China Syndrome

If you wanted to find a place where the Old Economy gets some respect, you could go to the airport blindfolded and get on an international flight at random. Apart from the relatively few countries with fully modern economies, most places are still very backward by U.S. standards. These are the countries with a lot of trash by the roadside — usually on fire. They have big, smelly crowds of poor people at the airports and bus stations…and currencies with a lot more zeros than the dollar.

But they can be great places to live and invest.

A few years ago, China allowed its businesses to sell shares to the public. There were various categories of shares — only some of which could be sold to foreigners.

The market went wild. Chinese housewives lined up outside of the stock exchange building in Shenzhen. Fights broke out — similar to the one I saw in London – – as the women fought for an opportunity to buy shares.

Foreigners got excited, too. And the shares boomed.

And why not? Almost any argument that can be made for investing in the Internet could also be made for investing in China. The only difference is that the Internet takes you into the New Economy. China is still trying to get into the Old one.

Imagine the population of America. Then, multiply it times four. And then imagine that nary a person owns an automobile. Few have telephones. None have air conditioning. No one has ever actually tasted a caf? latte. There are few good roads. Even the railroads are primitive. And if you want a pizza, you have to make it yourself.

You can imagine, I assume, the financial potential. And unlike the potential of the Internet, the progress that will be made requires no technological breakthroughs, no business makeovers, no improvements in the basic character of mankind. The demand and the supply are both visible, attainable and nearly inevitable.

This is China, a country that has about 1.2 billion people — of whom, about 1 billion are living in conditions that would have been considered appallingly primitive by Sam Houston or Karl Marx.

But unlike the Internet, Chinese companies are cheap. There are nearly a quarter of a billion willing, wanting potential customers for refrigerators, for example. But the largest appliance manufacturer in China, Kelon, sells for less than 10 times earnings.

The market for Red Chips — the Chinese shares available to foreign investors — rose throughout the early `90s. Investors saw the potential. Their expectations rose along with the share prices. But the market turned around in the middle of 1997 — with shares falling as much as 75%.

Now, investors are negative on China. And there are plenty of good reasons to be negative. The banks are holding a lot of debt that will probably never be repaid. They lent to state-owned enterprises with bad management and may hold as much as 30% of GDP in bad debt. Credit Suisse First Boston believes this will force a 20% devaluation of the yuan by the end of this year.

There has been a building boom — which has resulted in tremendous overcapacity. Vacancy rates in Shanghai are running at 35%. And still, reports Doug Casey, building cranes can be seen everywhere.

There has been a lot of improvement in Chinese management and accounting standards. But it is still wild. For this reason, investors looking for a China Play often look at companies in Taiwan, or those run by overseas Chinese. But the real bargains are in China, such as the refrigerator company I mentioned above.

I visited Shenzhen and Shanghai during a couple of trips in the 1980s. Shenzhen at the time was more of an urban planner’s bad idea of a town than a real town. It had been laid out, with rough concrete streets under construction everywhere. But there were few buildings. It was the “city of the future,” for which the future had not yet arrived.

In the 1930s, Shanghai was the most international, fashionable and commercially robust city in Asia. But 10 years of war and 30 years of great leaps forward had turned it into a gray, gritty, ugly, depressing dump. There were one or two decent hotels, but that was about it.

“I sat in the superb bar on the 85th floor of the Grand Hyatt,” writes Doug Casey, describing Shanghai as a much different place than I recall, “smoking a Cohiba Lancero and sipping a Courvoisier, surrounded by vintage art. It was dark and foggy with light drizzle and, as a large blimp drifted by about 40 stories below me, its aerostat illuminated with advertising in Chinese. It became clear that I was already living in the world of the Blade Runner.”

The “cities are full of department stores that are completely indistinguishable from those in the United States…jammed with shoppers, mostly talking on their cell phones.” There are “good restaurants on almost any street. And a world-class Peking duck for two, with all the drinks and extras, is only $30.” Obviously a lot has changed. “And the rate of change is accelerating,” Doug believes.

China is still, officially, a communist country. But “in fact,” writes Doug, “China is in many ways freer and lower taxed than the United States.” The state, he says, “is an increasingly small parasite on a rapidly growing enterprise.”

There is also the threat of social or political trouble. The Falun Gong, are taken quite seriously in China. The country’s rulers have been challenged in past, bloody civil wars by quasi-religious groups. The Boxers, the Taiping and the Yellow Turbans each almost overturned Chinese dynasties.

China’s present leaders no longer believe in communism. What they believe in is staying in power and getting their cut of the profits. They appear to be remarkably pragmatic about it — and seem to understand Clinton’s insight: it’s the economy, stupid. And while much can go wrong, there is also reason to think that the economy will continue to flourish even if the politicians make a mess of other things.

Doug believes China is ideally suited to the demands of the 21st century. “Japan was well-equipped to deal with the 20th century — a structured, mechanistic, industrial clockwork kind of world. I don’t think it will mesh well with the 21st,” he writes.

“Chinese attitudes,” he says by contrast, “suit them ideally for the 21st century — a freeform, opportunistic, digital kind of world.”

The Chinese are risk takers. Which is a good thing, for China is full of risks. But there are huge opportunities too — opportunities at least as great as the Internet. And unlike the Internet, those opportunities are still cheap.

Doug is recommending a Chinese company in the pharmaceutical business. He expects the shares, which are now trading now below $3.50, will reach $10 by this summer and as much as $20 by yearend.

Best wishes for Super Bowl weekend.

Bill Bonner

Paris, France January 28, 2000

*** The Rocket Chips seemed to be in free fall yesterday morning. They were down 97 points before unfurling the parachute. When the day was over, they were down just 30 points.

*** The Dow was down five — so was the S&P…modest losses in a market that plainly didn’t know where to go.

*** Mark Skousen says the Nasdaq will surpass the Dow. Maybe…but where? Both of these indexes will probably go a lot lower before they intersect.

*** GM rose yesterday. GE fell. The first is underpriced. The second is overpriced. You won’t go too far wrong betting that this trend will continue — the convergence of the Gs.

*** QUALCOMM began the year at 200. Now it’s 125. Easy come, easy go. Etoys lost 20% of its value yesterday. But Mary Meeker’s “great brands” — AOL, AMZN and Yahoo — all rose.

*** Meanwhile, the euro reached parity with the dollar and just kept on trucking. It closed at 98 cents. Could Europe have reached a secret goal — unofficial dollarization?

*** Almost all the metals are going up — silver, platinum, copper, palladium. But gold? It is under too much central bank selling pressure. Could it be that the Fed and the European central bank have agreed to keep the dollar and euro at parity? And maybe the Japanese too (taking two zeros off the currency)? That is, have they colluded to remove competition from the world currency markets?

*** Hmmm…this is an interesting thought. Do they see gold as irrelevant — since they can now concern themselves with dollar reserves, rather than gold reserves?

*** The French Petroleum Institute says that a `70s- style oil shock could occur in 2002. A chart shows a narrowing gap between production capacity and actual production, which closes completely in 2002. With no excess capacity, oil prices could rise swiftly.

*** Oil has already risen swiftly. It was under $11 a year ago. Now it’s 150% higher. The economists who figure the inflation rate have been underweighting items whose prices increase. They assume people substitute cheaper items. But do airlines switch to natural gas? Do factories and power plants begin burning wood? Not right away, in any case.

*** And consumption continues to increase. Oil powers the Old Economy. And the Old Economy has to do a lot of expanding in order to improve living conditions in Indonesia, India, China and most of the rest of the world. Remember — the “Old Economy” is still the future for most people.

*** How to profit? How about selling UPS…and buying the companies that furnish it with oil? Occidental Oil yields a 4.6% dividend and sells at a P/E less than a third of UPS. Oil analyst Tom Petrie, as reported in “Barron’s,” believes Occidental stock should go up 60% in six to 12 months.

*** The closer you look, the more suspicious the tech’s and Net’s earnings turn out to be. Only 35% of Microsoft’s earnings come from selling products. The rest come from tax credits, investments and the treatment of employee stock options. The bottom line? A lot of the reported earnings and profits are bogus.

*** According to Bianco Research, stock market capitalization as a percent of GDP hit 81% in 1929, 78% in 1972 and now stands at more than 150% — nearly twice as high as the previous record.

*** When I feel the need for punishment, I open the “International Herald Tribune” to the editorial page. I usually get more than I was looking for. “The new capitalism,” writes William Pfaff, “which serves only stockholder interest, approaches a crisis. The new globablism, which serves only business corporation interest, is already in crisis.” The cause? “It is the subordination of workers, customers, public and social interest — even patriotism — to profit.”

*** Another writer, whose sleep is also troubled by “globalism,” whatever that is, writes, “The real issue is how to manage diversity in a world of close contact among cultural identities and ethnic practices that will not melt away.” And, “the clear challenge is one of wealth distribution” which the president of the World Economic Forum tells us without smiling, will require “new multilateral structures for global governance.”

*** So many words. So little meaning. So much nonsense.

*** And more claptrap: President Clinton proclaimed a “great goals” campaign for his last year in the White House. What happened to the “Era of Big Government is over”? Clinton revealed a grab bag of discredited ideas, which amount to more fraud financed by theft.

The Daily Reckoning