The Perpetual Chinese Bubble Machine
Pao Mo in action…why China is the "biggest opportunity we investors have ever seen," but still a beast to treat with caution…
The last jerk who smirked and muttered, "those inscrutable Chinese" aloud was probably acting in a 1940s Charlie Chan movie.
The last person who thought it was probably a reporter. Sometime this week.
Every time you catch a bit of news on China, that inscrutable thing seems to ooze between the words…there’s that gee-whiz, tsk-tsk, head-shaking tone to it all. And often, outrage.
Among investors, one half seems to think China is easy pickings. The other half thinks it’s, well, too inscrutable to risk. Both are wrong.
Successful investors will need to understand how China progresses. But it’s not inscrutable. The Chinese do what they do for a reason – and their reasons always make sense in context.
Let me say it plainly. China is the biggest opportunity we investors have ever seen. (I trust none of us is over 150 years old.) The last one that was this big and as likely to stay at the top for a long time was a young country called America.
But here’s the deal: Right now, it’s a bubble. Most of the headline stocks are already priced to fall – in fact, if you can name a Chinese stock off the top of your head, you probably shouldn’t invest in it.
Chinese Stock Bubble: A Bubble up Close
Americans are getting their first chance to see a Chinese bubble up close. Most of the investors who were caught in the 1992 and 1994 Chinese stock crashes lived in Asia, not America. Those crashes centered on China’s state-owned enterprises.
China began listing stocks in 1990. At first, it made it easy for state-owned enterprises (SOEs) to go public. It was much more difficult for China’s newly developed private companies to get a stock listing.
But who cared? Capitalists were so starry-eyed over the noble experiment of "Commie" groups going honest that they bought whatever they could willy-nilly. The theory-heads egged them on, blathering about how getting government out of business was so right.
Unfortunately, right ideas can make wrong investments. Those who bought the rafts of new Chinese stocks bid some lousy businesses up to levels that would make a dot-com tycoon proud. With the same result.
Going forward, we have two kinds of investments coming our way now. There are still many more SOEs coming to market. In fact, until this July, the Shenzhen market had a three-year freeze on IPO’s. It was only SOEs coming to market.
Chinese Stock Bubble: Eager to Get to Market
China still has some 30,000 to 60,000 SOEs to manage, and it would like to lift the burden of many of these from the state’s shoulders by continuing to privatize them. I would be very cautious about investing in these without seeing plenty of good data and a solid business plan.
Meanwhile, Chinese citizens who have started private businesses from the ground up are eager to get their babies to market, too. They are listing in China again, as well as Hong Kong and the United States. These often make very good investments while new. But these businesses are quickly bid to the moon…you need to discover them early in the process.
Understand this: China is intent on developing strong businesses, but it is still reluctant to let private enterprise go ahead too rashly. The Chinese Communist Party cannot let business become so important that would threaten governmental power and control. Capitalism is a tool, not a religion here. The basic system is still socialist and will be for a long time yet.
Also, with high unemployment, a number of credit-bloated banks, a still-rudimentary commercial banking system and difficult tax problems, China must keep tapping the brakes and moderate its pace. It cannot afford enough boom to court a bust. Any country would do the same if it foresaw the problem.
And every time China reins in business, trade or public opinion, it is going to catch a blast from the media. You better just expect it and remember that this is a process, this getting rich thing. It is not something a country does seamlessly overnight.
Chinese Stock Bubble: Exports
Nevertheless, China’s recent growth is impressive. For the last three years, the global economy grew only 2% a year…but China’s expanded 8% a year, and should grow at that pace for some time yet. How? The answer: exports.
China has what every country wants but not all can get: growing exports. It took three things: a change in the economic system with government’s blessing, places and ways to make trading easier and lots of workers willing to labor cheaply. Capital and technical know-how go without saying.
The change in government had to come first. Under Deng Xiaoping, former head of the Chinese Communist Party, China slowly turned away from Maoism and decided that "to be rich is glorious." By the way, the current head of the Party, Jiang Zemin, was Deng’s chosen successor. So the trends Deng set in motion before he died in 1997 continue.
You as an investor should catch this important point about China’s fast-growing economy, though. As you know, when a company is very small, it’s easy for it to double sales. When it sells a billion dollars worth of widgets a year and has captured the top spot in its market, it’s not so easy to keep doubling.
We think of China as huge. And so it is in terms of its size, population and world stature. But economically, in 1978 when China began to open to trade, it was very small, given its size and resources. It is still well back of "fully industrialized" status across the country.
China’s average household income last year was $4,400. That’s low. If it were evenly spread, it would be low for most people. But it’s not. The average in the eastern cities is three times as high as in the western provinces. Plus, an estimated 150 million unemployed migrants from the poorer west have traveled east. They hover around China’s great cities seeking jobs, any jobs. They work cheap.
Chinese Stock Bubble: When Privatizing, Go Slowly
And each time China closes down an SOE and throws it into the private sector, people lose jobs. SOEs tend to have too many workers. That’s another reason China must go slowly in privatizing. If it goes too fast, it will make unemployment so bad it could topple the government.
Privatizing China’s thousands of SOEs piled up the fuel for China’s expansion. It was finding a place to trade that set it on fire.
In 1978, China decided to set up special zones within the country to ease foreign trade and investment and allow Chinese to develop their own businesses. The first five special zones were created in 1980. By 1984, 14 more cities joined the list. Then in 1985, China decided to expand the network to include large swaths of the east coast and the Yellow, Yangtze and Pearl River basins.
Westerners rushed in, knowing nothing. They found that one day, all was well. Contracts were signed, money invested. Then, suddenly, contracts were cancelled and sunk money was lost.
That’s when you started hearing the cries that China has no rule of law. It’s true, strictly speaking. China follows the opposite system: the rule of men. A true system, but the two don’t mesh easily.
Europe followed a rule of men for much of its history, too. Kings, queens and local nobles once had this same power system. Power was a matter of the right connections, the right alliances. In China as in an older Europe, laws may exist, but whoever is in power gets to decide how and when to apply them.
Chinese Stock Bubble: The Rule of Men
This is very important to China. A matter of dignity. It is changing, but it is still key to doing business there. With its larger role in international trade, China is accepting the role of the written contract. But other, subtler points to a rule of men persist and shape how things are done in China. Where there is a rule of men, personal relationships are extremely important.
Not all Western companies will succeed in China, and those that do have learned how important it is to understand who is due what. They realize that certain things are expected in return for help…not necessarily a bribe as in other countries, but a bit of recognition, an introduction, an invitation, a courtesy…whatever.
The other point about a rule of men is the way it handles change, as the people who hold power (now the Communist party on down to any local officials) decide whether and when to enforce it. One way to creep up on change is to hold back the power. For instance, as we already saw with the currency, officials might "overlook" taking more than allowed outside the country. That way, things can change without declaration. If they work, progress is made and the laws may catch up later. If they don’t, the law can suddenly be enforced and those in power can quite honestly claim that they never passed a bad policy and are only affirming the way things have always been.
There’s more change going on in China than the popular press can even tell us. Much of it will continue to happen below the radar.
But overall, China is an extremely attractive investment now. It has joined the World Trade Organization, and it will adopt rules and practices that foster smooth trade. Not always smoothly, but eventually. Its politics will continue to offend democratic sensibilities at times. But it desperately needs money. And that makes the long-term outlook for its development of more industry and trade is very strong.
Not long ago, half China’s GDP was spent covering the debts of its inefficient and bankrupt SOEs. China can’t afford to go back. But you as an investor can’t afford to neglect China’s history and culture, either. It will go forward in its own fashion.
For the Daily Reckoning
November 26, 2003
Investing advisor and skeptical analyst extraordinaire, Lynn Carpenter has helped investors earn profits in everything from oil and steel to emerging technologies, defense stocks, Swiss annuities and commodities.
"Breathtaking!" they called it.
The news is being heralded on British TV this morning – after jiggling the numbers, the U.S. economy was found to have grown at an 8.2% rate during the 3rd quarter.
"The recovery really caught fire," said an economist with UBS securities. Rejoice. Rejoice. The talking heads on television were practically clinking champagne glasses; the news was greeted with celebration, praise and admiration. But last night, it came toward your editor’s face like a lemon pie.
"Didn’t you hear the news," asked a bullish fund manager with whom we were enjoying a drink. "The U.S. economy grew at more than 8% last quarter."
You and your fellow gloomsters don’t know what you’re talking about, he probably wanted to add; you’ve lost a lot of money.
"I bought Amazon.com a few years ago. It has gone up ever since," he continued.
You see, dear reader, being a cranky ‘prophet of doom and gloom’ is not always easy work. You have to bear the taunts of young fund managers with more money than you have…and more hair.
The subject inevitably turned to gold:
"If you wanted to invest in a commodity, why not buy something with better prospects, such as copper or tin," he asked. "The problem with gold is that it is not frangible…you can’t break it down or use it up. A commodity that never gets used up is not exactly a sure- thing investment, if you know what I mean. Maybe they’ll find a commercial use for it some day. Then, it might be a good investment. Until then, well…"
He did not need to complete his sentence. In a few words, he had made the Case Against Gold such as it is. Gold is no longer needed as money; paper works perfectly well. The U.S. economy is growing at more than 8% per annum, for Pete’s sake. Who needs gold? And, as a pure commodity, gold is a loser.
And yet, you editor does not buy tin. Nor bauxite. Nor lumps of coal. He buys gold. He buys gold because he suspects that the people controlling paper money today are not as smart as they think they are…and no smarter than those who ran paper money systems of the past (all of which failed…)
And he buys it because he suspects that there is a kind of rough justice in the world – where people cannot get anything they want, anytime they want it…but where people get instead, more or less, what they have coming.
He buys gold because he believes it is more authentic ‘money’ than a piece of paper proclaimed money by the Bank of England or the Department of the Treasury…and he suspects that his kruggerands and gold Louies will have value long after the Bank of England and the U.S. Treasury cease to exist.
He buys gold because he has no way of knowing what lies ahead. Maybe the dollar and the pound will be around for a long, long time – without any link to gold. But he notices that the longer people are able to borrow money…with no unhappy consequences…the more money they borrow, and the unhappier the consequences become.
And now over to Addison, with more news:
Addison Wiggin in Paris…
– Skyrocketing government spending…the plunging dollar…an "engine" on fire…
– Forgive us. Yesterday, in commentary we were writing for the UK edition of the Daily Reckoning, we mocked an analyst at JP Morgan for accepting the U.S. government’s GDP figures. They claimed 7% annualized growth reported for June to September. How wrong we were! The Conference Board has now revised its Q3 numbers to put growth at 8.2% – the highest rate in 20 years. Oh là là…
– Consumer confidence also hit a 12-month high in October. Yet all the good news failed to ignite the markets. "Stocks flat despite data showing strong GDP growth," says the Wall Street Journal. The lumps either didn’t believe the revision, or they’ve already priced it in. "A classic ‘buy the rally, sell the news,’" writes Anna Troupe for Elliott Wave.com. The Dow and S&P both rose, but slightly – 16 and 1.8 points, respectively. The Nasdaq slipped 4 points to 1,943.
– "Treasuries shrug off slew of strong data," remarks a headline in the Financial Times. Demand for U.S. government bonds stayed strong, pushing the 10-year benchmark’s yield down a skosh to 4.17%. Strangely enough, the U.S. numbers withered demand for government bonds elsewhere in the world. Prices fell in Japan, Euroland, and London. In Tokyo, however, equity traders – fresh from a bank holiday – read the revisions, caught the fever, and pushed the Nikkei back up through 10,000.
– U.S. government bean-counters might be happy to report incredible growth; global markets might be foolish enough to take them at face value. But the dollar remains under intense structural pressure…and seems destined for a collapse. Hard. Fast. And soon.
– Your editors have been pondering for some time the prospect that wanton profligacy inside the beltway would put government debt at risk. You’ll recall a couple weeks back that Jim Bianco, of Bianco research, told us it would "never happen." Such a move would put the modern financial system at risk. Well, yeah, that’s the point, we thought quietly to ourselves at the time.
– But lo and behold: yesterday, Moody’s warned the U.S. to clean up its act. Rather, "Improve Finances," reports the Financial Times, or else. It’s all well and good to cut taxes to put on a happy face for the world – and spending money in the hands of the world’s happiest consumers. But if the U.S. wants to preserve an AAA rating on its bonds, says Moody’s, it will have to raise them again…or cut spending. Ha!
– Our own bond sleuth, Dan Denning, has been following the prospect of a U.S. credit downgrade with his proprietary BED Spread indicator. This morning Dan reports: "Darned if the BED Spread isn’t just getting smaller and smaller each week. Since we last looked at it, the yield on a basket of Uncle Sam’s debt rose slightly to 4.6% (as measured by the government debt exchange traded fund GVT). On the other hand, emerging market debt yields, as reflected by EMD, fell under 9% this week to close at 8.99%.
– "The BED spread fell about 7% to 4.33." That’s a significant drop over last week’s 22% decline. What does it mean? Well, Moody’s said it better than we can.
– Still, government hacks, wonks and policy weirdos appear to be willing to do anything – even mortgage their children – to keep the U.S. in the driver’s seat of the "single- engine world economy," as Stephen Roach calls it. The OECD, for its part, appears to be willing to go along for the ride. Predictions for 2004, due out today, but leaked to the Italian newspaper La Repubblica over the weekend, show European Union growth revised down from 2.4% to 1.9%…and U.S. growth revised up from 4% to 4.2%.
– Beware, we say, like schoolchildren before an angry principal, trying our best to muster up respect. "Monetary, as well as fiscal, policies," warned Marc Faber in a recent issue of Strategic Investment, "are ‘marvelously successful’ at stimulating consumption of cars [and other consumer goods], but ineffective at stimulating production and net capital formation. Imports meet the rising domestic demand while net capital formation occurs not in the U.S. – but in China and other low-cost production centers outside the U.S."
– Indeed, "GDP [in China] is predicted to expand by 8.5% in 2003," writes Chris Bourke, editor of Profit Watch, a sister publication published in London. "Spend-happy consumers sent sales roaring ahead by 10.2% – the fastest monthly growth rate in two years. Telecommunications sales skyrocketed by 75%…car sales roared ahead by 48%…furniture sales chalked up an impressive 40% gain…" [More Pao Mo commentary from Lynn Carpenter, below…]
– No coincidence, then, that the beltway bunglers, ignoring distasteful lessons of history, resumed the "trade war" yesterday. This time, they took aim at another Chinese industry: Color TV sets. The Commerce Department ruled that televisions from four Chinese firms were being sold in the U.S. at less than ‘fair value’ and announced provisional anti-dumping duties of 28% – 46% on their sets. "U.S. television makers and unions complained," reports CNN, "that imports from China and Malaysia had mushroomed to 2.65 million sets a year in 2002 from 210,000 two years earlier."
– Curiously, no ruling was made against Malaysian televisions.
Bill Bonner, back in London:
*** On the news of the fastest-growing economy in nearly 20 years…gold sold off 40 cents.
*** We cannot help but remark that the 8.2% growth in the U.S. economy is mostly an increase in consumer spending. Few new ways of earning extra money are being developed. Instead, what is being encouraged are new ways of spending it. Auto sales rose at a 25% rate in the 3rd quarter. Residential construction went up at a 22% rate.
And where did the money come from? Largely from a tax cut. The Feds cut taxes, thereby giving consumers the means to spend more…while actually increasing government spending at the same time. And thus did the economy grow at 8% – by spending money no one actually had. If growth continues at this rate, we will all soon go broke!
And we suspect we’re not the only ones who’ve noticed. A chart comparing gold to other commodities shows gold rising at a steeper angle. Gold has little industrial usefulness. And yet, in what appears to be a worldwide expansion, gold is rising faster than useful resources. There must be others who doubt that you can spend your way to prosperity…who are suspicious of money you can create out of nothing…and wonder about ‘growth’ that comes as a result of going ever more deeply into debt…
These poor, lonely people…bearing the slings and arrows of CNBC and fund managers as we do…how we feel for them!
*** It’s just like the late ’90s…even the IPOs are back. "Four firms go public on busiest day for IPOs since 2000," the LA Times tells us.
But it’s not exactly like the late ’90s. Then, the U.S. bubble was financed by overseas investors hoping for a good return on their investments from new era technology. Today, the Bubble has been reloaded by government. Tax cuts, interest rate cuts, and foreign central bank buying of U.S. debt – all have kept the debt bubble expanding. Glory Hallelujah.