The Puzzle of Carruades de Lafite

The Puzzle of Carruades de Lafite
by Andy Xie
Caing.com, 07.07.2010
Lafite’s second label sold for about 200 British pounds per case until rising ten-fold over the past five years, epitomizing the pleasure and pain from China’s cult of luxury

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Andy Xie is a former Morgan Stanley analyst now living in China.

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Ten years ago I wrote that, whenever China buys, the price will go up and, whenever China sells, the price will go down. I recently modified the second half of that to, whenever China sells, the price will go up too, because I expect China’s factory wages to quadruple over the next decade.

The slogan is a play on China’s size. In economics, most observations are based on small perturbations to a complex system. For example, when a small country joins the international trading system, economists estimate the impact on the country’s economy based on price convergence with international prices. When a large country like China joins the global trading system, the impact is felt both ways. In some areas, like natural resources, for example, China’s impact dominates, hence, the change of relative prices for everybody.

One area that I believe China will have a great impact on in the future is the luxury market. The strong preference for “famous Pands,” much like in Hong Kong and Taiwan, has now begun to exert a surprising strength as the size of wealthy consumers grow in China. When one treks through luxury shops selling watches and bags in Europe, almost all have Mandarin-speaking salespersons.

There are clearly different degrees of preferences for luxuries among different nationalities, even when one controls for all economic variables like income, age or family size. One important factor is what economists call the discount rate. It measures how much one wants to be paid for deferring consumption. Long-term interest rates are supposed to measure this factor. But, with a global capital market, money flows around the world to arbitrage interest rate differences. In addition to this, central banks inflate the supply of money to stimulate the economy. Interest rates no longer reflect the differences in consumption patience.

The discount rate can partly explain the global imbalance. President Obama has been putting pressure on China to appreciate its currency, in an aim to decrease the U.S.’s trade deficit with China. But I seriously doubt that this will be effective. You need only to glance at the differences in spending behavior between Americans and Chinese in Paris. Apart from Europeans, these two nationalities probably dominate the tourism market in Paris. Americans cut their travel in 2008 and ’09. But now they are back in Paris with a vengeance. Some have said Americans rushed over to benefit from the euro devaluation, rushing to Paris for a bargain.

The problem is that Americans are deep in debt. Why should they bother if visiting France has become a bit cheaper? They should be saving money to pay off their debt. But, Americans are in Paris for a good time again. They stay at nice hotels, drink good wine, and eat expensive French food.

On the other hand, Chinese tourists go in groups, stay in cheap hotels, eat instant noodles and then spend ten thousand euros on an LV bag. I disagree with the choice. LV bags are sold almost exclusively to the Chinese and Japanese, believing it is a prestigious luxury Pand. In fact, the product has been designed to profit from Asia’s misunderstanding of western luxury.

My view on LV bags is beside the point. The main point is that Chinese leave with something that will last, while Americans put everything in the stomach. This fundamental difference in behavior won’t change with a yuan revaluation. If the yuan goes up, it will benefit LV sales, not American exports.

Luxuries like bags and watches are consumption goods. But they last for a long time, roughly at the half way point between consumption and investment goods. Hence, a country with a lower discount rate or interest rate should have a higher preference for luxury goods. This force is extremely potent when a poor country becomes rich and its inherent preference for luxuries is strong. When this country is as big as China, its impact is felt in every corner of the market.

When a new economic force like China comes into the global market and when supply is constrained, prices for luxury goods will rise relative to other goods like necessities. Diamonds, especially the hard-to-find big ones, are in this category. (If your guy can afford one, put the pressure on, ladies. Say it’s a good investment!) When the supplier can increase production but wants to fix the price, the supply goes up just enough to accommodate China’s demand. Mercedes-Benz cars and LV bags fall into this category.

Two years ago in another column, I discussed China’s impact on the luxury economy. Here I want to discuss China’s impact on luxury French wines. Not many asset classes have made new highs above mid-2008 levels. Gold is one. French fine wine is another. The residential property in China made a new high in October 2009. I can’t recall anything else. Among the three, French fine wines seem to have performed best. The French fine wine index (Liv-100 index) is roughly up by 37 percent from one year ago and 24 percent this year to date. Its upward momentum remains strong.

There is little doubt that the force behind the current upward momentum is Chinese buyers, not Wall Street traders. Bordeaux wine producers are all talking about China. Chinese buyers seem to dominate the en premieur (酒花) for 2009 vintage that will be available in another year. In the first growth wines, Mainland Chinese buyers are increasingly pricing out the Japanese, Taiwanese and Hong Kong people.

French wine is different from an LV bag. When the cork is popped, it’s gone. Of course, you can store it as investment. But the process is complicated and costly. In terms of Chinese demand, investment is still a secondary consideration. Drinking is now a bigger factor.

Drinking expensive wine is probably the ultimate consumption. One could swallow a lot of money – and quickly. It seems inconsistent with the dominant Chinese preference for accumulation. Why is there so much demand from China?

An important factor seems to be the need to luPicate business relationships. Like Japan in the 1980s, drinking is an all-important component in developing business relationships. For some reason, this phenomenon is replicated during the economic development phase in places across the world. A little intoxication may be necessary for successful economic development. When one sinks a lot of money into an underdeveloped economy, it needs courage. When many do the same, it then becomes a self-fulfilling prophecy.

LuPicating relationships with government officials may play a more important role in China’s fine wine demand. In the East Asian investment and export-led development model, the government usually plays an important role. In China, this role is even more influential because of government ownership of most assets and deal-making that is often dependent on individual approval. When befriending government officials, private businessmen obviously pay for the best.

The business drinking culture has been changing in China. Like elsewhere, liquor consumption has been declining out of health concerns. Obviously, liquor is more effective at loosening people up and advancing business relationships. But, its deleterious effects on health have dampened consumption. When wine is not effective, the liquor is still needed. That is why China’s liquor consumption is declining but still at a high level.

The role of alcohol consumption in entertaining for business has produced a unique Chinese phenomenon – the massive demand for Chateau Lafite wine. Lafite is one of the five first growth wines in Bordeaux. France classified Bordeaux wines as first growth and unclassified them in 1855 for its World Expo. At the time, four chateaus: Lafite, Latour, Haut Pion and Margaux were classified as first growth. In 1975 Mouton also qualified. Chateaus in some of Bordeaux’s areas like Pomerol and St. Emilion didn’t participate in the classification. They have started their own classification system. Some of their wines are more expensive than the five first growth wines. Nevertheless, the first growth label travels well, especially to a new market like China.

Among the first growth wines, Lafite has taken a life of its own, rising much quicker than the fine wine market as a whole and other first growth wines in particular. For example, Lafite of 2000 vintage has appreciated by about 550 percent in pound sterling since 2005, compared to 180 percent for the market as a whole. The most comparable wine to Lafite is Latour. The latter’s price of the same vintage has risen roughly in line with the overall market. The price differentials between Lafite and other first growth wines from other vintages are not as dramatic as for the 2000 one but are still large. Something special has happened to Lafite in the past few years. That something is China.

China has been experiencing a Lafite phenomenon in the past five years. It has become almost the official Chinese wine for business entertainment. There have been many attempts to explain this. The most popular one is that the Chinese translation is easy to say and sounds nice. I am not sure this is the best explanation. Drinking for business entertainment in China isn’t the most sophisticated pastime. Providing expensive wine is really for its own sake, because it is simply the high price, and not the taste, that is meant to impress. When a wine becomes expensive, it can take on momentum of its own. The fact that Lafite sounds nice in Chinese gives it a negligible advantage.

Is the Lafite Phenomenon a bubble? As Greenspan says, one can never be sure until it bursts. It is possible that Chinese drinkers appreciate something in Lafite that other drinkers never did. Hence, as the Chinese become richer and spend more on wines, Lafite benefits from this source of demand more than others. So the Lafite phenomenon is price revaluation, not bubble.

An alternative scenario could be that other first growth wines would get the Lafite treatment overtime. The Chinese demand for Lafite is due to lack of wine knowledge. As Chinese drinkers become more sophisticated, the demand for other first growth wines will increase. This could be a rising tide that will gradually carry over to other fine wines.

The second scenario is possible. The Lafite sensation has something to do with the French system for wine production. The laws prevent the great wine chateaus in Bordeaux from increasing production. The most important restriction is that they cannot irrigate. The chateaus have to cut out half of the grape buds to improve the quality of the other half. Wine producers in Australia and the US use irrigation, and can produce four times as much wine from the same acreage of land. Bordeaux wine producers have to go for quality and high prices rather than quantity. Thus, when a new source of demand comes, the prices go up.

Indeed, the Lafite price is so high that it has led to a large fake industry. Some analysts estimate that 70 percent of China’s Lafite consumption is counterfeit. I personally experienced this on a few occasions. The people who served me fake Lafite didn’t know it, because at the very least, the prices seemed genuine. And the fakes were probably decent wines, possibly some good second growth poured into a Lafite bottle. They just weren’t the real thing. The forgers have targeted the legendary 1982 vintage in particular. Many rich Chinese have bought large stocks of 1982 Lafite. The odds are that these are all fakes. There are very few bottles of the vintage left. It is highly unlikely that one can get several cases of the real thing.

When the Chinese economy matures in ten or fifteen years, prices for Lafite may come under pressure, as entertaining for business changes. The final demand would come from personal enjoyment, making the wines more price sensitive. Japan has already gone through such a cycle.

While I am not sure that the Lafite phenomenon is a bubble, I am quite sure that Chateau Lafite’s second label, Carruades de Lafite or little Lafite in Chinese, is a bubble. The production of fine wine requires the vine age to average 30-40 years. Vines older than 80 years must be replaced. Hence, a chateau is always taking out old vines and planting young vines. But grapes from young vines cannot produce high quality wine. Great chateaus like Lafite and Latour use the grapes from young vines to produce second label wine to recover some costs. These second labels are usually quite cheap. They are usually much cheaper than second growth wines.

For example, Lafite’s second label, Carruades de Lafite, sold for about 200 Pitish pounds per case until five years ago. Since 2005, the price of Carruades de Lafite has increased roughly ten times. Its price sometimes rival the prices of non-Lafite first growth wines and is usually higher than great second growth wines. Little Lafite is not a bad table wine. But it is definitely not a grand wine. Its meteoric rise is really due to mistaken identity.

As Lafite’s price becomes a small fortune, the search for a substitute is a natural market response. In China, the substitute is little Lafite. The choice is way off the mark. If one shifts from Lafite to Latour, Haut Pion, or Margaux, it would be rational. Their qualities are similar. When Lafite’s price is so much higher than that of others, they should become the next choices. But, in Chinese, little Lafite has the connotation of Lafite’s junior Pother, probably similar but a bit less good. Hence, it becomes the substitute for Lafite. Moreover, as its price has risen, it seems to confirm its worth. At least the choice doesn’t look cheap to the host.

The magnitude of price distortion in the Carruades de Lafite is probably similar to that of internet stocks in 2000. Of course, over time, the bubble bursts. So why should we be upset about it? The problem is that it has become an insult to other great winemakers. I’m really ashamed of the enormous Chinese demand that has created this phenomenon. I personally witnessed Chinese tourists unloading cases of little Lafite at enormous prices in Bordeaux to ship back to China.

French wine chateaus maintain traditional methods for making wine. It is arduous, costly and often unrewarding. The top chateaus can afford a lot of labor and fine equipment to maintain quality and sustain high prices. Most chateaus in Bordeaux are not so lucky. They suffer through low prices and low quantities. I visited one unclassified chateau about two kilometers from Chateau Petrus, the maker of the most expensive wine in Bordeaux. Its wine is quite good. For some good vintages, it is comparable to the second labels of the first growth chateaus. But it sells for one fiftieth of what Carruades de Lafite does.

A market is efficient when consumers are informed and make rational choices. An efficient market motivates producers to improve quality and control cost. The virtuous cycle leads to great Pands that last. The French wine market is like that. I am afraid that Chinese demand is decreasing the market efficiency and may Ping down great Pands over time. When winemakers see the price a result of propaganda, not quality, they will focus on marketing and decreasing investment for improving quality. It would be a tragedy if Chinese demand, by Pinging easy money, Pings down a French legacy that has lasted for five centuries.

originally published at Caing.com