Great People – Terrible Economic Model
As I have repeated in a number of past issues, China is following its own version what author Eamonn Fingelton has called the East Asian Economic Model. According to Fingelton, this model was first followed by Japan in its WW II puppet state in Manchuria, then in post-War Japan itself, then Taiwan and Korea and now China. The Chinese version of the model relies on protectionism, heavy promotion of exports by subsidies and an undervalued exchange rate and a State/Communist Party directed over- allocation of resources to investment including real estate and infrastructure projects. The model has been enormously successful in its early stages in raising living standards but as the movement from the countryside subsides and exports in the current global near recession can’t be dramatically increased, the Chinese model has reached a dead end of diminishing marginal returns on capital.
This is where China is heading. All those airports, railroads, empty cities etc etc are going to turn in an ever lower return on capital. Chinese proudly point to their spanking new infrastructure. Americans in the post Civil War era could have proudly pointed to their new, partly subsidized coast to coast railroad system as well. But British investors in American railroad securities often lost their shirts.
So it is today with investors in Chinese stocks. Yes the Chinese people are hardworking, literate, relatively obedient and totally obsessed with getting rich. Good qualities for investors and ones that go a long way to offset what is really a terrible economic system. But investors have to be careful.
Observers have noted with some wonderment that the Shanghai A Share Index has gone down for three straight years. No surprise as far as I’m concerned. The companies in the A Share Index are largely majority state owned enterprises (SOEs). These companies on balance destroy capital. Their investment decisions are often made with State/Party directives in mind and they are recipients of subsidized below market bank loans. And the SOE’s have preferential treatment as far as access to the Shanghai stock exchange goes.
The contrast couldn’t be greater with true private sector Chinese companies which in many ways are starved for capital. I have looked at a number of private Chinese companies and with company after company I can find no or low debt. Growth is funded out of internal cash flows. Most of the true private sector companies have had to raise equity capital abroad in New York or Hong Kong.
Forcing their own companies to raise capital in the US doesn’t make a whole lot of sense for China, which has such a high savings rate and a huge cache of foreign reserves. What seems to have happened is that the bulk of China’s savings are misdirected into the state sectors while the true private sector companies have to scrounge for capital abroad. This has led to a number of problems and value discrepancies.
It is curious that the Hong Kong stock exchange wasn’t more aggressive in getting these Chinese companies to list in Hong Kong. As discussed in a previous essay, after an initial infatuation phase the Chinese companies listed in the US have become “orphans”, misunderstood, suspected of being frauds and grossly undervalued in many cases. Of course it hasn’t helped that some of them were indeed frauds.
One Way to Buy China—Invest in Southeast Asia
Investing in companies is ultimately about investing in people. One ideal combination (not the only one to be sure) is the Chinese work ethic (the Puritan ethic as it used to be called in the US) without the Chinese economic and legal system. And in a number of Southeast Asian countries, especially Singapore, Malaysia, Thailand and the Philippines, that is what you get. You get a business community which is signifcantly Chinese in origin. Chinese entrepreneurs are legends in this part of the world. But you also get market friendly legal/economic systems that are either British (Singapore, Malaysia) or American (the Philippines) in origin or at least heavily influenced by Western legal traditions (Thailand).
It goes beyond that. Southeast Asia is the destination of an ever increasing number of Chinese tourists as well as foreign investments. China is the number one destination for ASEAN (Association of South East Asian Nations) exports. So to a large extent Southeast Asia is part of the China growth story but without some of the drawbacks. Of course, if China were to have a really hard landing that would be a negative for Southeast Asia as it would be for the rest of the world.
But Southeast Asia is more than a China story. Consider:
- Southeast Asia is also the destination of an increasing number of Indian tourists and foreign investment.
- The banking systems and external debt situations—partly as a result of the Asian crisis of 1998—are in sound shape as opposed to those in the West, the more opaque and unbalanced Chinese system and the corrupt and bureaucracy laden Indian economy.
- The market driven nature of Southeast Asian economies means the overinvestment imbalances of the Chinese economy are absent in Southeast Asia. State intervention in Southeast Asian economies compared with China or the West is relatively minimal.
- The major Southeast Asian economies are growing at healthy but not unsustainable five percentish rates.
- As an added bonus the English language is the working language of ASEAN and is also widely used in Singapore, the Philippines, Malaysia, Brunei, Myanmar and even Thailand.
- The majority of ASEAN countries are democracies. ASEAN has the longer term potential to become a meaningful economic entity. (Hopefully not exactly like the European Economic Union.)
The major exception to this otherwise favorable picture is Vietnam. Vietnam has a Chinese style State/Communist Party controlled political and economic system. It’s no wonder Vietnam has been such a big disappointment in recent years. Vietnam spent a thousand years or so fighting off Chinese attempts to make the country into another Chinese province. But as any visitor will attest Vietnam seems in so many ways – culturally, politically – like China.
The one disadvantage for foreign investors in Southeast Asia is that most of the companies are small and do not have ADRs in New York. But herein lies the opportunity for those willing to take the time. These markets are underfollowed and growth opportunities do exist. These companies have websites usually in English. Information thanks to the internet is not the problem it used to be.
Some Statistics on Southeast Asia
2012 GDP Growth% Gov Exp/GDP% Population(Millions) Chinese Orig % incl mixd
Singapore 2.4 17.7 5.4 74
Malaysia 5.1 28.2 29.0 25
Thailand 6.0 24.1 64.5 30-40
Philippines 5.5 19.2 97.7 25
Indonesia 6.3 19.8 244.5 3.7
Sources: IMF, Economist, Wikipedia
Regulators from Hell (1)—Will All Chinese Stocks in the US Be Delisted?
The SEC said Dec. 3 that Deloitte Touche Tohmatsu CPA Ltd., Ernst & Young Hua Ming LLP, KPMG Huazhen and PricewaterhouseCoopers Zhong Tian CPAs Ltd. have refused to cooperate with accounting investigations into nine companies traded in the U.S. The SEC hasn’t named the nine stocks it’s focused on. The issue is the US accounting affiliates will not provide documents required by the SEC for its investigation of fraud because they claim this would be in violation of Chinese law. The SEC is threatening the US firms with penalties if the documents are not provided.
If the SEC order is carried out to its logical conclusion all Chinese stocks will eventually have to be delisted from US stock exchanges since no accounting firm acceptable to the SEC will put itself in the position of having to not comply with an SEC order . This would mean the delisting of hundreds of companies including some major ones like Baidu or Sina. It also may bring problems for American multinationals that operate in China and require local auditors for these operations. This SEC order would bring about a major destruction of value for US investors as the rug of liquidity would be pulled out from under these Chinese stocks. Leveraged buyouts would be transacted at a fraction of these firms’ true value. I cannot judge who is being unreasonable in this case—the Chinese or the Americans – and there certainly is a need for vigilance against fraud with Chinese stocks. But from the viewpoint of the American investor in Chinese stocks this SEC action has a “burn the village in order to save it” feel. One would hope adult behavior could prevail and this issue gets sorted out. One would have thought this issue could have been sorted out before the Chinese firms listed in the US.
The delisting of all Chinese companies would be another nail in the coffin of New York’s hopes to become the global center for equity financing. As if Sarbanes Oxley wasn’t enough. If the Hong Kong exchange were smart, it would open a special pathway for these companies to migrate from New York to Hong Kong.
Regulators from Hell (2) – Go for the Money
“The American extortion of Standard Chartered is nearly over. The British bank is ready to pay off, sorry I mean settle with, the rest of the US mafia crew otherwise known as federal regulators, with a fine of US$330 million for breaching US sanctions against Iran…The US is tough on foreigners, but it is anything but with its own companies. In the past decade, the US Treasury Department granted exemptions to almost 4,000 US companies to do business worth billions of dollars with countries under sanctions, such as Iran, Sudan and Cuba.”
-Alex Ho, MY TAKE, South China Morning Post, Dec 7, 2012
The above is one unhappy Hong Kong journalist’s opinion. But it is pretty much my opinion as well. HSBC and Standard Chartered have been made to pay enormous fines for ostensibly violating American foreign policy. HSBC and Standard Chartered have a long and honorable history going way back in Hong Kong. They are still respected institutions there and comprise, along with Bank of China, the note issuing banks in the territory. The American regulators on the other hand represent bankrupt Federal and State governments. Because of the size of the US economy and the role the dollar plays in the world economy, dollar transactions must be cleared through the US. Like the medieval barons of old who exacted extortionate tolls on commerce transiting through their territory, the US regulators are doing likewise.
-Peter T. Treadway
Dr. Peter T Treadway is principal of Historical Analytics LLC. Historical Analytics is a consulting/investment management firm dedicated to global portfolio management. Its investment approach is based on Dr. Treadway’s combined top-down and bottom-up Wall Street experience as economist, strategist and securities analyst.
Dr. Treadway also serves as Chief Economist, CTRISKS Rating, LTD, Hong Kong.