Forgotten Commies 2007 07

8/14/2019 Forgotten Commies 2007 07

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The Forgotten Communists July 2007

This article is published exclusively for clients of Brait Specialised Funds, and is not to bedistributed or circulated without prior permission.

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Tiananmen II?

Conspicuous consumption by the wealthy has recently created a massive visibledivide between the few haves and many have-nots. While historically the very

wealthy kept a low profile, this reticence has definitely ended. More emotionallycharged issues, such as the very wealthy flouting the one child policy (theresulting fine, some RMB 100,000 per child and a prohibition on stateemployment for the household being little deterrent) perhaps have morepotential to create social unrest.

The government learnt a very hard lesson in 1989. While some types of protestsare tolerated (generally workers, pensioners or peasants on local issues, or if itis students, on state-approved issues such as protests after the US bombing ofthe embassy in Belgrade and the Japanese prime minister’s visit to a warshrine) any attempts to organise against the authorities will be crushed, a 10

year prison term being typical. In 1989 students organised demonstrations thatbrought the country to a coordinated standstill in most cities across China.Attempts to organise national protests are now dealt with very harshly (Ref.1) .

Free Markets Need Information

Information is not open in China. All information must be cleared by theauthorities before release. There can be no “Chinese Bloomberg” under thecurrent political system. The Chinese press are not permitted to travel withoutthe prior permission of the local authorities in their intended destination. In mostcases, company information is not disclosed at all, even for the very largeststate-owned enterprises (“SOE”). Where a company is listed, disclosure isgenerally of limited value due to the web of SOE relationships and related partytrading.

China Mobile, the world’s largest mobile phone company, is listed in Hong Kong.It is 74.6% owned by China Mobile Communications Corporation (“CMCC”), a100% government owned SOE that does not publish any information. Inaddition, CMCC does extensive related party business with China Mobile, as doa number of other SOE’s, none of which are in the public domain. While thedirectors of China Mobile claim that all the related party transactions are fairlypriced, without the ability to analyse CMCC’s figures, there is no way to know ifthis is the case. Given that the majority of the China Mobile executive directorsare also on the board of CMCC, and the CEO and Executive Chairman of ChinaMobile is the President of CMCC, the conflicts of interest are clear. And this inone of China’s leading companies.

Similar structures exist around most of the listed SOE’s, including Asia’s largestcompany, Petrochina. Its parent company, the Chinese National PetroleumCorporation (“CNPC”) and other SOE’s, are buyers of RMB 185.1 billion ofgoods and services from Petrochina, some 27% of total turnover. They also





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likely to be vast, for example after a chemical spill USD 6bn has been spent onthe Huai River alone over the past 10 years, and 60% of it is still unsuitable forany purpose (Ref.6).

Shares in SOE’s are owned at every level, with the Central government

controlling large corporates including China Mobile, Petrochina and the 4 largebanks (and many others). Provincial and local authorities also own SOE’sincluding their own local banks. Tax revenue has been booming at Central level,but the provinces and local authorities have been squeezed, just as Beijing isrequiring them to provide more services. Most local governments resort to “blackbudgets”, where the proceeds of development and sale of expropriated land,hidden from the Central government, are used to cover expenses. That thisexpropriation is often illegal, generally benefits corrupt local officials and is donedespite the opposition of local farmers has caused localised unrest (Ref.1) . SOE,generally with the tacit agreement of the local authorities, are often deeplyinvolved in money making schemes (primarily property development and more

recently share speculation) totally at odds with their intended businesses. Hencewhen Beijing regulates to control what it sees as excessive investment in aparticular sector or tries to prohibit land and share speculation, the localgovernment structures are likely to turn a blind eye.

To try and stem dramatic asset price inflation, Beijing has regulated banklending for share and property speculation. For example, several Chinese bankswere fined recently on disclosure that Shanghai-based SOE China ShippingGroup Corporation used nearly 90% of a RMB 2.7bn banking facility tospeculate on share IPO’s, and in Beijing China Nuclear Engineering Group ( aSOE builder of nuclear power plants) illegally used 87% of its RMB 2.4bnborrowings in property speculation and share IPO’s. It seems that exposure tothe asset price expansion is fairly widespread!

China’s biggest competitor, is China!

The biggest growth driver in China is that every regional official wants growth inhis province. New investments that create jobs and increase output will bepushed through, often, it appears, with little regard for profitability, theenvironment and sustainability. The dramatic growth in the Aluminium and Steelindustries, where China has no sustainable comparative advantage (cheaplabour being a relatively small cost input in these industries), has been hard toexplain economically. However, a steel mill and aluminium smelter were seen as“must haves” for the development in your region, even if, as is the case, youwould never be a low cost producer (China’s lowest cost steel mill has asubstantially higher cost per tonne than either Brazil or Russia’s highest costproducer (Ref.7) ). Even at the current domestic prices, which are substantiallyabove a few years ago, the average producer in China is not making profits.Steel over-capacity is estimated at 100m tonnes, and likely to grow another 70mtonnes in 2007 (Ref.6) .





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The predicable response from Beijing once the massive over-investmentbecame apparent (China is now the world’s largest aluminium smelter andproduces 1/3 of global steel output) was a belated removal of tax rebates onexports, a prohibition on bank lending for new mills, enforced M&A and stricterenvironmental rules. Yet the capacity increases have continued as new projects

“sidestep” or ignore the rules, with a 16% increase in steel productionanticipated in 2007. In addition, Beijing has backed away from the threatenedenforced closure of uneconomic capacity due to fear of strikes (Ref.7) .

Currently vehicle manufacturing is the fashionable investment. Every city wantsits own car plant. When China joined the WTO in 2001, there were only 13models of car available, at prices roughly double the US equivalent. There arenow more than 160 models manufactured locally by more different companiesthan the rest of the world put together. Local demand has grown from 2m unitsin 2002 to 7m now (Ref.3).

However, capacity has grown even faster than demand, with the resultant fightfor market share resulting in the entire industry being loss making in aggregate,and once again prompting regulations from Beijing, this time prohibitingexpansion by companies that have an existing capacity utilisation of <70%(which appears to be much of the industry).

Sedan Automobiles 2007 2006

Capacity Units 6.65m 5.4mSales 4.5m 3.6mSurplus Capacity 2.15m 1.8m

(Ref. 6)

Why would a loss making vehicle manufacturer, with huge surplus capacity (in arecently built plant), want to double capacity? Good question!

Your Friendly Banker (every Province needs one)

From a Western perspective, it’s hard to conceptualize an environment whereproject after project goes ahead, most of massive size, with little economic

justification or hope of a return. In a market economy, the financial sector playsa resource allocation role, but in a planned economy it merely plays an

accounting role (Ref.8) . Both lending and deposit rates are set by the central bank.State-owned banks lend to other SOE’s at these regulated interest rates oninstruction from local authorities, not based on their assessment of risk. As longas SOE’s have open lines of credit, the fact that they may be running at a loss isno hindrance to continued operations and indeed expansion. Given that, and thegovernment targeting of output and employment creation, the need to make areturn on capital, central to developed markets, is totally absent.





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China is “hugely over-banked” with the bank assets to GDP ratio (some 160%)being by far the highest in the world (Japan is a very distant second) andgrowing rapidly (Ref.9) . This ballooning of bank assets relative to the size of thereal economy is totally consistent with the evidence that a substantial proportionof the book relates to loss making SOE’s whose facilities have to be repeatedly

extended to enable the debt to be “serviced” and avoid it being classified asnon-performing. Like SA, there are 4 larger commercial banks, but there is alsoa myriad of 2 nd tier and regional players. If the Bank of China is typical, thesesmaller banks will not be bought by the big 4, who already have a nationalbranch footprint. Bank of China has 11,000 branches and is closing 200 perannum. In addition, the Bank of China wants to avoid what was diplomaticallydescribed as “local, cultural and structural” issues with the 2 nd tier banks (Ref.9) .

Some macro-economic views (by some high-powered people)

The liberalisation of China’s economy, while pegging the RMB, creates immense

pressure on the financial system. To date the government has successfully usedlegislation and regulation to contain inflation problems, but several stresses arebuilding:

• The size of the trade surplus and foreign exchange reserves – growth inthe future at the current pace is not sustainable, constrained by bothpolitical and economic limits.

• The misallocation of resources – epitomised by the historic and no doubtfuture bail-outs of bank non-performing loans.

• While CPI is constrained, there is rampant asset price inflation.

The liberalisation of the banking sector without a competitive exchange rate and

effective supervision and regulation will cause a banking crisis. In Mexico, thebanking crisis in 1984/5 cost some 20 – 25% of GDP! (Ref.10 and this guy should know!)

The RMB peg means that China effectively imports the US’s monetary policy(you can target either the level of inflation or the currency, but not both). It isimportant to control your own monetary policy, but China needs to develop itsown capital markets prior to floating the exchange rate. (Ref.11)

However, dramatic changes can be ruled out, especially as regards the RMBpeg. “China is based on the principal of gradual reform and self decision making.The trade surplus is due to many factors of comparative advantage, not just the

level of the RMB. In fact, the Chinese economy cannot necessarily take astronger RMB given the effect on exporters’ margins and wagecompetitiveness.” (Ref.12)





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Conclusion

China is a centrally planned economy with tight restrictions on information.Outside the inner circle, who can know what actually is going on, and for thatmatter, given the many perverse incentives created within the system, how

accurate is the information received by even that inner circle in Beijing?The idea that the development is driven by a global labour price arbitrage, asespoused by some sell side strategists, is totally simplistic. Industries wherelabour costs are a small proportion of overall cost, and where China has nosustainable comparative advantage, are amongst the fastest growing. Labourrates in neighbouring Asian economies are in many cases more competitive, yetthe same scale of investment is lacking. In addition, the rapidly ageingdemographic profile means the labour force will soon start contracting – withindustry sources already talking about the current shortages extending downfrom skilled employees to the unskilled.

Regions within China aggressively compete for any new investment that willgrow output and employment, with little regard for sustainability. I believe that amassive proportion of the fixed capital formation is in projects that will neverdeliver positive returns, or is related to the asset price bubbles in property andshares. While this is of course not sustainable, the government is totally awareof the risks. Unfortunately “there is no off switch, it will take a major collision tochange the current growth momentum” (Ref.1) . In essence, being aware of therisks is one thing, being able to ameliorate them without widespread socialdisorder is another.

At the epicentre of the “China miracle” is the banking sector. For a start, ourwestern view of the banks as a stand-alone sector in the economy isinappropriate – they in effect are merely a branch of government, providingindirect subsidies for investment and loss-leader pricing. Political recognition ofthis fact outside China would add considerable fuel to the brewing trade war.

It is clear, however, the image of the Beijing central committee executing a“fiendish master plan” to extend global domination over the long term (oftencited as a possible explanation for investments that make no economic sense) islaughable. The central government is engrossed in a policy and regulation

juggling act to battle the spiralling economic imbalances and cannot even controltheir own regions! They are riding the dragon, not steering it!

The potential for unrest in China may be largely ignored internationally, but it isfully appreciated locally. This is a police state that does not tolerate dissent.Beijing’s obsession with small, incremental policy adjustments is likely to proveineffective at preventing a massive asset price bubble inflating from even thecurrent levels. The high level of property ownership and rapidly growing shareownership in urban areas then raises the risk that a crash in asset prices couldcreate a dramatic political upheaval. Timing, however, is anyone’s guess!

Forgotten Commies 2007 07

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