China: More Evidence of Increasing Risks

This probably doesn’t need to be pointed out in my blog because I have been beating the idea to death, but sharp-eyed Logan Wright in his latest Stone & McCarthy report comes up with some pleasingly simple evidence that hot money is pouring into the country from every pore. In his words:

Foreign direct investment in China has surged in the first three months of 2008, totaling $27.41 billion, up by 61.3% year-on-year. Paradoxically, however, the NBS's fixed asset investment data show a 6.5% year-on-year decline in the use of foreign-sourced capital as funding for fixed asset investment. In other words, 61.6% more money is flowing into China for investment purposes than the same period last year, but the use of that capital has declined by 6.5% year-on-year. While there will undoubtedly be some delays between the receipt of registered capital and the use of the funds, these diverging trends suggest that the foreign direct investment statistic includes some speculative capital inflows betting on appreciation of the yuan, which will continue to fuel monetary growth, requiring additional sterilization by the central bank.

FDI inflows surge but actual foreign investment drops slightly over the same period. This doesn’t prove anything because we would need to look much more closely at the actual numbers and the timing of disbursements, and Logan himself acknowledges this, but for the two numbers to move in such dramatically different directions over the year is at the very least counterintuitive. Unless you believe of course that a big part of recent trade and FDI flows are simply disguised speculative capital, in which case it makes perfect sense.

The evidence is largely circumstantial, but by now there has been so much circumstantial evidence of hot money piling up that it is hard to avoid the conclusion. By the way, if speculative money is looking for any way possible to enter China, and one of these ways would obviously be from over- or under-invoicing exports and imports, wouldn’t this also suggest that the speculative inflows hidden in the trade numbers have rising materially in the past few quarters? If so, China’s real trade surplus is likely to be a lot lower than we think. Perhaps the export-related slowdown is greater than we believe it to be.

Meanwhile the equally sharp-eyed Shirley Yam at South China Morning Post has also been digging away at some numbers and has come up with interesting results. In today’s edition she wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control. “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks. As she explains in her article,

This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm. I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast. Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

This kind of thing worries me not because I care about the how managers choose to spend and/or waste money. It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity.

Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years. In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control. The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).

Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems. Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside. But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time. This is not a coincidence. It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.

Comments

[User 179384]

Great Article. Good Read.

[chinesepetti]

Enter your comment hereAll Mr Petti's pupils and seeking alpha readers here; the story about Mr Petti just does not add up! According to Mr Petti's views (you can read all his articles about China on this site ; strangely he only wrote about China), everything in China is in crisis even the air is filthy so why he is making a living there; getting paid from the red Communist school; why not go back to Wall street to work for Bear Stern ? Bear Stern is not dead yet.

It is time for Mr Petti and his loyal pupils to disclose his relationship with the red Chinese government now!!! And all readers on this site should also make such a demand; otherwise it's an insult to the intelligence of all seekingalpha readers!

[chinesepetti]

If you guys really like to make some moeny out of China; listen to Jim Roger's advice and start to learn Chinese; is it logical to read what the Chinese say about it's economy if you are serious about bet your money in China? Here is a latest Article from Yahoo China finance by Dr Liang Wen Bin, Head of Wealth Management of China Merchant Bank regarding the currency impact on Chinese Banking.
金融界网站4月16日讯 在国家统计局公布今年3月份CPI...

　　梁博士说，此次央行这么�... 的积极回应。央行也有自己的�...

　　他说，各大银行的信贷规�...

　　在谈到人民币汇率破7的时...

关键词：准备金 CPI 央行 人民币 金融界

I might translate it for you guys if I have more free time.

[chinesepetti]

Sure Price control will not kill the inflation; however for a country like China with 1.2 billion people it is extremely important to use price control as a temporary measure in order to stablise the situation so other policies (for example revalue the currency and give tax benefit for R&D investment for improving productivity) can follow. This is very like what The Fed Ben did with a drastic rate reduction and flooding the market with liquidity so the credit situation can be stablised.

If you guys read Ken Fisher; you will understand the most effective measure to overcome inflation is investing in advanced technology to lift productivity, it will take time and lots of capital. China might be lucky in that regard because the internet which makes techonology transfer much easier and cheaper around the world.

At last we I agree to talk about Petti if you guys back off talking down about China; I welcome any constructive criticism on China though! I love to help you guys to understan what is really going on in China so we could make some serious money out of this great historical opportunity.

[RUFCrazy]

I'd like to see fewer bloggers write about a bubble that we can't even invest in - Shanghai - and write about the absurdly low PE's of the China small capos traded here in the US. A majority of China OTC BB stocks trade at 3-5 PE's which equate to 40%-50% discount rates, yet are growing on average about 25%-30% per year (some 100%, many above 40%). Examples of these include CNEH, CHME, UTVG, SGTI, CPHI, CSGH, LTUS or GTEC. Or talk about the success stories of China OTC BB's that have made the transition to major exchange listings - companies like HOGS, FSIN, HRBN, CSR, SDTH - these still trade at 25% discount rates and 10 terminal PE's yet are growing well in excess of 25% per annum.

GIVE ME A BREAK WITH THE CHINA BUBBLE CRAP !!!!!!

I want you the author to take a serious look at each and every one of the companies i mentioed above and then tell me about the (nonexistent) CHINA SMALLCAP BUBBLE.

[ChinaMart]

Agree 10% with rufcrazy2. There are more than a few China microcaps traded in the US with 50-100% yoy income growth, trading at PE multiples that are absurd.

[chinesepetti]

GDP is USA is about 1% to negative 1% and the PE of blue chip DOW is still about 18; China GDP is more than 10% and the average PE of Shanghai blue chip composite(after 3 month decline) is about 19. Any school kids can tell me where the Value is!!! And do not forget this fast growth will be there for at least next 5 years.

[chinesepetti]

Mr Petti; Talking about risk, would you please share our alphaseeking readers some of your working experiences in Bear Stern regarding risk assessment.

Mr Petti the greatest risk assessor from the the greatest risk institution Bear Stern!!

[chinesepetti]

Mr Petti the greatest risk assessor from the the greatest risk institution Bear Stern!!

[J.D]

Good article. It's so difficult to tell what's going on in China even when the data is apparently available, but overall things aren't adding up.

I don't know how any investors could make reasoned decisions about small or micro cap Chinese stocks. Do they do P/E and other ratios on all three sets of books? Even valuing the big firms seems like a wild shot in the dark.

[chinesepetti]

Mr Petti the greatest risk assessor from the the greatest risk institution Bear Stern!!

[chinesepetti]

sell china and buy citi. good night and good luck!

[chinesepetti]

buy Bear Stern and sell china; so Mr petti could get his old job back!

[EKP]

Mr. Michael Pettis, I have always enjoyed your comments and insights about certain aspects of the economy in China. Because you stay and work in China, you add a lot of creibility to your analyses. With the issues you mentioned, I think the A Shares have accurately reflected the situation in China. What I don't unerstand is why the H shares in Hong Kong didn't do the same recently. In fact, the H share indes is trending up.
Thanks.

[RichardSchweitzer]

Perhaps it has been dealt with elsewhere in this Blogger's writings, but it would help to have some notation or reference to the cost of capital aspect, including in respect to state controlled enterprises (rather than GDP references).

A comparison of cost of capital to various forms of enterprises with varying ties to the state to the cost of capital in western economies might be quite enlightening.

This is not a very "transparent"... area. But, from what does show through, it does seem that the cost of capital continues to be lower in China than in the west. As the flow of "new" labor into the markets slackens, and output costs rise (as indicated) that advantage may decline, though not precipitously.

[chinesepetti]

Mr Petti the greatest risk assessor from the the greatest risk institution Bear Stern!!
buy Bear Stern and sell china; so Mr petti could get his old job back!

[huangthomas]

This is an excellent article. Mr. Petti is paying more attention to human behavior, especially those of Chinese. Chinese behavior is not unique as one of the human ethnic groups sharing most of the genes, but it tends to be more exaggerated in many cases. They have the same greed as you can find in the Wall street.

[LoveShorting]

To Chinese Petti: It is Bear SteArnS ... don't forget the A and S.

By the way, I am long Chinese ADR's. Did well with LFC and STP before they came back down. Now enjoying the ride with CEO and others.

[chinesepetti]

Mr Petti the greatest risk assessor from the the greatest risk institution Bear Stearns!!
Buy Bear Stearns and sell China; so Mr petti could get his old job back!

[J.D]

See the SCMP today for articles on the Yunnan land protests, Tibet re-education, and torture of an inner-Mongolian bookshop owner. Risks in China seem to be increasingly moving beyond economic issues into social stability and acute ethnic tensions.

Let's hope the harmonious society can be maintained through increased action under the reform and opening up policy, and a re-emphasis on realizing the autonomy and personal freedoms guaranteed under China's constitution.

[chinesepetti]

Stop occupation in Iraq Now before you invest your money in China; Chinese do not want your bloody money! Otherwise keep your money to save Bear Stearns and Mr Petti!

[chinesepetti]

Stop now! Shame shame shame!!!