Shanghai Surprise

After a visit to China, Karim Rahemtulla is still puzzling over the Chinese government and economic systems…and can’t help but wonder: is China is pulling off an economic miracle, or just the wool over the world’s collective eyes…

Last week, I spent several days in Beijing and Shanghai, hosting a Supper Club Venture Capital meeting.

China is a conundrum. It makes no sense. And people accept that as normal. It is a country that has collided with capitalism and is now trying to manipulate it. It is country with a government that is adept at sleight of hand. What remains to be seen is whether China is pulling off an economic miracle, or just the wool over the world’s collective eyes.

After having a few days of pondering the puzzle of China, visiting with companies and catching the local real estate scene, our group sat down to discuss what it was that did not make sense about the commerce that we were seeing.

Subsidizing China: A Day of Financial Reckoning

We looked at a bunch of Chinese companies. Most of them were leveraged to the hilt with more debt than equity. Most were government spin-offs that were now private and publicly trading in the U.S. OTC market. When asked about how they were able to pay their debts – loans owed to the state-owned banks – they replied almost in unison that the loans were a low interest rates and renewable in perpetuity, and that the banks really did not force them [expect them??] to pay them back until they became profitable. One way around this, one executive intimated, was to keep two sets of books, one perpetually showing low profits or a loss. I asked point blank if this “government subsidy” was commonplace, and the answer was a resounding yes! The comment that was most telling was when one company officer, a U.S. trained MBA blurted out, “This wouldn’t work in the U.S.” I guess not, unless you were WorldCom or Enron!

The conclusion that I reached from this research was that China is not a transparent country, the government is subsidizing every level of the economy, from pensioner to taxi driver to major corporation, and that there will be a day of financial reckoning when many businesses go bust because the government will not bail them out by injecting more capital into already debt-ridden banks. And, you cannot trust any statistic that the government publishes.

Chinese banks, a.k.a the government, are saddled with hundreds of billions of dollars in non-performing loans. That is, if you use their published numbers, which are shaky at best. Yet, they continue to lend businesses whose owners are making money, not from product they sell, but from how much they can siphon out of the company knowing they are not being held accountable. As I see it, it goes something like this: You get a loan that you don’t have to pay back. You produce goods that you then sell below market to generate cash flow. You then show a loss from operations, since you spent more to make the product than you are selling it for. You pocket some of the cash flow, since the debt service is non-existent. You use your newfound profits to put deposits on new office space and apartments that you are planning to flip – since in China you don’t have to pay for the space until it is completed, and by then if prices have collapsed, you can just walk away. And since few Chinese pay taxes in this “voluntary system,” most of your “earnings” are also tax-free. So why does the government put up with this?

There are two reasons that I can come up with. First, corruption in the Chinese government is about as common as smog in Beijing. The skids are being greased at every level. Capital is being provided for these companies via share sales in the global markets to keep the party going after the loans run out. Basically, this is how business is being done. Now, this may not be the case for every Chinese company, but elements of this type of chicanery cannot be isolated incidents or the number of bad loans would be much lower.

The second reason, and just as troubling, is that the government cannot control the new capitalism that has been unleashed across the country. People are seeking a better lot in life and finding it through commerce. With 1.3 billion people, it could be an ugly scene. So, the government is filling the trough of liquidity, basically subsidizing the entire urban population, to avoid an uprising. Money is flowing, goods are being sold, buildings are being built – and all within an artificial cost structure.

Subsidizing China: Shanghai

While Beijing has a relatively short history of modern capitalism, Shanghai has a long relationship with money. Known to some as the Pearl of the Orient, and to others as the Whore of the Orient, Shanghai is truly one of the world’s great metropolises…when you can see it.

When you CAN see the city, you see modernity surrounding you. Subways, massive freeways that fly through the city center, suspended 40 feet above ground, a Maglev train to the new airport that I clocked at 430 kilometers per hour, and a port second-to-none. In my estimation, Shanghai, home to over 13 million people, has more skyscrapers than Manhattan. It is also more polluted, more gridlocked, and just as much fun.

I thought Beijing had the best markets, but Shanghai has even better ones. Here you can find all manner of goods and services that are available in the world’s largest and most cosmopolitan cities. Five Star hotels abound, modern theater, huge malls with every imagineable offering from Europe and the United States, a McDonald’s around every corner. If it wasn’t for the smells and strange rooflines, you could very well be in any modern capital. (Speaking of McDonald’s, The Economist magazine has long put out a Big Mac Index as a measure for valuing whether a currency is over or undervalued. I have been using this index as a guide for more than a decade and it has proven quite accurate. My Big Mac meal in Shanghai set me back $2.19 – about half what it would cost in the United States. This is a good indication, along with the 15 cents I paid for a Snickers bar and the 30 cents I paid for 16oz Pepsi, that the Yuan could appreciate quite a bit from current levels).

Of course, the lower strata of the population do not see it this way. As in any big city, there is a lot of poverty in Shanghai, and it is in your face everywhere. Parents with invalid children begging for pennies, people walking around picking every trash can clean of its putrid treasures – you name it, and you will see it in Shanghai.

Shanghai is almost not China. There is very little overt sign of government control of this commercial Mecca. It bustles like Manhattan, entertains like LA and offers Miami-like temperatures and beaches. It is China’s version of Laissez Faire economics. Anything goes here and the aura of the old money, first made by the large opium houses, abounds. On the streets, you are as likely to see a Bentley as a rickshaw. Shops range from opulent malls to back alleys where one can still score knock-off Gucci and Louis Vuitton purses (about $10 a pop if you bargain hard enough.) This selling of pirated and knock-off goods is enduring China’s version of a crackdown. Instead of selling openly in the markets, you are led down a series of back-alleys to small rooms with all the goods on display. China will pacify the West on the surface, but underneath, it’s business as usual.

Spending a few days in Shanghai almost made me a believer in the China miracle. It was a real city, with real history and real money. But, it was just one city in a sea of billions of people, many who have yet to experience a working toilet in the 21st century. China has four such cash cows: Hong Kong, Shanghai, Macau and soon Taiwan will be sucked into the fold. None of them are too happy with being associated with a government that still tries hard to control every facet of life. It isn’t working, and I think China will go the way of the USSR – a weird sort of capitalism with no looking back.

China is a conundrum. It defies economic principles with low inflation, high growth, and huge money supply, and a socialist government all in one…someone is lying somewhere. My advice on investing in China is this:

1) Trade Chinese stocks and look for emerging market like crashes as buying opportunities.

2) To really profit from China, fly over with a few suitcases and spend as much as you can, buying goods at artificially low price


Karim Rahemtulla
for The Daily Reckoning

May 11, 2005

P.S. The only thing that you should not do is to ignore China. It is THE giant of Asia and there is no country even close. India may be an established democracy, but it is does not hold a candle to the development in China. That being said, India may prove to be the opportunity that China was ten years ago. For now, China is a juggernaut that looks to be growing to the moon…and as we know from past experience, that may not be a good sign in the short-term.

Karim Rahemtulla is the investment director of The Supper Club, an exclusive venture capital group that attracts entrepreneurs and start-ups looking for backing. The highly sought-after forum allows its members access to investments that the general public will never see – until the big profits have already been made.

“Some people just have a gift for prophecy,” said an American woman in Paris on Monday. “The people I read think something really bad is going to happen. Of course, I don’t know, but I want to be somewhere safe when it does. According to what I read Nice, France, down on the Cote d’Azur, is one of the safest places in the world. It was either that or the Four Corners area in the United States…you know, where Arizona, New Mexico and some other states come together. I don’t speak French, but I thought I’d take a look at Nice. It is very, well, nice…”

The woman is worried about fat tails!

Fat tail events are things that are so unlikely you’re not supposed to worry about them at all. Like the risk of nuclear war or a stock market crash. They are called “fat tails” because they appear on the far extremities of bell curves…where the lines are supposed to tail out to nothing. Instead, they often bulge; they grow suddenly fat – there are most extreme events than statisticians think there ought to be. Things that are not supposed to happen do happen more often than most people expect. We don’t know how great the risks of nuclear attacks really are…but we’d much rather wait it out in Nice, France, than in Farmington, New Mexico. The food is better, the beach is closer…and both the women and the buildings are prettier.

We turned on our computer this morning and got another fat tail warning – Yellowstone National Park may blow sky high at any moment! There is the potential for a massive volcanic eruption at Yellowstone. Such things happen every million years or so…and it’s been a long time since the last one.

Should you bother to try to protect yourself? We don’t know…but we’re tempted to put up a few more cans of string beans and tomatoes this summer, just in case.

In the financial markets, too…we have the impression that the earth is beginning to rumble. Here in Britain, every day seems to bring more bad news. The day before yesterday, factory output was at a 10-year low. Yesterday, retail sales took their biggest plunge in 10 years. And in the United States, we have this stunning news from The Financial Times:

“Real wages fall at fastest rate in 14 years.”

We are tempted to stop right there. We have been saying for years that consumer spending cannot make people rich; instead, it makes them poor. You don’t get rich by spending; you get rich by saving…and building new businesses, new factories, and new and better products. You get rich by foregoing consumption in favor of production – so you can produce better automobiles, for example, than your competitors. But the United States has done just the opposite. It consumes…and allows its competitors to invest and produce. That’s why GM and Ford are now facing bankruptcy (not immediately)…while Toyota is reporting the strongest sales and highest profits ever.

We even think we know the deeper reason for this…yes, dear reader, this is the profundity we’ve been lured towards for the last few days. We tried to resist it. We tried to fight it. We looked for a self-help system…a profundity hotline number we could call…a 12-step program. But we could find nothing that would stave it off. So, we finally gave in to it. Yes…and now we see the fat tail event, too.

More news, from our team at The Rude Awakening:


Tom Dyson, reporting from Baltimore…

“Warren Buffet has placed a colossal bet against the dollar, but what if the dollar keeps going up and he’s forced to liquefy? Will the market finally get its man?”


Bill Bonner, with more views:

*** Real wages are falling for the very reasons we’ve described so often in these daily reckonings. In the new, globalized division of labor there are billions of people ready to do Americans’ work more cheaply. They save. They invest. They build new factories. Their wages and profits increase. Ours decline.

And yet, the biggest single asset people all over the world own is the U.S. dollar in various forms – notes, bonds, stocks…

At some point…perhaps soon…people will realize that those assets are not worth as much as they think they are. They could rush for safety at any time – which would cause the very disaster they fear: the dollar would crash, stocks would collapse, bonds would become nearly worthless. We don’t know what will happen, but we suspect the odds of this kind of fat tail event are much, much higher than the odds of a nuclear war or a volcanic eruption in Yellowstone National Park. And it’s much easier to protect yourself.

*** We haven’t done too badly, dear reader. Investors’ Business Daily has a Mutual Fund Index that shows how well the typical investor is doing. It’s down 5.12% for this year. The Wilshire 5000 is about where it was seven years ago. Most investors have made no money. In fact, they’ve lost money – in fees, commissions, and other Wall Street costs. And day after day, someone announces bad news. GE this week, GM the week before.

But we made our “Trade of the Decade” back in early 2000. It was simple enough. Sell stocks…buy gold. Since then, stocks have gone down. But gold? It’s up from $266 when George W. Bush first walked into the White House, to over $425. We don’t know what it will do from here…but it is still a good way to protect yourself from fat tails in the markets.

*** And here…a reader worries about something else:

“There is something phony the way some presidents and the military have been fighting wars since the Bay of Pigs when John Kennedy double-crossed Cuban invaders who were depending on air coverage from the United States.

“Then in Korea, Truman chickened out when China crossed the northern border of Korea. Truman ordered McArthur not to bomb the bridges, and thereby thousands of our fighting men were killed, wounded, or made prisoners and tortured.

“Then, in Vietnam, we bombed forests and dirt trails, but allowed enemy troops from the North access to the South. And again thousands of our men were killed, wounded or taken prisoner and tortured.

“Now we have the same idiotic war in Iraq where we allow Iran and Syria to outflank our troops and kill hundreds of our men and Iraqis by suicide bombers coming across the borders.

“And all it would take to end that war is to bomb a few palaces in Iran and Syria – in other words, hit them at the top level where the big guys are. But for some stupid reason, Bush and his cohorts are playing some sort of political One World Game at the expense of our young men.”

The Daily Reckoning