[Note: a revised edition of this was originally scheduled to be published in an upcoming newsletter but I have (temporarily) moved back to Shanghai and think all this information should be pushed to a broader audience]
On March 15 Bo Xilai, a prominent Party secretary was publicly sacked. A week later rumors of a coup were reported to have taken place by Bo’s allies in Zhongnanhai, the central leadership compound in Beijing. Several days later a Ferrari crashed at 4am in the morning in Beijing but was immediately scrubbed from the media, prompting speculation that it was possibly driven by Bo’s playboy son. And earlier this week Bo Xilai was officially removed from the Politburo while simultaneously his wife was arrested in connection to the murder of a British expat.
Quite a wild month.
To make matters more colorful, in the West it seems everyone from farmers to factory workers, from interns to captains of industry has an opinion about what is going on in the middle kingdom. But the truth is, outside of the Politburo, no one really knows what has been decided and what will be implemented. And this is by design.
While the Party no longer owns all forms of communication, it does control and screen what all media outlets publish via strict censorship regulations. Foreign owned and operated media are selectively blacklisted and social media sites such as Facebook and Twitter have been blocked since July of 2009. Domestic Twitter-like services such as Sina Weibo are routinely ‘harmonized’ (hexie) of politically sensitive material. This includes crashes such as the aforementioned Ferrari, the Wenzhou high-speed train incident that killed 40 last summer and thousands of other documented taboos. In fact, last week all Twitter-like services had their comments disabled in a governmental effort to eradicate and purge “rumors” from the interweb. Thus, the continued existence of this ‘Great Fire Wall’ creates as IT guru Bill Bishop laments: one world, two internets.
In short, today’s China watchers, Sinologists and tea-leaf interpreters are yesteryears Kremlinologists.
Beijing is a black-box. We can analyze the inputs and outputs but as Bismarck might say, we never really get to see how the sausage gets made.
For example, throughout the dark days of the fourth quarter of 2008, analysts at banking and energy firms hired lookouts in Hong Kong, to observe and note the arrival of coal and iron ore shipments. The analysts believed that by tracking these bulk deliveries it would allow them to accurately gauge the potential economic activity that could be taking place on the mainland. Similarly, by looking at output statistics such as energy consumption and energy production levels analysts can predict what the economic growth rate is – after all, without electricity you cannot power homes, factories or offices.
However one of the problems at looking just at these inputs and outputs is that they cannot accurately gauge what kind of productive activity has taken place. This is not an argument regarding whether or not activity is taking place, but rather the argument should be whether or not the activity is productive, profitable and sustainable. The answer to that is, no.
Productive and unproductive economic activity
However before we look at the various economic indicators being reported by intelligence firms, let us take a step back and look at this economic black box from a theoretical standpoint.
Does central planning work?
If you follow the Misean or even Hayekian belief that socialists economies cannot inherently calculate, that central planners cannot effectively and efficiently allocate resources in a productive and profitable manner a priori, then the answer to this question is always no.
Central planning of the mortgage industry was disastrous in the US and everywhere it has been tried, as illustrated most notably by Michael Lewis in Ireland, Spain and Dubai. A century of central planning of interest rates throughout the East and West has resulted in a continuous series of deleterious boom-bust cycles that distort risk and misallocate resources on a massive scale, a fatal experiment that continues to this day. Similar attempts to governmentally coordinate and manage healthcare, education and any other industry results in similar regulatory capture, cronyism, misallocations and monetary sink holes.
If socialism and central planning does not work in theory or in practice, if you recognize the Soviet Union fell apart because as Thatcher suggested, you eventually run out of other people’s money, then the latest incarnation – an experiment of socialism-with-Chinese characteristics cannot work too. Period.
Selling snake oil
In a recent debate held in NYC, financier and China-bull Peter Schiff argued that China is headed in the right direction and that it does capitalism better than the US. To back up his bold claims he suggested that China’s balance-of-trade surplus and seemingly low debt-to-GDP ratio were virtues that reflect a healthy economy.
The problem with these claims is that China’s balance-of-trade is wholly unsustainable based upon the mere fact that it is spurred by guihua, centrally managed five-year plans. The Soviets called them Pyatiletka and the Indians called it License Raj. The end result is planned chaos.
Since its victory over the Kuomintang, the CCP at every level has tried one ham-fisted development plan after the other. In his upcoming book, Mark DeWeaver meticulously details Chinese investment cycles over the past six decades and notes that the current boom-bust is fundamentally no different than myopic agricultural and iron smelting projects of the 1950s. Behind a veneer of opening and reform, the central government and its subordinates at the provincial level continuously creates quantitative output goals for each province (or as Chanos and DeWeaver have both noted: local governments exceed the central government targets, coincidentally). The end result is a total Balkanization of intra-provincial trade, massive subsidies and ultimately overcapacity.
For illustrative purposes let us assume that GDP can and does measure what it is supposed to. In the New York debate and on his radio show Schiff continually points to officially published GDP metrics that suggest China’s debt-to-GDP is roughly 65% compared to 100% in the US and 200% in Japan. However professor Victor Shih has suggested that the Chinese number is really over 100% GDP because of local and provincial government debt which has been and will continue to be “bailed out” by the national government. Though the fact of the matter is we really do not know what percentage level because there is no transparency; the media blackout coupled with the fact that national initiatives are difficult to follow through with at local/provincial levels: it is a bit hard to figure out what the truth is. Or more to the point, it is a Herculean task to investigate and write about a country with a continuously changing past!
Other China-bulls such as Jim Rogers lambast the BLS and routinely cite independent analysts such as John Williams who thrive by publishing alternative macroeconomic metrics, yet seemingly embrace the statistics published by the CCP. Which begs the question: why central planning somehow works this time around because it is China?
In the same New York debate, Ian Bremmer noted that 62% of China’s GDP is comprised from state-owned-enterprises (SOEs). In fact, to give you a more clear picture of just how dominating the government still is, here is a quote from a very informative book published last year, China’s New Place in a World of Crisis:
After several stages of reform, Chinese SOEs still dominate among large enterprises in China to a remarkable degree. SOEs account for 70 per cent of the Chinese top-500 enterprises, 94 per cent of assets and 88 per cent of profits. The Chinese SOEs also contribute 93 per cent of taxes generated from, and employ 89 per cent of the total workforce in the Chinese top-500 enterprises.
And as both Ian and Minxin Pei noted, post-2008 these SOEs are not being privatized. In fact, Minxin would later state that there are over a dozen nationalized industries that private entrepreneurs cannot enter, including energy, banking and telecom. These are the “commanding heights,” the key industries that Vladimir Lenin believed were strategic to controlling the country. And since the financial crisis in 2008, SOEs have grown once again, reversing the trend since 1985 (where SOEs accounted for approximately 70% of GDP).
Or as Minxin noted: the Chinese government effectively still owns and controls a lion’s share of China’s economy, in contrast the US government – despite its faults and foibles – owns perhaps a mere 1% outright.
So as an investor, what can be known in this seemingly nihilistic information environment? China-bears such as Jim Chanos have looked at shorting companies and enterprises that have exposure to China. In particular, organizations that deal with Chinese real-estate. This includes mineral sourcing companies like BHP and Paribas and complementary earth moving firms such as Caterpillar.
The charts above are from The Wall Street Journal, which calculates the average of the change in house prices in 70 cities. As you can see, coupled with artificially low interest rates, the $586 billion infrastructure stimulus Hu Jintao announced in November 2008 resulted in a surge, a boom in real-estate prices due to the frenetic lending and loosening of loan requirements.
However in an effort to fight the inflation forces it had unleashed and to contain the potential fallout of defaults, the People’s Bank of China began raising capital reserve requirements for the domestic banks and enacted a series of down payment increases. The net result – along with other policies and the simple fact that this phenomenon was economically unsustainable – was the subsequent crash.
Patrick Chovanec of Dragonomics explains this phenomenon, stating that in China:
Developers kept expanding investment by 30% a year, piling up nearly a year’s worth of unsold inventory, confident that the government needed them – and would ultimately support them – to maintain growth. In the meantime, the central bank was reining in credit to counter rising inflation, including spiraling home prices. When developers finally ran out of financing options, they had to start dumping their unsold inventories to raise cash – and the market tanked. Drop one ball and others follow. Land sales – which local governments are relying on to fund basic services, as well as repay their stimulus bank loans – are at a standstill, and some analysts expect private housing starts to fall by 20% this year.
China’s state-owned banks have continually underestimated local government loan risks. In fact, in February the Chinese government instructed all banks to “roll over government loans.” Provinces and cities owe $1.7 trillion in construction related loans, “[m]ore than half those loans were scheduled to come due over the next three years.” If banks are not allowed to carry out their primary function of measuring risk (via interest rates) or to approve and deny risky ventures, why call them a bank?
To give you a clearer example of property supply outstripping demand, a recent news report from Al Jazeera noted that the new Kingkey 100-floor skyscraper in Shenzhen – which opened last year – is only 20% leased and those are at discount prices. The same mania is illustrated with the $300 million skyscraper built in the village of Jiangyin in which a solid gold bull statue sits on the top floor. Thus Mark Thornton’s skyscraper index theory is probably right once again.
Will the Chinese consumer save the day?
Some analysts such as Martin Wolf spuriously believe that a rebalancing will occur in the near-future in which the current export-oriented, fixed-asset dominated plan will give way to an economy increasingly dominated by private consumption. Wolf is optimistic that this can occur because:
China may indeed manage the transition to a very different kind of economic growth. The country still has vast potential to catch up. But the challenges of adjusting to the new pattern will be huge. Plenty of middle-income countries have failed. It is difficult to argue against China, given past successes. The best reason for confidence is that top policy makers lack such complacency.
Wolf uses the following chart that includes some head-scratching future assumptions:
These assumptions play a central role in a more pessimistic and debatably more realistic future described by Michael Pettis, who argues nearly every week, that Chinese policy makers simply are not enacting the reforms or privatizations that would lead to a consumer-oriented economy, one in which the private citizens are no longer bailing out state-owned enterprises. In his words:
And yet savings continue to rise. This is the opposite of rebalancing, and it should not come as a surprise. Beijing is trying to increase the consumption share of GDP by subsidizing certain types of household consumption (white goods, cars), but since the subsidies are paid for indirectly by the household sector, the net effect is to take away with one hand what it offers with the other. This is no way to increase consumption.
Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference. So national savings continue to rise.
China, in other words, must stop transferring income from households to the state and in fact must reverse those transfers. As Chinese household income and wealth become a greater share of the overall economy, so will Chinese consumption.
Repressed interest rates transfer wealth from household depositors to state and business borrowers, so interest rates must be gradually raised to approach nominal GDP growth rates, and as this happens the hidden transfers will be reduced to zero or close to zero.
Contrary to what Schiff, Rogers and others may claim, the Chinese economy is almost entirely driven by political considerations. But lacking CSPAN, we are not privy to what discussions take place behind closed doors. Perhaps Mao Yushi – a proponent of liberalization and privatization – is actually listened to. Maybe Wang Yang is setting the stage for democratic elections and further political reforms. However despite these hypothetical’s, one thing is clear: the CCP does more retcon and retretcon than just about anyone outside of Skywalker Ranch. Who knows what will be in store next week. And just imagine if the Soviets had photoshop!
The Seen and Unseen
The New York Times recently published a piece regarding the intersection of unemployed Western architects who have moved to China to work on these mammoth face-projects:
The client, in the case of the Harbin Wood Sculpture Museum, is the local government, which occupies a glass building with a red Chinese flag next door to the construction site. “The top-down system can make things very simple,” Gillen says. “The leader says, ‘I want it; you make it,’ and it’s done.” Never mind that the projected ticket sales for the museum’s exhibitions, which are anchored by the collected works of a locally renowned wood sculptor, could never match the building’s extravagant price tag.
Such an issue might stop a project in the United States. But in China, the primary concerns are prestige and development for its own sake, and the leaders would move heaven — and lots of earth — to get the museum built. “These projects are the Louis Vuitton bags of architecture,” says one foreign architect, who has worked on several marquee buildings in China. “Every city in China wants one now.”
Four years ago we witnessed a garish display of televised glitz in Beijing. The sparkly show-and-tell amounted to little more than unproductive monetary mausoleums — stadiums and entire venues were demolished after the Olympics. Now we are seeing it in other areas throughout China, colossal monuments of misallocation and non-productivity. Take for instance Kangbashi, a carefully planned city built to accommodate 300,000 people, that remains relatively barren today. Or the high-speed railway itself, deep in debt and mired in political favors. In fact, $77 million was embezzled from the Beijing-Shanghai High-Speed Railway project alone. Thus given the lack of media transparency, one can only guess at the graft involved with the airports, 3/4 of which lose money.
But this issue is wholly ignored by both the NY Times reporter and the architects themselves, concluding with:
Gillen is not paid to worry about the museum’s future or its development value — just to ensure that it is built. And that often requires handling shifting demands that would be almost unimaginable back home. When the pit for the wood-sculpture museum’s foundation had already been dug, for instance, the government made a startling request to double the area to 66,000 square feet. The demand meant drafting a new set of designs and digging the foundation several yards larger to create a new underground gallery space. “In the U.S., the contract would’ve been ripped up and renegotiated,” Gillen said. But MAD complied with the request without complaint. It was another lesson in the Chinese art of making guanxi, or cultivating relationships. Who knows what commissions a cooperative attitude might lead to in the future?
In an effort to celebrate Party grandeur, their face-projects will ultimately be no more economically productive than their blighted 18th century Potemkin counterparts. When the dust settles the CCP will be left with little more than a bevy of Ryugyong hotels, Pyramids on the Bund, dozens of financial white elephants whose razzle-dazzle amounts to financial stagnation and perhaps even decline.
While it may be a bit premature to predict a mass exodus, FDI dropped for its fourth consecutive month. Perhaps foreigners have finally figured out that the CCP cannot calculate. Or maybe it is 2008 all over again. If I were a betting man, I would wager that the proverbial can will be kicked down the road yet again, perhaps another stimulus or three. But we already know, a priori, what will ultimately happen at the end of that plan. And contrary to what hucksters may say, the laws of economics are immutable and culturally agnostic. This time will be no different than the last.
- Financial Reform in China? Don’t Bet on it. (China Law Blog)
- Chinese Banks ‘Great Shorts,’ Won’t Be Broken Up: Chanos (CNBC)
- No, Chinese inflation isn’t a good sign (CSM)
- China doomsayer sees crash coming (MarketWatch)