Peter T Treadway, PhD
Historical Analytics LLC
305 761 4718

January 29, 2011

“We do not believe in Chinese exceptionalism. China’s economy is no different from any other, in spite of the inevitable Chinese characteristics. If there are such things as economic laws, they work just as well in China and for Chinese businesses as they do in other markets.”

From Red Capitalism, The Fragile Financial Foundation of China’s Extraordinary Rise, p ix


“What Chinese parents understand is that nothing is fun until you’re good at it. To get good at anything you have to work.”

From “Why Chinese Mothers Are Superior” by Amy Chua, Wall Street Journal, January 8, 2011

In the long run the laws of economics apply everywhere and there is no escaping the dismal science’s somber logic. But our knowledge about economic laws is incomplete. Economics – believe it or not – is really about people and the decisions they make about work and money. What traditional economic models don’t factor in – perhaps because it can’t be quantified and it’s politically incorrect in academic circles to even talk about it – is the character of a people.

From the viewpoint of a free market economist China is following the wrong economic model. Of course anything would be better than the1949-1978 Chinese “model” of continuing chaos and suppression of private enterprise. But today China is following its own version of the mercantilist East Asian model, which involves predominantly state rather than market-directed investment, over-reliance on exports (largely at the expense of the United States), undervalued exchange rates and excess reliance on investment vs. consumption. The model is deeply flawed and unless modified sooner or later will reach a dead-end as Japan has discovered. But “sooner or later” is not a useful concept for investors for whom timing is everything.

As I have previously argued, East Asia is populated by disciplined, hard working, well educated people obsessed with material improvement and conditioned by the obedience/work-oriented Confucian ethic. This type of people can take even a flawed economic model a long way. Read Amy Chua whose Wall Street Journal article about Chinese tough love and “tiger mothers” has caused an international uproar. Chinese mothers program their children to work and achieve. The bottom line for economic forecasters: from an economic perspective all those tiger mothers turn out hard-working model citizens.

Flawed economic model or not, China actually has three factors going for it. One, its disciplined hard-working population. Two, its almost automatic snap-back from the disasters of the Cultural Revolution and the Great Leap Forward. Third, the massive migration from the countryside. The China bears will argue that points two and three by now have run their course and that hard work with the wrong model only goes so far.

Confucian-influenced post-war Japan was the world’s number one wonder-economy from1945-1990. By 1990 the entire world had concluded with awe (and incorrectly) that there was something exceptional and superhuman about the Japanese. By the late 1980s the warning signs were all there for those who ignored the consensus—the declining birthrate, the bubbles in real estate and stocks, the endless supply side knots in which the Japanese domestic economy is tied. The trouble is the naysayers who shorted Japan in the eighties lost their shirts. Timing is everything.

Now of course Japan has hit a wall and is politically unable to extricate itself from its own East Asian box. Hopefully the Chinese leadership will not fall into this same trap. They have seen the Japanese future of the East Asian model. It doesn’t work.

The Chinese Financial System Is Different

Understanding Chinese banks is key to understanding how capital allocation in China deviates from the free market model. And how China’s return on capital could decline over time requiring ever higher investment rates to maintain high rates of growth.

Western banks at least in theory have as their goal the maximization of profits. (Their massive failure to do so in 2008 is a separate subject) Loans and investments are made at the banks’ discretion with that objective in mind. But as Carl E Walter and Fraser J.T. Howe assert in their must-read book Red Capitalism quoted above, “It is the (Communist) Party, and not the market that runs China and its capital-allocation process.” (p78) And, much more so than in the West, it is the banks that are at the core of the Chinese capital-allocation process.

The shares of the major Chinese commercial banks trade in Hong Kong. As a former Wall Street bank analyst and as someone who has taught graduate level courses in equity valuation, I am chagrined to say that I’m really clueless when it comes to valuing Chinese bank stocks.

At the risk of simplifying too much, the Chinese banking model may be described as follows: All the major Chinese banks including the so-called big four commercial banks are majority state-owned or in the case of the three policy banks totally state-owned. At government direction, these banks loan the bulk of their funds to state majority-owned enterprises (SOEs) and local government entities. The SOEs and local entities borrow with some degree of subsidy. Thus the government owned and controlled banks raise deposits from the public at negative real rates and lend at subsidized rates to a variety of central and local government-owned and controlled entities. Sometimes these borrowers pay the banks back, sometimes they don’t. Capital generally goes to State (Party) approved uses and not necessarily on the basis of risk and expected return. That’s where the Chinese model differs from the free market model. China’s real private sector is largely excluded from this process and has to go to Hong Kong and New York to raise capital. Died-in-the-wool free market devotee that I am, I see serious potential for the misallocation of capital in the Chinese system.

Because of China’s need to grow and invest at the high rates of recent years and because of repeated problems with nonperforming loans, the Chinese banks every so often need total recapitalization. This has been accomplished at various times by major capital raises in the Shanghai and Hong Kong stock markets, dipping into China’s foreign exchange reserves, offloading bad loans at par into so-called Asset Management Companies (AMCs) and then recycling them back on to bank balance sheets and a whole host of related transactions that could be classified as financial legerdemain.

Anyone buying the stock of one of the major State-controlled Chinese banks must do so with the expectation that within a few years the bank will require bailing out by the government and that this bailout will be forthcoming. The dramatic expansion of bank loans over the last two years virtually ensures major nonperforming loan problems down the road. How our buyer comes up with a valuation for a bank’s stock under these circumstances to me is a mystery.

It’s easy to see how all this fits into the East Asian economic model. State-favored (in the Chinese case Party-favored) SOEs and local government entities receive subsidized capital from the banks much of which tends to go to real estate, capital and commodity devouring heavy industries and commercially unproven capital projects like the new high speed rail system. When the government wants to juice the economy, the banks turn on the lending. The SOEs are protected against foreign competition by tariff and non-tariff barriers. Incidentally, according to Walter and Howie, despite China’s signing on to the WTO, foreign banks account for only two percent of Chinese bank assets. No competitive threat there.

Most free market economists would argue that the Chinese system is a blueprint for the misallocation and waste of capital, a declining productivity of capital and real estate and commodity bubbles. But when will the chickens come home to roost? Nobody knows. Thanks to all those tiger mothers, the Confucian work ethic and China’s real and efficient private sector, China could turn in good GDP numbers a lot longer than it might if the same system were tried in the undisciplined West.

One further note: Japan might have been luckier than China. The Japanese export machine was in full throttle over 1945-1990 and the US was there to take Japanese exports. Today exporting to the US is no longer the growth strategy it used to be. The Chinese leadership may have to make some decisions soon especially if indeed the bulk of the rural to urban migration is pretty well over for China and as China ages in the coming years.

Print Money and You Get Inflation

That’s one economic law that even tiger mothers can’t overcome. Over 2009-2010 China has been printing money and increasing bank loans at an excessively rapid rate. I, along with many others, have been predicting inflation would pick up in China and now it’s here. Agricultural problems related to weather are a factor and perhaps in the future economists will include “weather instability” as a regular feature of their economic analysis. But I believe the current inflation in China is primarily a monetary phenomenon. I have outlined the mechanism in The Dismal Optimist many times. In order to maintain China’s undervalued exchange rate against the dollar, the Peoples Bank of China (PBOC) buys dollars with renminbi. The dollars are added to China’s giant pile of foreign reserves and most likely invested in US Treasuries. The renminbi thus created winds up in Chinese banks as high powered reserve money. Adding to this, the government over the last two years has directed the banks to fund the four trillion yuan Chinese stimulus program. M2 has grown in China by 27.7% and 19.7% for 2009 and 2010 respectively. Bank loans have grown by 33.0% and 19.4 %( November) for the same periods.

The stated rate of inflation in China as of December 2010 was 4.6% on a year over year basis. But most observers think that number significantly understates the real rate of inflation. House prices for one thing are up some multiples of that. There is genuine anger in China over the increases in consumer prices. The PBOC has slowly been increasing interest rates on bank deposits and increasing bank reserve requirements in response to this. The administrative measures and price controls that are being slapped on various sectors indicate the problem is worse than the CPI numbers suggest. These measures, which would bring howls of criticism from economists were they to be applied in the United States, are another indication that markets are still not trusted in China.

It’s pretty clear in hindsight that the Chinese stock market was looking ahead to all this in 2010. The Shanghai A Index turned in a -12.9 % return in 2010 making it one of the world’s worst performers. A pathetic performance for the world’s new number one wonder-economy. The underperformance may continue for a while.


Dr. Peter T Treadway is an independent consultant and money manager and Adjunct Professor in Asia. He is currently is principal of Historical Analytics, a consulting and investment management. He pens a monthly letter (The Dismal Optimist) for clients. He is also Chief Economist for C T RISKS, a new Hong Kong company that will assist Asian financial institutions with their risk management problems.

Dr. Treadway previously served as Chief Economist at Fannie Mae (1978-81), and prior to that, was an institutional equity analyst at Smith Barney (1985-98). He was ranked as “all star” analyst eleven times by Institutional Investor Magazine. Dr. Treadway also worked at The Board of Governors of the Federal Reserve. He holds a PhD in economics from the University of North Carolina at Chapel Hill, an MBA from New York University and a BA in English from Fordham University in New York.

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