Gamesa, China's Rules and Why I'm Going Short Emerging Markets

Includes: FXI, GCTAF, GE
by: Romeo Fayette

More anecdotes of China's disregard for international business practices as per a Spanish company, Gamesa (OTCPK:GCTAF):

Earlier this week, I noticed an interesting article in the New York Times, "To Conquer Wind Power, China Writes the Rules." I have a client who forged a business in wind project development, plus alternative/renewable energy proponents are sprinkled throughout our portfolios, so I took a gander. The story pretty much adds another chapter to the "lawless China" saga:

...[Spanish company] Gamesa has learned the hard way, as other foreign manufacturers have, that competing for China’s lucrative business means playing by strict house rules that are often stacked in Beijing’s favor.

Nearly all the components that Gamesa assembles into million-dollar [wind] turbines here, for example, are made by local suppliers — companies Gamesa trained to meet onerous local content requirements. And these same suppliers undermine Gamesa by selling parts to its Chinese competitors — wind turbine makers that barely existed in 2005, when Gamesa controlled more than a third of the Chinese market.

But in the five years since, the upstarts have grabbed more than 85 percent of the wind turbine market, aided by low-interest loans and cheap land from the government, as well as preferential contracts from the state-owned power companies that are the main buyers of the equipment. Gamesa’s market share now is only 3 percent.

With their government-bestowed blessings, Chinese companies have flourished and now control almost half of the $45 billion global market for wind turbines. The biggest of those players are now taking aim at foreign markets, particularly the United States, where General Electric has long been the leader.

Chinese Wind Turbine Makers - Market Share

Click charts to enlarge:

It's not so much the fact that Gamesa has lost its foothold, rather, it's the fact that they took a gamble on establishing a presence in a developing market [China], and in return for their support of the region, Gamesa was exploited by the Chinese. Yet, there comes a time when you get pushed too far though, when pride overcomes profit...

Gamesa is not crying foul — for reasons that are also part of the China story. Although the company’s market share in China has atrophied, the country’s wind turbine market has grown so big, so fast that Gamesa now sells more than twice as many turbines in China as it did when it was the market leader five years ago. So as Gamesa executives see it, they made the right bet by coming to China. And they insist that they have no regrets...

“If we would not have done it, someone else would have done it,” said Jorge Calvet, Gamesa’s chairman and chief executive.

I have no empathy for Gamesa. That quote makes me think of all those Wall Street CEOs, who--under the mantra "as long as the music is playing, you've got to get up and dance"--had to sell their souls in subprime CDOs to keep up with competition. Inadequate excuse.

It gets better: it wasn't enough for China to exploit Gamesa; once the Chinese wind industry was established, China had an opportunity to prey on those foreign multinationals who had set up shop within their borders:

On July 4, 2005, China’s top economic policy agency, the National Development and Reform Commission, declared that wind farms had to buy equipment in which at least 70 percent of the value was domestically manufactured... In the United States, where there are no local-content requirements, the wind turbine industry uses an average of 50 percent American-made parts.

Trade lawyers say that setting any local content requirement — let alone one stipulating such a high domestic share — was a violation of the rules of the World Trade Organization, the international body that China had joined just four years earlier.

But the Chinese government bet correctly that Gamesa, as well as GE (NYSE:GE) and other multinationals, would not dare risk losing a piece of China’s booming wind farm business by complaining to trade officials in their home countries.

[Compare that to] The provincial government of Ontario in Canada now wants to take a page from China’s playbook by trying to require 25 percent local content for wind energy projects and 50 percent for solar power projects in the province. The Japanese government responded by filing a W.T.O. complaint against Canada in September, asserting that Ontario was violating the W.T.O. prohibition on local content requirements. By contrast, Japan has never filed a W.T.O. complaint on any issue against China, for fear of harming diplomatic relations with its large neighbor.

In the end, it's another anecdote to illustrate China's disregard for contract law. I suspect that there was a time when developing America operated in much the same fashion... Although contract law and international commerce have matured markedly since the 19th century.

I can't help but compare investors like Gamesa to the morbidly obese, 'I know these chocolates are bad for me, but they're so yummy.' They know better, but they just can't resist. From Reuters:

China attracted $91.7 billion in foreign direct investment (FDI) in the first 11 months of 2010, nearly 18 percent more than in the same period of 2009, the ministry said.

Although China has a tight regime of capital controls, there is concern that some hot money has been entering the country in the guise of legitimate trade and investment flows. Yao said the commerce ministry would work to ensure that no FDI cash was being illegally redirected into asset markets.

Emerging Market euphoria is overreaching again.

Foreign investment in such a shifty economy looks even more speculative given the added risk of political immorality. Yet, the risk premium for investing in Emerging Markets--especially China--has withered away. A post from Bloomberg this week casts me back to the late '90s & Long Term Capital Management, entitled "No More Bears for Emerging Markets":

Individual investors are pouring money into emerging-market stocks at the fastest pace since 2007 as... three of the world's largest banks predict shares will hit record highs next year.

The last time investors were this bullish, the MSCI Emerging Markets Index sank 11 percent in three months...

"There's a growing realization that in some ways emerging markets are a safe place to be."

We all know the dangers of euphoria. And after the shadow banking crisis & Greece, we all know the everpresent dangers of SIVs/off-balance-sheet liabilities. In a place like China where lawlessness rules, I can't justify investing into such a euphoric market.

I leave you with a note from Hugh Hendry:

The world of investment has parallels with theology. Repetition and the passage of many years, especially a decade, can transform the rational into the fanatical...

I also cannot completely shake off the analogue [between China and the U.S.] of the 1920s/30s. in 1929, global economic growth was to be found almost exclusively in the creditor country, America. From 1927 to 1929 the debtor countries of Europe struggled to reconcile the savagery of austerity cuts without having recourse to a weaker currency. The fixed gold standard offered no redemption to soften the tremendous social costs of unemployment. And when domestic demand finally faltered stateside, the decline was made more dramatic by this lack of offsetting economic growth elsewhere.

(The rigors of yesteryear's gold standard reminds me of today's Yuan peg, which renders U.S. Dollar devaluation useless since no trade/budget surplus can be wrought from it. In fact, a weakened dollar has exacerbated the effect of U.S. crude imports and recently, commodity inputs & food prices. For the Chinese, such inflation is the double-edged-sword of a Yuan peg.)

...The comparison breaks down when it comes to assessing how pro-cyclical the Chinese have been in thwarting the steep recession of late 2008.

[Yet now, Chinese] QE2 misgivings say more about their anxiety of food price inflation taking root and threatening their precious social cohesiveness...

China's insistence on undervaluing and managing its currency whilst capital flight to its shores pushes more freshly printed renminbi back into its expanding banking system is evidence of the international economic order seeking equilibrium if not through the external value of the renminbi then through higher domestic Chinese prices...

But it is just about possible that their benevolence [in supporting global growth through the crisis] is changing as they seek to rein in their own domestic price inflation... this is an environment rich in policy error contingencies.

Just ask Gamesa.

Suffice to say, our portfolios are void of most Emerging Markets, particularly China. In fact, I'm poaching FXI to enter an outright short position.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in FXI over the next 72 hours.

Original article at The Buttonwood Tree.