China and Emerging Market Investing: Real Basis

An article in The Economist citing two recent papers confirmed what I have been saying for years about the Chinese economy. My premise is that without proper rules, the Chinese system allocates capital inefficiently and does not provide adequate information to the markets. This is especially true today as a result of the stimulus package, which has allowed banks to allocate hundreds of billions of dollar to inefficient state owned firms, while starving China’s 40 million more efficient small and medium-size private firms or so enterprises, which employ at least 75% of its workers and produce 68% of industrial output.

The first paper was produced for the Hong Kong Monetary Authority and written by Giovanni Ferri, of Italy’s University of Bari, and Li-Gang Liu of BBVA. Its finding was that Chinese state owned banks profits were the “product of subsidized financing by state banks, which lets them borrow much more cheaply”. The result was that capital would be allocated inefficiently and that there would be future losses.

Of course I do not think that the losses are in the future. They have happened steadily since 1995 and have risen with each cycle. Since the collection and bankruptcy system are inadequate, these loans are still on the books. We are finally beginning to see the effects of this latest crop of defaults in the system since despite banks having 30% more loans paying interest, most banks' earnings are down this year.

The other paper from TJ Wong and Danqing Young, of the Chinese University of Hong Kong, and Xianjie He, of Shanghai University of Finance and Economics, shows that there were not “correlations between the share price and the shift in reported value of investment instruments, goodwill and the impairment of assets”, nor did an improvement in accounting practices show up as a closer correlation between earnings and the performance of the share price. In other words, investors “have little faith in the numbers.”

Although not specifically answered by the papers, in my view the investors' lack of faith is justified because there are insufficient economic incentives or disincentives or legal disincentives within the system to provide accurate, complete or timely information. So investors ignore the information. What basis, then, do they invest on?

I believe that a popular new book (“Animal Spirits”, by Nobel Laureate George Akerlof of the University of California, Berkeley, and Robert Shiller of Yale) answers this question. In the book, the authors describe why investors sometimes invest irrationally. They list five classes: 1) Confidence: basically expectations whether rational or not, positive or negative. 2) Fairness: does the investor think that the system is fair. 3) Fraud: this is not only about bad faith, but the level at which the system can deliver a credible legal disincentive. 4) Money illusion: people do react to inflation especially if it is low economists. 5) “Stories” People believe irrational but plausible tales like US housing always increases and China is recession proof.

I believe that the combination of many of these factors affects the way investors in China and many emerging markets invest. For example, one story is the assumption that emerging markets will grow much faster than developed markets. Over the past fifty years this assumption has not been correct. Emerging markets have enjoyed periods of rapid periods of growth, but usually in response to reversible reform. Without sufficient credible legal disincentives and enormous conflicts, emerging markets are more subject to fraud and the waxing and waning confidence helps explain the volatility of these markets.

Disclosure: No positions

Comments

[CautiousInv...:]

We all know that Chin's exports have nosedived but spending on factories and properties surged 30.5 percent in the first four months from a year earlier. Money supply grew by a record and new loans have exceeded a 5 trillion yuan government target for the whole year.

As the author notes, China’s credit boom is hurting banks’ profit margins and is starting to add more bad loans to balance sheets. But this is where East meets West, with both hoping banks can earn their way out of this mess

The government is betting that the boost to the economy from increased lending will offset the cost of bad loans in the future. But, like in the US, if the recovery stumbles and/or banks prove incapable of earning and retaining sufficient capital to offset growing loan losses, we are back to square one.

As different as we are, we share the same foibles.

May 30 09:13 AM

[huangthomas:]

There are three ways of doing things: right, wrong, and Chinese ways. The central government requests the provincial government to share 70% of the cost of the 4 trillion yuan stimulus. Local governments have no right to issue bonds. Where the money is going to come from? They are asked to borrow money from large banks, they are all state-owned.

Did we ever payback our national debts? Do you expect provincial governments to pay back the loans from the banks? Pay interest? So, they are NPLs. Eventually, the central government is required to bail out SOE banks. That is the whole story. It is simply a Chinese way.

May 30 10:25 AM

[ursmax:]

You say the small companies are producing 68% of output with 75% of the workforce, therefor big comps are producing 32% of output with 25% of the workforce.

This has small comps at 0.9% output per 1% workforce vs. 1.28% output per 1% workforce at big comps. I strongly suggest u re-think which sector is the more productive one.

May 30 12:05 PM

[William Gamble:]

CautiousInvestor

"East meets West, with both hoping banks can earn their way out of this mess"

Like that, nice point. Well put.

Thank you. There are two differences. I first started writing about the Chinese legal system about 10 years ago. The problem with the bad loans in China is that there are no way to get rid of them.

Feel free to correct me, but I read several years ago in the CCB prospectus that it was illegal to foreclose residential property. In the US the foreclosures are seen as a problem. They are actually not since they are cleaning up the real estate market.

I do not believe that the new 2007 bankruptcy law applies to state owned businesses, yet that is where most of the bad loans will occur if for no other reason than that is where the money is going.

Bankruptcy is the plumbing of economics. If it gets clogged up the bad stuff pollutes the rest of the system. The bad loans from the AMCs (see my article Really Bad Banks on this site) are still around. So the bad loans being created now will hurt earnings. And yes, it was a bad idea to save AIG. Hopefully there will be orderly bankruptcies in the US for some other big banks like we are seeing with GM and Chrysler.

The second problem is that banks and bankruptcies have the same economic function, to allocate capital to the most efficient part of the economy, which in China like most countries are the SMEs. Unfortunately that is not what is happening. Instead the system is allocating capital to well connected large state owned business (see Prof Huang Capitalism with Chinese Characteristics). This will make sustain recover hard once the mountain of money goes to the wrong place and increases over investment in the wrong places.

I have traveled to over 40 countries. I love the cultural differences, but I believe that people order their economic lives based on the rules of the game, the legal infrastructure, not their culture.

May 30 12:17 PM

[William Gamble:]

Local officials burst unannounced into a middle school in Hubei province one afternoon and started sifting through the staff-room’s ashtray to enforce a ban on rival cigarette brands. The "cigarette marketing team" discovered three "non-compliant" cigarette butts and subjected the school to "public criticism" for "undisciplined practices," London’s Telegraph reports. Officials and teachers in Hubei province will be fined if they "fail to meet their targets" or are caught smoking brands from neighboring provinces. One village was ordered to purchase 400 cartons of cigarettes a year for local officials. "The regulation will boost the local economy via the cigarette tax," said Chen Nianzu, a member of the Gong'an cigarette market supervision team. In total, Gong'an officials and teachers have been ordered to puff 230,000 packs of Hubei-branded cigarettes.

[Editor’s Note: China has 350 million smokers, about a million of whom die each year from smoking-related illnesses. Despite anti-smoking campaigns, cigarette taxes form a major component of China's annual tax-take at local level.]
www.telegraph.co.uk/ne...

May 30 01:12 PM

[Sober Realist:]

Mr. gamble,
One investment thesis that has caught my attention is the following: "China's billion plus people will provide an immense market for Internal growth and consumption."

So I ask, how big is China's so-called "middle class" or does it even exist? Can china convert from an export-driven economy to one more reliant on internal consumption?

I ran across the following article from two days ago:
www.theglobeandmail.co.../

The downfall of the American free spender doesn't guarantee the rise of his Asian counterpart. While there is plenty of support for the China-will-lead-the-way theory of global recovery, which hinges mostly on government stimulus spending, there is less for the Chinese consumer rising to the occasion. Analysts who keep close tabs on how China is faring at creating a strong domestic consumer market warn that the country faces serious obstacles on the road to Western-style consumerism, and it could be decades before these are cleared away.
“There's nothing that really supports a consumer society in China right now,” said Jennifer Richmond, China director with Stratfor, a global intelligence company. “In 10 years, we might see the seeds of it. But the likelihood of the Chinese supplanting the American consumer is quite slim.”
China's consumers account for about 35 per cent of GDP and just over 3 per cent of the global economy. By contrast, U.S. consumers still account for two-thirds of the vastly larger U.S. economy and about 17 per cent of global GDP. “The mathematics are daunting,” said David Rosenberg, chief economist and strategist with Gluskin Sheff + Associates in Toronto. “For every 1 per cent decline in U.S. consumer spending, Chinese consumer spending has to grow by 5 per cent just to keep things where they were.”

And another article from a couple days ago:
www.time.com/time/prin...

"With history books replete with tales of V-shaped recoveries following steep downturns, financial markets have become giddy, hoping that signs of bottoming beget the long-awaited rebound. Nowhere is that more evident than in Asia, an increasingly China-centric region convinced it will lead the world out of its long nightmare.

If it were only that easy. Contrary to the lore of the ?Asia century,? the region continues to suffer from a lack of internal support from its 3.5 billion consumers. The private-consumption share of developing Asia?s overall GDP fell to a record low of 47% in 2008?down from 55% as recently as 2001. In other words, Asia remains an export machine. Developing Asia?s export share rose from 36% of pan-regional GDP during the financial crisis of 1997-98 to a record 47% in 2007. And recent research by the International Monetary Fund shows that Asian exports continue to be underpinned by demand from consumers in the industrial world?especially from the U.S. Despite a surge of trade within Asia, the bulk of these intraregional flows have been concentrated in parts and components that go into finished goods eventually consumed by developed economies.

Little wonder that in the aftermath of a record contraction in U.S. consumer spending in late 2008?4% average annualized declines in the final two quarters of the year in real terms?every major economy in Asia either slowed sharply or tumbled into deep recession. More than ever, the region?s fate remains made in America.

This is where hopes of an Asia-led rebound are most tenuous. After a dozen years of excess, the overextended American consumer is tapped out. The ?green shoots? crowd?those believing global recovery is nigh?drew special encouragement from a 2.2% rebound in real U.S. consumer expenditure in the first quarter of 2009. That encouragement is about to be dashed. Outright contractions in retail sales in March and April point to a renewed decline of at least 1% in real consumption in the current quarter."

I did a little digging over at Stratfor and also found this:

"The Problem of Export Demand
But for China, the real problem remains export demand, not whether they can kick-start manufacturing and subsidize exports to keep product flowing. Exports are the true engine of the Chinese economy, equal to more than 30 percent of GDP. Exports fell 17.5 percent in January, compared to the same month a year earlier. They plummeted 25.7 percent in February, and then recovered slightly to post just a 17.1 percent drop in March. This deceleration of contraction was trumpeted as an improvement. But it is still very bad for an export-dependent economy to see exports drop by nearly one-fifth along with similar drops month after month.

The government will have to keep its fingers crossed that it can meet the official 2009 estimate of a mere 5 percent export contraction. Meanwhile, imports have dwindled by 43.1 percent, 24.1 percent and 25.1 percent in the first three months of the year respectively, despite the government’s strenuous efforts to use fiscal policy to increase domestic demand. Other attempts to create a domestic demand-driven recovery have included the issuance of coupons and vouchers for rural consumption of big-ticket items like appliances and automobiles. And while these have spurred sales, these are not sustainable patterns, they have required a substantial portion of government money, and in many ways, they have simply absorbed surplus goods sitting in the warehouses and on lots rather than spurring new manufacturing.

The government has offered tax breaks and rebates to help exporters keep exporting whether profitable or not. It is offering incentives and threatening punishments for companies to retain workers whether necessary or not. And it is urging banks to loan more money — and the first three months have seen a massive increase in domestic loans to companies (though primarily to state-owned enterprises, not the private sector) to help them fulfill their employment and export requirements — whether profitable or not. At the same time, real estate prices are falling. On the surface, this may seem positive for those looking to buy. But it may have a major impact on Chinese companies that have been using inflated real estate as collateral for loans. So even as China is showing economic activity, it may be digging a deeper hole than before the current crisis.

The problem for Beijing is that the days of 12 percent and 13 percent GDP growth look to be over for quite a while. Moreover, China’s recovery remains heavily dependent upon a major recovery of global consumption (particularly in the United States). But that is by no means guaranteed. While there are signs of hope for the U.S. economy, they do not necessarily mean consumption levels will surge again as if nothing has happened. Even a U.S. recovery in the second half of 2009 followed six to 12 months later by Europe would leave China’s recovery another year or more in the future. Which leads to the dilemma Beijing faces."

And where is the Chinese middle class:
www.thedailybanter.com...

There are those who have been trying to warn us for a while now that China's middle class was merely an illusion. In a 2007 article for BusinessWeek, Arthur Kroeber, editor of China Economic Quarterly, stated blankly that, "China doesn't have a middle class.". He blamed deceptive figures released by the Chinese government for our misperception of the situation, and estimated that total purchasing power in China to be half of what was being reported at the time. And such purchasing power was concentrated among the well-off in a few privileged urban areas. "As far as significant retailers are concerned, out of China's 1.3 billion people, 1.2 billion simply don't count," he stated.

Such views were recently echoed by David Goodman, professor at the University of Technology in Sydney. Goodman argues that the "middle class" that we see in China's urban centres are an exclusive elite forging ever-closer links with the ruling Communist party. "They are neither independent of nor excluded from the political establishment, which on the contrary seeks actively to incorporate them," he states. He attributes this development to former party leader Jiang Zemin, who "opened the doors for capitalists to join the party."

While everyone seems to have an opinion about China, these arguments seem to be supported by recent events. As China's manufacturing sector has witnessed a significant drop in foreign demand, its earnings, as well as the money that in turn pours into government coffers, have dropped substantially. As a direct result of this, the growth of China's domestic economy has plummeted."

And recently a business who lives and works in China made the following comment on SA:

On May 28 10:10 AM
"...As for the specifics cited, all that I can say is that the Chinese banking and SOE-dominated economy is bankrupt. This last stimulus package -- equal to one-third of its foreign capital reserves -- was necessary to prevent the system from seizing into a series of defaults.

If the US and EU decide to halt treasury payments due to the CCP's government sponsorship of the North Korea regime, the social-economic consequence would return China to its cultural revolution era -- overnight.

Chinese people understand that reality relative to the dictatorial structure of the regime under which they live here. As I gather you do not, Chinese people understand Chinese history a la the 14 dynasties preceding the CCP. All 14 are considered by those whom I talk and study with to be dictatorships that repeated patterns of social-economic dysfunction that eventually resulted with demise.

Hence why common Chinese citizenry save (cash, not via financial instruments) at such high rates. The people here live in fear. I mean fear...

Most Chinese people personally experienced some aspect of the last social-economic breakdown of the country (i.e., the Cultural Revolution). They know the craziness, the inhumanity that results from a system, this system that is absent rule of law and those First Amendment Rights of freedom of speech, press, and religion.

Until those systematic inequalities are resolved to the satisfaction of the majority of the Chinese demographic, your article serves as a disparate collection of statistics and analysis."


So my general thought is that there will never be a "middle class" in China without the dissolution of the CCP.

May 30 01:47 PM

[Sober Realist:]

An article published in Seekingalpha also highlights the problems discussed by Stratfor that China is really avoiding real structural changes to their economy:
China: Exports vs. Domestic Demand, The Argument Rages
by Michael Pettis
seekingalpha.com/artic...

By the way, China's exports continues to plummet, 23% in April.

May 30 01:52 PM

[Sober Realist:]

Mr. Gamble,
You actually pretty much answered my question about the "potential rise of a sizeable middle class in China" with a comment you gave on a previous article of yours (if you have anything to add, please do):

On April 28, '09 William Gamble said:
"I agree with Jun Ma about the peak and the next valley. I am just not sure that China can change its model. This is the same reason why I am not sure that what economists often look at as great fundamentals necessarily translate into sustainable economic growth.

Latin America's per capita income in the 50’s was 25% of the US. Asia’s was 10%. It was thought that the mineral wealth, sophisticated society, education, and people would allow Latin America to catch up in 30 years. Today Asia’s per capita income is 25% of the US, while Latin America is 20%.

Africa has enormous potential and had had since I was born almost 60 years ago. It has never lived up to it.

Economists are just beginning to understand something that I think is crucial. The rules. (see Good Capitalism, Bad Capitalism, Power and Prosperity. Good government is the magic ingredient that helps all of the other assets actually produces wealth. It’s like two business firms. One succeeds. The other doesn’t. Good management is the difference.

Still however good a manager is, it is rare that they are always right all of the time. The average age of a Dow company is only 40 years. The average tenure of a CEO is 10 years. Half that for a Fortune 100 company.

The question is whether China can change with the same set of leaders. I am not sure if it can. When leaders everywhere get into power they compensate the people who keep them there at the expense of the economy as a whole. As time goes on the situation becomes worse.

To change China will have to change its model or the W will turn into an L."

May 30 02:25 PM

[William Gamble:]

In response to another reader

How would your article apply to the superpower nation of the United States of America?

The American banking industry was subsidized recently through Fannie and Freddie who were allowed to borrow at partially subsidized rate since there paper was backed by the US government. The results in the US were disastrous and resulted in an inefficient allocation of capital. But I believe that the experience proves the point of interference by governments in the banking system. Where ever it occurs whether in the US, France, India or China, it limits the ability of the banking system to be an efficient intermediary for allocating capital.

Were the allocations in the US banking industry and bailouts proper allocations of resources compared with China which enjoyed much greater growth rates?

Present and past growth rates in China are subject to a large debate. If you look at electricity consumption, which some economists feel is a proxy for growth, China may not be growing at all. (See Professor Thomas G. Rawski www.pitt.edu/~tgrawski/) Of course no one really knows.

I do not trust any government to give accurate information since their incentives and disincentives tend to encourage not telling the truth, unless there are legal disincentives. All information has value, it will not be given out unless there is consideration or a legal disincentive, like free speech or an independent judiciary. Neither exists in China. They do exist in other emerging markets.

The joblessness in the U.S. is predicted to grow alarmingly.

The jobless rate in the US is a problem. Of course, jobless rates in most of Europe were actually worse for most of the last decade. We really do not know what the jobless rate is in China because they really do not publish the numbers. The number most bandied about is that there are 20 million migrants who are unemployed but again without proper incentives and disincentives no one knows.
Iit would appear that the view you express makes one believe it emanates from a “holier than thou” attempt at “wrapping oneself in the American flag”. Do the Ponzi schemes of American banks and indeed the Federal Reserve constitute a higher level of resource allocation than that prevailing in China?

I think that wrapping ones arguments in any flag it’s a bad idea. I try to wrap my arguments in what I know of law and economics and game theory. In my view The ‘Ponzi’ schemes of American banks were the result of a failure of information. In a normal loan, the creditor has the incentive to get the best debtor and then monitor that debtor. The problem with securitization is that it changed the incentives. The bank’s incentive was to find any debtor and then once the loan was sold, not to monitor. Of course there are many fathers to this disaster. Take a look at the recent article, “Death of Kings” in the New Yorker for a suggested list.

As to allocations, state owned banks allocate to state owned companies for political reasons because both are run by the state which is run by politicians. A good example is GM, which should have been let go, but it is kept alive at taxpayer expense for to protect jobs and to provide smaller cars, which people do not want to buy from GM.

Since emerging markets, according to your article, have not grown faster than developed nations in the past, are you simply extrapolating from the past to substantiate your predictions for the future, ?

My view is that growth in emerging markets is always preceded by legal reform that lessens the power of government. Law can be used two ways. It can limit power or extend it. When the law limits power it is economically efficient and when it extends power it is economically inefficient. You might want to take a look at Professor Huang, Capitalism with Chinese Characteristics. His thesis was that China grew fastest when the coutryside were allowed to be more entrepreneurial as opposed to state capitalism in Shanghai. Also look at Good Capitalism Bad Capitalism

Politicians everywhere have an incentive to extend their power, that’s what they do. If the law does not limit them, which it often does not, then the economy will become less efficient and growth could slow. For example, in the 1950s, per capita incomes in Latin America were 25% of the US and Asia was 10%. Now Latin America’s incomes are 20% of the US while Asia is 25%. Countries with well govern systems like Brazil and Chile will grow. Countries where the government like Ecuador, Venezuela, and Bolivia lessens the efficiency of the economy by increasing its power over the economy will not grow.

May 30 04:39 PM

[RiskReturnO...:]

Interesting perspective. Clearly, many points that are difficult to argue against, specifically China's "unique" legal & political system.

As Seeking Alpha is about investment ideas to get some alpha out of portfolio return, may I suggest another way to play the economic growth of China, without being bothered by the issues identified above regarding legal / political / accounting / banking system

Invest in China's growth through Taiwan -- EWT offers you a chance to participate in China's economic growth, but through a more open, transparent, "Westernized", fair legal and political framework. Taiwan has been democratic society, with President and Congress voted by the 23 million hard-working, innovative residents. Having being governed by Spain, Dutch, Portugal, and Japan, Taiwan has taken the "best practices" from all over the world. The legal systems is part Japanese, part American. Banking and accounting systems are comparable to US and UK standard.

EWT allows you to benefit from growing economic between China and Taiwan; in addition, Taiwan is levered to US technology spending, so well positioned in the next phase of US tech growth.

From technical / trading perspective, EWT is breaking out on very high volume, as foreign and local investors do not want to miss a chance in a lifetime opportunity to play "catch up" in the valuation of Taiwan shares, following the historic change in economic ties between China and Taiwan. The 50 day MA is crossing the 200 MA on very high volume, suggestion large accumulation by big players!

For those who track Taiwan shares, it first peaked in 1990 (with the Japan market); then it peaked again in 1998 (with the South East Asian Tigers; then it peaked again in 2000 (with Nasdaq); the last peak was in 2007 (with the global equity bubble). As the economy transforms from tight linkage with Japan, Asia Tigers, US Tech, to now China, investors are buying the shares at roughly 50% of 1990 prices! This is a HUGE discount to China shares, which are trading at 2007 prices already.

Essentially, Taiwan had two "lost decades" (one following Japan in the 1990-98; one following US from 2000-7). Now is the time for the shares to make up for all the lost time (due to geo-political risks). Even if EWT trades to $20, it would still be comparable to 1990 high -- when the China market was just opening up and trading at 1/10th the current level.

In summary, EWT allows investors to participate in a once in a generation opportunity to benefit from China's growth, without having to worry about key issues clouding China equities.

May 30 04:54 PM

[Danny Furman:]

Just presenting the other side because this is such a 1 sided crowd (not something I wrote):
seekingalpha.com/artic...

May 30 08:18 PM

[expat in China:]

The Middle class of China is real and is our market position!

There is over 20 million millionaires but they are on the top of the triangle with 400 million on the bottom of the triangle. Well that leaves 900 million in the middle who own 2 apartments and have a mini commercial truck to drive. The regimented ;life of Collage, then marry, then child resulted in 300 million young mobile families 35 years old with 2 apartments and 1 car 1 motor scooter. Most families work and operate their own business while savings 25%.

Emerging markets and China in particular have cultural growths that do not keep up with economic and global trade requirements resulting in ethical performance challenges. The supply chain management is extensive with many multinationals finding that "LCC" Low Cost Country supply is not great for export and spills occur in the product cycle resulting in resource consumption and equal cost to the home country.

The only reason to be in China is to be part of the growing middle class. The function of contract law, unbiased representation and legal outcome success is limited. The green money is the binding non spoken articles of agreement and will ensure your success however fortune 1000 multinationals can not successfully be in the green money game.

May 30 08:43 PM

[JX:]

"For example, one story is the assumption that emerging markets will grow much faster than developed markets. Over the past fifty years this assumption has not been correct."

It's due to reverse survivorship bias: the best performing "developing" countries graduated and became "developed".

May 30 09:14 PM

[VALUEDIV:]

Like every national economy, China has its share of misallocation of funds. However, unlike the last 50 years of the USA's post-WW II GI driven growth and post- 1975 "financial creativity" growth, China is investing in all of the areas Obama would like to- infrastructure, solar energy, housing, and education. This means employment and the need for materials and machinery...this means growth!

On the other hand, I fail to see any impetus or economic mechanism to restore us on a growth path. We will be fortunate to remain stagnant without severe economic regression over the next 2-3 years. We cannot print more fiat currency without losing our position as the world's reserve currency; yet we MUST to save ourselves. The
flight to Gold has just begun and oil prices are going back up rapidly (40% in last 3 months). This brings inflation into the picture with high unemployment. Everything is relative in this world. The one eyed man is king in a blind world which is a good metaphor for the US position versus China.
God Bless and Save America.. Good fortune to all. DPR

May 30 09:50 PM

[Sober Realist:]

On May 30 08:18 PM Danny Furman wrote:

> Just presenting the other side because this is such a 1 sided crowd
> (not something I wrote):
> seekingalpha.com/artic...


I followed the link and read the article, but what I found more telling was the single comment at the end of the article from an American living and working in China:

"drDimick.com
From my three years throughout China, although not bilingual, what I hear and see indicates a lack of market (or macro) orientation regarding economic cycles. In effect, most here assume that "the crisis" has done its worse and the world is now on the mend.

Although not exactly what folks in the money business care to consider at this point, notation may be at least made as to the last time that the global economy experienced a down cycle in the absence of the Glass-Steagall Act...

There was a bounce after the 1929 crash. Less than two years later, a second, even worse drop occurred. Those who invested during the bounce did not see even-money until the early 1950's.

I am not a doom and gloom type -- actually, not much of a bull either. I only call attention to the historical significance because of exactly what China lacks... context of the past seven years (2001 to 2008) of rapid grow.

Here in Beijing, near Tsinghua University, I frequent street markets. Illegal street vending is my parallel indicator to Rockefeller's shoeshine.

The story goes... One morning, Rockefeller stopped en route to the office for a shine. During the polish, the young, enterprising man said, "Hey, I got a great stock tip for you this morning." Back in the office, upon reflection, Rockefeller began liquidating his portfolios -- some two years before Black Tuesday.

The rationale? Rockefeller was reported to say that if shoeshine boys, nurses, and 9 to 5 workers were boasting hot stocks, it was time to get out of the market. It was, in effect, over bought.

My indicator here in China is the "Street Vendor Factor." Although SOE's continue to dominate China's economic landscape, a nonscientific bellwether is who and what is being sold on the street, namely sidewalks.

Here in Beijing, during the last three months, I have noticed two anomalies. First, horse-drawn vegetable wagons; yes, here in Beijing, I am seeing more of them -- five in a row the other noon. Didn't see one six months ago.

Second, vendors selling clothes from the trunks of cars. The only time that I have seen this before was in Shenzhen last year -- one car, a guy selling ladies shoes. Surprised, I called my girlfriend in Wuhan to see if she wanted me to buy a pair for her right there, right then.

That second observation may indicate how the economic decline may be advancing into the government proclaimed middle class. Most of my Chinese streetwise sources, I note, usually poo-poo this supposed 350m amassing of a four-door sedan driving, franchise consuming demographic.

Both factors constituting my indicator tell me that, although the central government's $500b stimulus may be propping up the mammoth state banking and industrial complexes, the ice may still be melting beneath.

I have spent three years now here in China. My China business and investment book was published last month by Wuhan University Press Beijing. The text offers nothing new in terms of investment banking precepts and strategies; my hope is to offer context and orientation... namely hedging inbound and outbound considerations of China related propositions.

That said, I remain cool, at present, to the idea of following Chinese players any further away from this pond's shoreline, regardless of how big the body of water "appears" to be.

dr

May 30 10:14 PM

[Sober Realist:]

More interesting is this WSJ article
online.wsj.com/article...

---U.S. Treasury Secretary Timothy Geithner heads to Beijing this weekend to urge Chinese leaders to fundamentally alter the export-oriented economy that has created years of trans-Pacific trade tensions.
---... he is also planning to press Beijing to take drastic measures to turn China's economy into one that depends heavily on sales to domestic consumers and less on sales to the U.S. and other foreign markets, according to a senior Treasury Department official.
---The message signals that Treasury is beginning to look beyond the current crisis toward preventing a return to ever-mounting trade deficits and the constant political tensions they generate between the U.S. and China.

May 30 11:02 PM

[HaavBline:]

To RiskReturnOptimizer: I have a significant holding on EWT, I can appreciate your strong efforts. But frankly your statement "Having being governed by Spain, Dutch, Portugal, and Japan, Taiwan has taken the "best practices" from all over the world." was way too much hype.

The 'best practise' from the Portugese consist of this: "In 1582 the survivors of a Portuguese shipwreck spent ten weeks battling malaria and Aborigines before returning to Macau on a raft" and that was it.

The Spaniards spent a few more years, estabhed a few small settlements by the sea, but were driven out by the Dutch in 1642 after a mere 2 decades of presence. Neither the Portugese nor the Spaniards left any trace of 'best pratices".

The Dutch East India Company managed to hang around longer in more parts of the island, set up churches, schools and collected taxes, until they were driven out by ramnents of the falling Ming Dynasty forces in 1661.

The Dutch can claim they left some 'best practise' to Taiwan though. One particular aboriginal tribe are said to have significant Dutch DNA among them. And some of their woman does show the hints of Caucasian style beauty unusual in Taiwan. Needless to say, that brings that popularity in entertainment circles.

May 31 12:34 AM

[William Gamble:]

Sober Realist.

The best book on China's middle class would be Capitalism with Chinese Characteristics. Professor Huang does the best job of taking apart the Chinese economic model. Unlike many other authors, Rogers, Kynge etc. Professor Huang has actually dug deeply into the statistics and it is not about antidotes.

But the real questions is about stimulating consumer demand. An export policy (or any policy) is made up of numerous laws. Over time powerful groups develop vested interests in maintaining these laws. So it is very difficult to change them when circumstances change. Japan has a middle class, but low demand because they have been following the same policies (and party) for 60 years

May 31 05:34 PM

[William Gamble:]

expat in China

The function of contract law, unbiased representation and legal outcome success is limited.

Correct: This is because China and many other countries are what is called in game theory as a relationship based system. Most people feel it is part of culture. It is not. It exists everywhere and has for most of history. Two modern examples are eBay and the Mafia. (see Lawlessness and Economics, Dixit)

May 31 05:37 PM

[onebir:]

I agree with (almost all) of what the author says - published research pointing to poor capital allocation in China dates back at least five or six years.

But I think the logic of the original article is a little flawed. What's quoted from the Ferri-Liu paper implies that there's evidence of misallocation. But I don't see any arguments to suggest/explain why "this is especially true today as a result of the stimulus package".

Let me suggest two:
1) the banks are being forced to throw money at corporates. With greater discretion, relationships with state-owned enterprises are likely to play a larger role than usual.
2) I suspect smaller, privately owned enterprises are more likely to be export-oriented - foreign importers are outside the guanxi-web, so present better opportunities to this kind of firm. As such, they're likely to be particularly in need of liquidity, compared to large SOEs. Even if they're getting the same share of the extra capital the state is injecting, under current circumstances this is too little.

So the interplay between the existing system and the export-oriented nature of the shock could well be increasing problems with capital misallocation as the author suggests. Add to this reports that companies have used additional funds to speculate on the stock market.

May 31 09:44 PM

[Fiedler:]

Dangerous name WILL(iam) GAMBLE
:)

Jun 01 11:01 AM