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
