China's Spending Alternatives

by: Vinod Dar

The US-China nexus is, arguably, the most strategically vital in the global economy at present. The nexus entails China buying US debt, especially Treasuries, so Americans can keep buying Chinese manufactured goods, especially consumer goods. It is vendor financing on an epic scale. The nexus depends on the American assumption that China has no better alternative for its foreign surplus than to buy US Treasuries and the Chinese assumptions that Americans will keep increasing imports from China and that US Treasuries are a house built on granite and the safest place to warehouse very large amounts of surplus money. These assumptions are now becoming assailable.

The great majority of Americans with discretionary income are conserving cash by reducing consumption, including consumption of Chinese goods, because of a lack of confidence. So are anxious Brazilians and Indians; as are despairing Russians (whose last economic calamity was just a decade ago) and nervous Europeans; as well as pessimistic Japanese (who vividly recall their stagnant decade of the 1990s; things are much worse now for Japan, which is entering what ,in casual conversation anyway, is a depression); and indeed even worried Chinese, who are significantly increasing their savings since they have no safety net.

There is a global erosion of confidence, made worse by every new stimulus program, which in the US is an income transfer program from the productive and prudent to the unproductive and irresponsible. US Treasuries have no upside and considerable downside, in the opinion of many American investors (including this author). The Chinese have two emerging alternatives for their money.

Chinese foreign reserves are still expanding briskly even as global trade compresses. But this expansion is more a reflection of Chinese economic weakness rather than strength….exports are declining fast, as is internal consumption, so imports are plunging.

China has lost 20 million jobs in this cycle already. It needs to create 11 million net new jobs annually to absorb fresh entrants into its labor force. Reverse migration in China from cities back to villages is growing rapidly as unemployed villagers return home to subsistence, or worse, farming (China and the US have about the same amount of arable land but over 700 million generally unskilled and often physically frail Chinese work this land), causing rural stress and poverty to soar, which is a prescription for dispersed but endemic peasant unrest.

China’s urban real estate markets are crumbling, causing financial distress within the newly born middle class. Medium sized Chinese companies seem to be borrowing at very low interest rates - not to invest in plant, equipment and product development, but to speculate on the stock market (borrow at 3%; hope for quick 10 to 20 % gain from flipping stocks; pocket the win; do it again…..who needs money managers). The Chinese Communists cannot simultaneously suppress rural and urban unrest. They know that unless the population is pacified with jobs and opportunities for wealth creation, they will lose their political monopoly.

Force feeding the Chinese economy with even more generally unused or underused infrastructure, making it easier for real estate developers to borrow money, providing agricultural loans to farmers and agricultural companies who do not seem to have much debt service capability, and expanding the Navy has been the Chinese response to impel domestic consumption higher. This kind of force feeding has the political benefit of being highly visible, keeps corrupt party officials and crooked developers well fed, the Military placated and can absorb hundreds of billions of dollars very easily. It’s a choice between lending Americans the money to buy Chinese goods or lending Chinese the money to buy Chinese goods.

The second and more potent option is for the Chinese to engage in global natural resource financing to augment and “internalize” Chinese resource supply chains, enhance China’s geostrategic position and brand and gain foreign policy leverage over several nations. China has ready cash; the World’s natural resource industries need it. The fit is superior. It allows China, potentially, to transform its government investment model from passive investor/unwelcome exporter to aggressive financier/welcome importer. There is little marketing risk for China since its appetite for natural resources is very great. It can readily consume the output from its investments. There is also no technology risk. China has multiple avenues at its disposal ranging from its SWF to state owned or controlled companies to international companies domiciled in China where the Government acts as merchant banker to direct government to government transactions.

In recent days the Chinese have invested, via Chinalco, over $19 billion (joint ventures and convertible bonds) in one of Australia’s, and the world’s, largest natural resource companies (active on every continent in aluminum, copper, iron ore, industrial minerals, gold, diamonds). The Chinese have also put a few billion more into other Australian natural resource companies and projects. The most significant transaction, however, is the $25 billion deal with 2 of the largest Russian petroleum companies.

This deal gives China 300,000 barrels of oil per day for 20 years. The Russian companies will use the money to develop oil fields and prospects in Eastern Siberia (enormous, high quality, exploration potential), refineries and to build an oil pipeline. This transaction is a Volumetric Production Payment (VPP), which allows producers and financiers to do a deal despite wide differences in their view of prices because the two parties have different risk adjusted discount rates.

Quantities, delivery obligations and schedules (daily, monthly, annual, life of contract), collateral, performance warranties and penalties are part of the contract but price is not. The US oil and gas industry is very familiar with VPPs, which are often considered a last resort financing for small and medium E&P companies generally shut out from conventional financing. The money (it is debt, not equity) is usually paid up front while the oil and gas is delivered over a number of years. The underlying oil and gas reserve (proven producing and proven undeveloped for the most part) is the collateral.

VPPs require extensive due diligence and close monitoring and frequent reporting because exaggeration, fraud, bribes, etc. are not unknown. They have been viewed as a kind of subprime financing for E&P companies. The IRR of VPPs the author is familiar with has ranged from high single digits to high teens, sometimes in the low 20% range; the default rate has been low and capital risk has been mitigated by seizure of the underlying assets which can be readily operated by third parties or sold.

For China, VPPs have the twin attractions of being highly expandable (scalable) and diversified. If the Chinese can get average IRRs of 6 to 8% on VPPs, with the safety not much worse than that of US Treasuries, plus several strategic benefits then, of course, Treasuries yielding 3 % with important bubble and currency risk become quite unattractive. Certainly the search, transaction and monitoring costs of VPPs are much higher than for Treasuries, but the Chinese can afford to grow or rent the talent and transactional infrastructure needed to execute on a global scale.

The world could, quite easily, absorb $200 to $300 billion a year in Chinese VPPs. For example, the oil sands in Canada (Athabasca) and Venezuela (Orinoco) are excellent candidates: the resource is vast, very capital intensive, unusually long lived and production is a mining/manufacturing process rather than a drilling process. Venezuela in particular would salivate over a $10 to $30 billion VPP transaction with China. Other VPP prospects include onshore oil in the Sudan and Colombia ; deepwater oil in Brazil; Natural gas in Iran, Myanmar and East Timor; bauxite in Guinea and Jamaica; coal in South Africa and Colombia; Uranium in Kazakhstan.

China has a decade left to become a global power and serious rival to the US. It is still a poor, unskilled, country and its demographic profile is the second worst (Russia has the worst) in the world amongst nations of consequence . (More on these topics in another essay: China’s labor force will peak in a decade; a quarter of all people in the world over 65 will be Chinese by 2025 but only a fifth of the labor force will be Chinese; there is an increasing “shortage” of women; and India is projected to become the most populous nation by 2025). Time is not on China’s side. It must make profound and correct strategic choices, otherwise its national aspirations cannot be met. Its window of opportunity is surprisingly narrow. It cannot afford to squander treasure or time.

If the Chinese come to believe (this author does not know what the Chinese believe) that the US Treasuries are a house built on limestone, not granite, US protectionism is going to increase and the American consumer will engage in cash conservation for years, not months. Then the US-China nexus will crumble and with it will crumble US Treasuries. The demand from a former advisor to the Chinese central bank that the US guarantee its debt to the Chinese so the Chinese are protected from “reckless policies” is a signal. Freedom is having options. Chinese options may be growing while ours may be shrinking.

China has the money to buy American debt at its current pace or increase force feeding of its own economy or pursue international resource investing on an epic scale. It does not have the money to do all 3 things well on great scale. The Chinese are cautious and patient but they are not dabblers. If the Chinese, over the next 2 to 3 years, conclude that swift growth in domestic consumption and international resource capitalism are big and attractive options and decide to markedly phase down investing in US government debt, then what will the US response be?