conducting audits to verify financial statements.  Many Chinese firms are raising capital in the US under dubious circumstances, using take unders of bankrupt US companies to skirt listing standards.   Once highfliers Rino International, Fuqi International, China Sky, Orient Paper, and more are trading with seemingly extremely cheap PE’s of 4 or 5 with strong earnings growth. Investors are beginning to doubt the numbers. It begs one to wonder about the underlying businesses in Shanghai exchange issues where the accounting standards are much weaker.

The strong currency reserves is deemed a safety net, but if history is any guide, it may be more of a curse, than a blessing. The last two times  a country has held such a large reserves were the United States in the 1920s and Japan in the 1980s. Meanwhile, the consensus among economists and the US congress is that the Remnimbi is under valued, and there is bipartisan support to bring action, perhaps tariff’s. The Smoot Hawley Act of the 1930s, following the credit surge of the 1920s, was one of seven factors that lengthened the depression, according to a UCLA  study (1).  China’s commerce secretary noted that margins on exports are 2%, so any Yuan appreciation in excess will create large problems for the export industry. Meanwhile, China’s manufacturers can’t easily increase prices as they must compete with the likes of Vietnam, Pakistan, and India, whose wages such industries as textiles are one third the level. Productivity advances are not an option as they’ve relied on low margin high volume processes.

Like today, the US pressured Japan to appreciate their undervalued currency in the 1970s and 1980s. When Japan buckled, signing the Plaza Accord of 1985, depreciating the dollar against the yen and Germany’s deutsche mark, it ultimately leading to a spectacular bust. There is the question of how such a revaluation will impact China’s reserves position. Effectively, the US is asking for a hair cut on the debt owed to China. “Any movement — even a gradual one — causes a significant change in the value of  its reserves, which reached $2.5 trillion in March, roughly half of its GDP. If they have a 10% revaluation against the dollar, that’s the equivalent of 5% of GDP, which is a big amount to lose,” notes Wharton’s Franklin Allen. Indeed, “the Chinese central bank’s balance sheet resembles that of a hedge fund buying dollars and short-selling the yuan,” said Rickards, formerly of Long Term Capital Management.

The consensus is that it’s a given the Yuan is undervalued. But with such a large consensus expecting an appreciation, one begins to wonder how much of the money has flowed into or kept in China in expectation of an appreciation, leaving the currency vulnerable on the event. Government officials have voiced concerns that “hot money” has flowed into the country in anticipation of a revaluation, with money begin disguised as Foreign Direct Investment and trade, said Yi Gang, director of State Administration of Foreign Exchange earlier this year.  China appears stuck in the middle – either the  Remnimbi appreciates crushing the export industry or the hot money flows reverses in vacuum-like fashion.

Prior to the Asian flu in 1997, Russia had been experiencing strong growth by selling raw materials to the Asian Tigers, who had been engineering their own real estate bubble. When the credit dried up, Asian currencies began crashing, and Asia stopped buying raw materials from Russia. This provoked an unexpected Russian default the following year. China’s strength has been exporting to Europe and the US, who are now mired in debt and seemingly destined for slow growth.  Europe remains their largest export market, and the recent depreciation in currency, means a subsequent rise in goods sold.  There seem strong parallels – Asia in 1997 compares with Europe in 2010, as Russia in 1997, compares with China in 2010.

It takes more than a large population to become an economic power. In particular, it takes the right political and business environment. The World Bank scores countries on ease of doing business, taking into account ability to attain permits, protect investors, enforce contracts, tec. The G8 countries hover near the top of the list, with the US ranking 5th and France the lowest of the G8s, at ranking 3th(1). China, allegedly the next major economic power, ranks 89th, below El Salvador, Pakistan and Serbia, not a ranking that portends the next great economic power. “They want everything, but give nothing,” said JP Morgan’s Jamie Dimon.  Speaking to the ever pervasive element of corruption, a survey by YouGov showed that in China, “93% of business owners say guanxi, the networks and relationships is necessary to succeed in business,” while entrepreneurs in India and the US frequently say that success comes in spite of the regulations of the state.

Since the 19th century’s Open Door Policy, when President McKinley adopted policies to encourage trade with China, the West and its businesses have been lured by the temptation of populous, previously closed economies, often to become victims when governments pull the rug out from under foreign companies in favor of domestic, often government-connected companies. This typically occurs after foreign companies invest large amounts capital into plants and training, share proprietary business processes, and reveal technology. The pattern is to rule the companies violated laws, regulations, or fair competition, then turning those markets over to domestically companies, often linked to the government. The PBOC recently for the first time invoked an anti-trust laws against Coca Colas billion dollar buyout over of a local juice maker. GE’s Jeffry Immelt recently said “they won’t  let us win,” and “I really worry about China.”  Immelt went on to say that world’s largest manufacturer was seeking business elsewhere in countries that do not want to be “colonized” by China. Foreign companies are required to share stakes of new business ventures with local companies, at the risk of seeing an ally later becoming a competitor after technology has been transferred. Pfizer had a local partner in the H1N1 virus market. Following the purchase of Wyeth, the Chinese government forced the company to hand over it’s stakes in the valuable swing flu virus market to a local Chinese company, adding insult to injury by negotiating the rights to send Chinese scientists to the US to be trained in the manufacture of virus that could possibly be used in other industries. Indeed, this intellectual property theft is being branded shanzai, or bandit culture, and a source of pride amongst company heads. The question of whether the allure of China’s market and foreign investment will continue under this regime.

China’s business model of building for the sake of building constitutes one of the largest misallocation of capital the world has ever seen, one 30 years in the making. The government has traded its citizens’ standard of living for buildings, pollution, and power.  In a gigantic feedback loop, the government is rewarded for the misallocation with widespread admiration for it’s GDP growth with investments from foreign companies,  but an economy dependent on construction, cheap currency, duped investors, and an obedient society willing to sacrifice a commensurate standard of living.   However, things are beginning  to unravel.  The property bubble is beginning to prick with volume off 80% since April, says the head of the leading Chinese residential brokerage  firm. Demand for exports are falling, political risks from the US and the world are increasing, suicides are making headlines, and workers are striking.  ”The probability of social unrest and the level of intensity of the violence are directly proportional to the dependence of the citizens upon the state for their well-being,” notes Fred Jones of Jutland Capital Management, and there is no major economy more dependent than China on economic central planning.  Perhaps “this time is different” and  a centrally planned economy reportedly directed by 25 people has it all figured out.  Or perhaps, as with the Olympics, the rest of the story has not been told.

Trade Ideas:

  1. Credit Default Swaps : Hong Kong Property Derivatives
    • GFI’s HKU-REIS is a monthly real estate price
    • I-Traxx – Asia ex-Japan iTraxx investment-grade index ITAIG5Y=MP
  2. Credit Default Swaps : Japenese Corporate dependent on Chinese Exports
  3. Long Term FX Options against Hong Kong Dollar Peg
  4. Warrants on Chinese Banks
    • Instruments : X-Warrants issued by Deutsche Bank : Chinese Banks : link
    • Specific : China Merchants Bank
    • Specific : China Construction Bank
    • Specific : Cheung Hong Property
    • Specific : small banks : dahsing bank, wing hung bank, chong hing bank,
  5. Instruments : Industrial Materials
    • Specific : Short Rio Tinto
    • Specific : Cliff’s Natural Resources
    • Specific : Terex
    • Specific: Cement
  6. Hong Kong Property Stocks : credit
    • CITIC Pacific – link – steel and property conglomerate – link, reuters link
    • Shangdong International Trust
    • Xi’an International Trust
    • China Credit Trust
    • Yingda International Trust
    • Shanghai International trust
    • Ping An Trust
    • LGIV Bonds – link
    • hinese, cash flows, scale and distribution edge from merger
    • Japanese Swaps
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