Anti-Trust Policy in China Needs Some Economics

There has been a lot of interest recently in whether Chinese authorities are unfairly using anti-trust regulation against foreign companies favoring domestic firms.  This is an interesting question but the data is to sparse to really know whether the authorities are using it to favor domestic companies.  What has been almost entirely neglected is whether the Chinese authorities have good economic arguments that foreign firms are monopolists in the Chinese market and if they are, whether they are abusing their dominant market position to extract economic rents.   Let’s try to examine the economic argument closely.

The absolute pre-requisite for an anti-trust case is that a company have either a dominant position in a market or be a part of a group which dominates a market.  Anti-trust law was originally designed to target companies with a monopoly position in a specific industry but has also been expanded to examine industries with high concentrations of firms.  This means that anti-trust cases should be where individual companies or a small collection of firms have a dominant market position.

However, in no instance could any foreign firm that has been charged with anti-trust violations be found to have a dominant market position.  Let’s take two recent examples.  In the summer of 2013, China issued fines against six baby formula manufacturers for price fixing while three other firms were charged but not fined.  Now before even analyzing the meat of the charges, it is important to emphasize that there are at least nine major manufacturers of baby milk powder.  That would meet any definition of a competitive market place as no individual firm has a dominant position and there is no charge or evidence that the firms were colluding to set prices.

The Chinese government instead charged them with “disrupting market order” and fixing their own prices, at a price which the Chinese government unilaterally deemed too high.  It is important however to note why foreign firms charge “…more than double…” domestic brands.  Put bluntly, Chinese do not trust domestic brands of milk powder due to numerous scandals and are willing to pay significantly more for foreign milk powder.   Standing in a customs line returning from Hong Kong into China, the Chinese return with armfuls of two products: luxury goods and milk powder which in a way are the same thing.  Foreign producers saw the increased demand and raised their prices to maximize profit.  It is worth emphasizing that no foreign firm had a dominant position in the baby powder milk market or even among foreign manufacturers.  Returning to economics 101, foreign producers enjoyed a surge in demand and prices increased.  That is very different than an anti-trust violation.

More recently Mercedes was charged with antitrust violation due to what Chinese authorities said was high prices for car parts and services for existing vehicles.  In other words, Mercedes was charging too much to repair its own cars at its own dealerships.  This specific case is a bit more complicated than the milk case because this case does not involve Mercedes dominance in the overall car market but in Mercedes dominance in the pricing of its own car parts.  Let’s examine the this case closer.

Mercedes has a dominant market position in the sales of its own products.  Mercedes sets the prices for the products it sells.  The question should not however be whether the price of a Mercedes car part is too high but whether Mercedes is engaging in anticompetitive behavior in the secondary market of car parts to extract higher prices.  In every car market, China included, consumers have the choice of purchasing replacement parts and services from the manufacturer of the car or going to other mechanics and purchasing non-dealer replacement parts.  The primary argument cited by Chinese authorities is that if you were to build a Mercedes from spare parts it would cost 12 times the cost of the Mercedes rather than 3 times in other markets.  This indicates that Mercedes is charging significantly more than other markets but says nothing about anti-trust or anti-competitive abuses.

The question then becomes whether Mercedes was trying to keep other companies from selling replacement parts for Mercedes.  With the exception of a small number of parts, most car parts have off-brand manufacturers that will make replacement parts for Mercedes cars.  These are not branded as Mercedes but they are acceptable as replacement parts.  Similar to the milk case, Mercedes is not even charged with trying to prevent third party manufacturers from selling replacement parts to Mercedes owners.  In other words, consumers are perfectly free to buy cheaper replacement parts for their Mercedes in a competitive market, place given concerns over quality, they prefer to purchase branded Mercedes replacement parts.

The baby powder milk formula and the replacement Mercedes car parts have two interesting and common threads.  First, Chinese consumers are highly skeptical of the quality of Chinese products.  No amount of Beijing led witch hunts on foreign companies is going to change that.  Chinese consumers paid more for foreign baby formula because the chances it is laced with melamine is much lower than its domestically purchased equivalent.  Chinese consumers willing to pay more for a branded product they trust is not anticompetitive behavior by the foreign firm selling them the product but rather charging a premium price for a premium product.  That is simply good business sense.  Second, these “anti-trust” cases are not about market dominance or anti-competitive behavior  by firms but rather selling a product at a price that Beijing does not approve.  Just because a product prices are different either between competing companies or between countries is no surprise to any economist.  Firms have a variety of pricing strategies and sell their goods for different prices to different customers at different places.  There is no evidence that any of these firms either enjoy a dominant market position or engage in anticompetitive behavior.

There are two final notes worth mentioning.  First, Microsoft has recently come under anti-trust scrutiny in China for its supposed dominant position in operating systems and office software programs and how this impacts pricing.  What is so puzzling is given that approximately 90% of Microsoft labeled software in China is pirated, how can Microsoft be assumed to have a dominant position?  It seems more reasonable to charge the pirates with anti-trust violations.  Second, this focus on the price of the good now armed with anti-trust regulation continues Beijing’s obsession with   demanding foreign firms lower their prices.  Previously CCTV, just as much an arm of the government as the anti-trust regulators, had targeted firms like Starbucks for the price of a cup of coffee.  Even though evidence indicates that Chinese Starbucks are not outside the normal pricing range, Beijing tried to make the cost of a latte an anti-foreign firm political issue.

Whether or not Beijing is deliberately targeting foreign firms and not domestic firms, is difficult to say given that lack comparison data.  However, it is easy to tell that these so called anti-trust violations are not based upon economics.

Between Apathy and Risk

I admire Roy Ngerng.  I admire Roy Ngerng not for what he said, though I generally agree with what he said.  I admire Roy Ngerng because he spoke out willing to accept the risks of speaking the truth.  Much of the time when I write about Singapore, I feel like a fraud because I am not generally in harms way when writing about the enormous financial discrepancies.  Roy Ngerng who faces much greater risk than I do has accepted that risk and calling.

Though I generally do not read comments on my work, I happened to browse through the comments section at TRemeritus.com a few months back and a reader asked me to write about specific issue that has haunted me ever since.  To paraphrase with my interpretation, what will rouse Singaporeans from their apathy in determining their course as free men and women with God given rights?

The English philosopher John Stuart Mill stated that “Bad men need nothing more to compass their ends, than that good men should look on and do nothing.”  People make calculations on the risks of speaking out and too often decide to remain silent, allowing bad men to compass their ends.  This attitude of cynicism and self interest permeates views about those who accept risks.  One Chinese youth was quoted as saying people don’t do things for ideals.  The world is a sad and lonely place when people do not hold ideals and the people that do are considered lunatics.

I do not believe it is my place to advise Singaporeans who to vote for or what specific policies you should implement.  However, I strongly believe you should demand transparency, openness, and accountability from any government of your choosing.  I strongly believe you have the right to criticize your government or any other government without fear of retribution.  I strongly believe Singapore and Asia need more men and women like Roy Ngerng who are willing to accept the risks of speaking truth regardless of consequence.

Too often we think of doing the right thing as earning reward and benefits when frequently the reality is the complete opposite.  Doing right may earn scorn, derision, and retribution.  During my five years in Asia, I have met many wonderful people and found them insightful and  thoughtful.  I have however found too many people unwilling to stand up for what they believe is right.  Consumers and citizens are more informed now than ever before and instead leadership creates fear and infantilizes them insisting “you wouldn’t understand.”

Roy Ngerng has met his fundraising objective of paying for the fine, but go further by attending the Return our CPF meeting at Hong Lim park on June 7th.  Maybe I will come as just an innocent bystander to observe the proceedings. There is nothing about CPF, Temasek, GIC, or Singaporean finances that I can say that will make people stand up and make their voice heard.  The bigger question is whether the good men and women of Singapore will stand by and do nothing.

Brief Specific Points on the CPF (as I have already written much on the topic):

1.  There is no interest rate guarantee.  As I have long noted, there is no guarantee because you cannot guarantee yourself.  The government guarantees CPF funds and Singaporean tax payers are the funders of the government.  The Singaporean tax payer is “guaranteeing” itself.  This is the equivalent of buying life insurance from yourself and promising to put the payment in a separate account so that based upon your expected death, there will be the same amount for your children.  If there are ever problems with CPF and Singapore government finances, guess who will be footing the bill for this guarantee?  Singapore taxpayers will be paying for their own guarantee.  If something goes wrong and you have to bail yourself out, that is not a guarantee.

2.  If the government via any means is legally mandating citizens provide it revenue: that is a tax.  The CPF is a significant form of wealth taxation on Singaporeans. In the MOF response, they state that they keep all funds above the “guaranteed” rate meaning they are imposing an implicit form of taxation.  A government simply cannot pass a law requiring citizens that confiscates money and not call it a tax.

3.  Please raise your hand if you would rather have the guaranteed CPF rate of 2.5% (a total weighted 3.67% based upon all CPF funds) or the unguaranteed GIC rate of return of 6.5% in USD terms?  What about the 16% of Temasek primarily holding historical Singaporean state owned firms?  Anyone? Anyone?

4.  As I have noted before, as a matter of prudence, I support raising the guaranteed requirement.  However, to achieve those ends it would be better to let Singaporeans share the benefits of the GIC and Temasek through any number of various proposals, rather than make it that much harder to meet the minimum standard.  Temasek is comprised primarily of historically state owned firms and GIC, by the governments own admission, is comprised of public investment capital.  The people of Singapore should share this bounty rather than being forced into indenbtured servitude.

The Real CPF Problem

The Singaporean government recently increased the minimum amount required for Central Provident Accounts which as caused concern among many people.  Given that I have written numerous times about CPF, I will only recap the highlights before moving on to my primary topic about CPF today.

First, the Central Provident Fund is vital to understand Singapore government finances.  The CPF pays 2.5-4% on funds from savers but then loans that money to the government who issue long term debt securities and unsurprisingly pays a nearly identical weighted amount on what it borrows.  The Singapore government then invests the money in different ways, and by all appearances, keeps whatever in excess of the 2.5-4% it earns.  The CPF is a central organization to understand Singapore public finances.

Second, despite Singapore government claims to the contrary, the CPF is imposing enormous implicit taxes or costs on Singaporean savers.  If the average Singaporean had earned the average Singaporean wage since 1980 and saved the amount required by law but earned the GIC long term average rather than CPF interest, the average Singaporean would have approximately $850,000 SGD in the bank.  This is approximately $300,000 more than they would have earned with the same amount of savings in a CPF account.  To put this number in perspective, Singaporeans pay higher fees than what the typical hedge fund would charge.  The Singaporean government is directly harming everyday Singaporeans by mandating savings into a seriously underperforming asset for the governments benefit.

Third, Singapore operates a one sided model where the tax payer assumes the risk but the government gets the benefit.  If the investments do well, the government keeps everything above the 2.5-4% CPF interest payment; if the investments do poorly, and let’s assume, the CPF collapses, the tax payer will guarantee the payment to CPF holders.  In other words, risks are socialized while benefits are privatized.

More important than the technical shortcomings of the CPF is how Singaporeans think of CPF, Temasek, and GIC.  Officially, the Singapore government holds more than $800 billion in financial assets.  Temasek holds more than $200 billion SGD and GIC is estimated to hold around $400 billion of that total $800 billion.  Despite official pleadings to the contrary, Temasek and GIC are not private companies they are owned by the government, controlled by the government, and key officials are appointed by the government.  Temasek was created out of privatizing government assets.  SingTel, the largest holding of Temasek, was created from the Singapore Telecoms and Post Office Ministry.  DBS was originally the state owned Development Bank of Singapore.  These were and still are public assets.  A similar story holds true for GIC and CPF.

The assets of Temasek, GIC, and the CPF are the assets of the people of Singapore.  Only in certain people’s imagination are Temasek and GIC assets private and separate from the people of Singapore.  The earnings in excess of 2.5-4% that the government keeps for itself that it does not return to CPF savers are directly harming Singaporeans who are on average $300,000 poorer.  GIC and Temasek assets that the government insists are private despite all evidence to the contrary demonstrate the governments disdain for the blessing of the financial bounty it has received from the Singaporean taxpayer.

Kenneth Jayaretnam has proposed privatizing and floating Temasek and GIC to then distribute shares to the public.  There are many variations of this basic idea.  For instance, CPF savers could earn some amount tied to GIC or Temasek or the social security system could be privatized like Chile with savers allowed to invest via private asset managers.  Though the government claims to seek an ownership society, the mechanism and returns of the CPF are much closer in reality to the United States social security system where the government uses contributions as a cheap pool of borrowing with extremely low rates paid for contributions.  In fact, the most recent US social security actuarial report says that low income earners receive a higher total real return than Singaporean CPF savers in nominal terms.  Giving people ownership of the assets Singaporeans created and linking their savings to the returns of those firm would create an actual ownership society.

As a matter of prudence, I support raising the CPF minimum to ensure income levels for the elderly in the future.  However, the easiest and fairest way to accomplish this objective is to pay CPF savers a fair return for the investments that they are funding.  The government should not be allowed to confiscate earnings above and beyond the rate it pays on CPF funds.  It is complete hypocrisy by the government to publicize the supposedly amazing job it does managing Temasek and GIC which supposedly earn 16% since inception from public assets and 7% in USD term over 20 years from public assets, then plead poverty when paying CPF holders a paltry 2.5%.  The wealth of Singapore which has been funded by the Singaporean people belongs to the Singaporean people.

An ownership society requires that owners of capital the CPF savers are compensated based upon market rates, have the ability to move their funds to higher earning investments, receive information about their investments, and how much they are paying their investment managers.  The Singaporean government refuses to provide any of this information hiding basic information that would be considered standard information in the marketplace or if owned.  Tragic stories of Singaporean unable to access their considerable savings they supposedly “own” demand government accountability.

The Singaporean people are the ones to demand answers and changes to how their money is managed.

Are Singaporeans Xenophobic?

Singapore has been beset by charges and counter-charges of xenophobic attitudes towards foreigners.  A major financial center, regional economic power, and playground for the super wealthy Singapore has carefully crafted its image as foreigner friendly with welcoming immigration policies.  The rapidly rising level of foreign born residents has prompted a variety of concerns by many Singaporeans with charges and counter-charges of xenophobic attitudes.

Immigration provokes strong feelings around the world for both rational and irrational reasons.  It is important however to put immigration, the benefits, and the costs in perspective.  The United States has the largest absolute number of immigrants in the world with 46 million but also one of the highest numbers as a percentage of the total population among large countries.  Only Canada and Australia have higher relative numbers with 21% and 28% of the population foreign born as compared to 14% in the United States.

Small countries generally have higher levels of foreign born population than larger countries.  This happens for a couple of reasons.  First, there are numerous prosperous but small countries like Monaco, the United Arab Emirates, and Singapore.  As people generally prefer to migrate somewhere prosperous, these countries are magnets for migration.  Second, given the law of large numbers, relatively small numbers of immigrants into a small country can have large relative impact.  For instance, Monaco has less than 25,000 immigrants, but that represents 65% of the total population.

It is important to compare the absolute and relative level of immigration before we examine the charges of xenophobia.  Singapore has the 22nd highest number of immigrants when ranked as a percentage of the population.  To put this number in perspective, this is roughly three times the number of immigrants as a percentage of the population in the United States and 420 times China.  Even in absolute numbers Singapore has lots of immigrants.  Singapore has more total immigrants than China, Brazil, and Indonesia combined.

This however does not answer the question of attitudes towards foreigners or whether Singaporeans are xenophobic.  Speaking only from personal experience, Singaporeans have been respectful, agree, and disagree with what I have said but rarely have I experienced anything I would classify as anti-foreigner.  Ironically, the emails and commenter’s who have told me not to poke my nose into Singaporean affairs, to speak generally, are those who defend PAP.  The most anti-foreigner emails and comments I have received come from those, generally speaking, accusing others most vociferously of xenophobia.  People who have listened respectfully and challenged me are criticizing the party in power and those generally on the receiving end of xenophobia charges.

However, this fails to address what people think about immigration and why they believe what they believe.  As an economist, I believe in the free market which includes the free movement of goods, capital, and labor to where they can be most productive.  However, I also recognize that for many reasons, there are practical reasons this is difficult or impractical in the real world.  Too often proponents of a specific policy, even economists, fail to recognize the trade offs.  For instance, immigration has generally overall positive benefits but also very real costs.

Taking the case of Singapore, given the constraints to housing and land, large population inflows are going to place significant pressure on housing prices.  Furthermore, while high skilled workers doctors, scientists, and economists are better suited to immigration pressures to the labor pool, middle and low skilled workers are going to face the greatest pressures.  Consequently, immigration is placing upwards price pressure on housing and downward pressures on wages for most people in Singapore.

Criticizing government policies on immigration is not xenophobic.  There are real benefits to immigration but also very real costs.  Criticizing government policies on immigration is not xenophobic as people are facing very real pressures from the decisions.  Criticizing opponents of government immigration policies as xenophobic and bigoted reveals the weakness of the argument and inability to weigh the complexity of policy dilemmas involved.

Are Singaporeans xenophobic?  If they are, I certainly haven’t experienced it and the anti-foreigner rhetoric that has been directed at me as come from those criticizing others as xenophobic and as a substitute to refute my ideas.  No, Singaporeans aren’t xenophobic, they just want honest debate about government policies.

Subsidizing Profits, SMRT, and Temasek

In 2008 during the global financial crisis, United States politicians debated whether bailing out failing banks would set the precedent of ‘privatizing profits and socializing losses’.  Economists call this problem “moral hazard” when companies are not forced to recognize their risks and consequently accept higher risks knowing a third party will absorb their losses.  While the debate rages about whether major US and international banks privatized the profits and socialized the losses, this is standard practice with many Singaporean and specifically Temasek owned companies.

SMRT is probably the best example of this practice within Singapore.  As I have noted elsewhere,   SMRT and other Temasek firms enjoy tremendous privileges that other foreign or even other Singapore firms simply do not enjoy.  For many year, the Singaporean government has paid for the capital that that SMRT uses everyday.  The tunnels, the rail lines, the subway cars, and buses that SMRT uses everyday have been purchased by the Singaporean tax payer.

The financial effect is simple.  SMRT as a publicly listed company and a portfolio company owned by Temasek makes money only because of the generosity of the government and the Singapore tax payer.  Despite having recently declared a $62 million SGD net profit for the year, SMRT depends heavily on the gifts of the Singapore tax payer through gifted buses and other infrastructure.  If SMRT had to make principal and interest payments on the buses alone, it would require yearly payments of $150 million SGD.  The financial effect is this: SMRT profit is entirely attributable to subsidies given to it by the Singaporean tax payer and not high quality management at Temasek.  Put another way, Temasek and its senior executive are only able to declare a profit for SMRT because the Singapore government gives it money.

There are three more philosophical reasons this matter.  First, most people appreciate and respect the success of other when gained through skill, talent, and hard work but resent unfairly gained benefits.  This is why few people complain about companies like Apple or Google, they make a good product and compete with others.  SMRT has not achieved its profitability due to providing a top quality product against fair competition, but through political manipulation and public bailouts.

Second, SMRT is socializing the risk and privatizing the profits.  When losses are incurred it is the Singapore tax payer that suffers but when profits received, it is the executive of Temasek that enjoys the benefit.  SMRT is placing the risk on the tax payer but capturing the benefit for itself.  While individuals or firms taking individual or corporate risk should be allowed to keep those profits private or socialize risk and profits, it is truly objectionable to socialize the risk but privatize the profits.

Third, the true financial and economic cost of SMRT and related infrastructure is not being recognized.  As one economist noted, if something cannot go on forever it will stop.  Singapore, SMRT, and Temasek cannot maintain a loss making firm dependent on regular bail outs to report profits or eventually it will stop.  By hiding the true cost of ownership, maintenance, and investment, the government is attempting to protect its Temasek owned asset rather than the tax payer.

Mass and public transport is a notoriously difficult and generally loss making industry.  It is however, morally reprehensible to pretend that a company is making money and use tax payer money to create  profits for the investments of family members.  The people of Singapore are being defrauded by bearing the risk of investment but seeing none of the profits.

Note: This piece was prompted by a post in the TREmeritus.com last week asking whether SMRT was a public or private company.

Interesting Chinese News

Chinese real estate buyers overseas are quite savy bu the 73% vacancy rate in one Chinese city should worry even the biggest cheerleader.

Can China tap its reserves if it meets financial problems?  This guy says it is much more problematic than people realize and I agree.

An official bank stress test says that the large banks would only see their bank capital remain above 10% if bad loans surged five fold.  Count me as skeptical especially given what we know about how Chinese banks count bad loans and arbitrage risk weightings.

Chinese provincial GDP is falling rapidly.  Is this due to better counting (i.e. they have stopped making up their GDP numbers improved data collection standards) or is GDP really falling faster?

The Chinese government needs never ending real estate and land price increases for more reasons than one.

 

When a Bad Loan Isn’t Really a Bad Loan

I recently finished a report on Chinese banks and one of the most surprising discoveries are how Chinese banks think about bad loans and data.  In most of the world, definitely those with large financial markets, the definition of a non-performing loan is taken for granted.

What is probably the most surprising revelation in recent IPO prospectuses is just how honest Chinese banks are being in admitting that their definition of a non-performing loan differs significantly from international standards.  Huishang Bank in their prospectus states that a major regulatory risk is that “our loan classification and provisioning policies may be different in certain respects from those applicable to banks in certain other countries or regions.”  The Bank of Chongqing says nearly the same thing noting that “our loan classification and impairment loss provisioning policies may be different in certain respects from those applicable to other commercial banks and banks in certain other jurisdictions.”   Harbin Bank take this warning one step further writing in their recent IPO prospectus “…profits of our Bank may decrease significantly, and our business financial condition, results of operations and prospects could be materially (emphasis added) and adversely affected…” due to non-standard non-performing loan definitions.  In short, Chinese banks are telling you that their non-performing loan classifications are not standard or accepted outside of China.

Chinese banks go to great lengths to avoid classifying a loan as non-performing with very different standards.  A 2012 NBER paper led by Franklin Allen from the Wharton School noted that “…the classification of NPLs has been problematic in China.  The Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step has not typically been taken until the principal payment is delayed beyond the loan maturity date or an extended due date, and in many cases, until the borrower has declared bankruptcy and/or gone through liquidation.”

Amazingly, Chinese banks not only admit their loan classification standards leave something to be desired but give specific examples.  Let me give you a couple of especially egregious examples.  Harbin Bank classifies a loan as doubtful if after a loan restructuring still cannot pay back the loan.  Bank of Chongqing classifies a loan as substandard if a building project has had no activity for at least one year and doubtful if the business has not been operational for at least 6 months.  Huishang classifies a loan as substandard, with at least a 40% loss, if the borrower is unable to obtain new funding to service their debt obligations. To summarize Chinese loans are classified as non-performing if after restructuring a firm still can’t pay, you have been out of business for at least six months, and your situation is so dire you can’t find another lender to roll over your loans.

Chinese banks however are not just defining away the problem of NPLs does arise they play accounting merry-go-round to make them disappear.  The Wall Street Journal recently wrote about a plan by large Chinese banks with investment banking arms to sell bad loans to the investment banking arm, taking the troubled off the traditional banks books, and then let the IB arm try to turn it around.  The bank does not have to report the NPL, even with incredibly loose definitions, and gets a higher than market price for the loan.  The investment bank get deal flow to boost numbers.  This however, continues to push the risk further down the road and continue the build up.

There are three final points.  First, banks appear to structure products to avoid NPL classification.  When lending for advances, the first payment will not be due for an extended period of time allowing the very real possibility for very real delays.  How long exactly?  To use a recent example, when Shanxi Zhenfu Energy roiled global financial markets with the possibility of a default on a product created by China Credit Trust, this overlooked a key fact.  Shanxi Zhenfu Energy had been bankrupt for nearly a year when the technical default occurred due to the fact that the original loan was made in the second half of 2010 but the first payment was not due until February 1, 2014.  This means that much of the debt incurred during the worst excesses of the credit expansion may not even require repayment yet, further masking loan quality.

Second, amusingly, for me anyway who has written about GDP and inflation irregularities, a major risk identified by Huishang is that “we cannot assure you of the accuracy of facts, forecasts, and statistics derived from official government publications contained in this prospectus with respect to China, its economy, or its banking industry.”  In other words, Chinese banks don’t believe official statistics.

Third, this is the reason the Chinese market and international analysts are so worried about finances in China.  For quite some time, Chinese banks stocks have hovered around P/E between 4 and 5 because the market doesn’t believe the NPL data. Banks with secondary offerings have been accepting large discounts with IPO’s cheaply priced to traditional models and falling post-IPO due to the large doubts about the accuracy of NPL data.

There are enormous financial risks and one of the largest is the lack of reliable data as described by Chinese banks about their own finances and the overall Chinese economy.

Note: This is the first post in a series of posts about the Chinese banking industry based on my paper.

Speaking on Chinese Banks

Last week I had the privilege to speak at the China International Banking Conference(in Chinese) organized by Asian Banker.  Though they did not know it when they invited me to speak, I had just finished a report on the Chinese banking system focusing on some of the unique risks.

The presentation I gave to the largely Chinese crowd is here.  While I believe there are significant risks that have not been addressed, I also try to moderate those who write like the building is on fire and everyone should leap from the building.  I will write later this week about the specifics of what I found but needless to say, there are significant risks in the Chinese banking system that simply are not being addressed.

When I spoke, a senior Chinese banker took some offense to my characterization of the risk build up in the system and what the data indicates.  After giving my data based talk with lots of information culled from IPO prospectuses and annual reports, you could sense the tension in the room.  A Chinese economist from a Chinese bank proceeded to talk and agree with many of the issues I had raised.  The tension deflating impact of these comments was palpable.

Potentially the most concerning issue to me is not the specific risks within the Chinese banking system but the current psychology of risk in China today.  China has enjoyed rapid and sustained economic growth for so long that most people seem to have forgotten the idea of risk.  If there was ever a seemingly text book case of This Time is Different psychology, modern day China is it.  The Chinese banking official who took exception to my comments about risk did not even wait for my data from Chinese sources or citations of annual reports and IPO prospectuses, but complained about my lack of understanding of Chinese culture and how this time is different.

Maybe this time will be different, but risk continues to exist and will catch up with you one way or another.

Note: I will be writing specifically about my Chinese banking report later this week covering some of the highlights in a couple of different posts.

China News

Seems like everyone is watching real estate in China.  A glut of real estate that it outpacing urbanization and real estate firm debt equal to 55% of GDP is stressing the system.  Even developers that advertise their apartments only get down to -22 C, are having a tough time selling apartments.  However, it isn’t just individuals but also business and specifically trusts that are getting cold feet about Chinese real estate.  Developers raised 49% less through trust products than in previous quarter.

Credit is even dropping for other sectors and ones that need it.  With shipbuilding facing enormous over capacity and buyers not waiting to reject ships, banks are facing the risk of losing twice on a loan: first to the shipbuilder and the second to the buyer if they reject the ship if it is late or defective.  This is causing banks to rein in credit growth to ship yards putting even more pressure on the system.

Wal-Mart is pushing back against Chinese government harassment.  They say that manufacturers that fraudulently label products they sell should be held responsible.  Did you notice Beijing has only gone after foreign firms?

Capital Use and Measuring GDP in China

A more arcane but incredibly important area of economics, that gets overlooked, is how to measure GDP.  The classical example goes like this.  Assume you have two guys who live in a country and each guy has $100.  The first offers to pay the second guy $100 to dig a hole.  The second guy tired from digging the hole, offer the first guy $100 to fill the hole back up.  According to economic accounting, this accounts for $200 of GDP even if nothing was actually accomplished.

Theoretically, GDP growth of this nature can continue infinitely.  However, in reality, this type of GDP growth results ultimately in significant losses, though it can continue for some time before it collapses.

The reason I mention this relatively arcane discussion about how to calculate GDP is that this problem is incredibly relevant to understand the potential difficulties facing China.  Let me emphasize that I do not have a good answer and the data on more esoteric  or politically sensitive issues is even worse than the baseline numbers.

In the past week there have two pieces in Quartz about the poor quality of older Chinese housing that is now collapsing and another on whether China actually has a housing bubble because so much of the housing stock is being turned over.  While it is perfectly reasonable to ask what impact China’s existing housing stock has on promoting or preventing a bubble, this overlooks two much more fundamental and important issues.

First, how efficiently is capital being allocated in China?  Analysis of Chinese finances and a potential bubble typically focuses on a housing bubble or over capacity in specific industries like steel or solar.  However, there is evidence that there is wide spread misallocation of capital throughout the Chinese economy and that the capital is poorly utilized.  Houses are being built, torn down, and rebuilt and GDP goes up but the quality of that GDP, similar to the example of holes, is in real doubt.

Second, if capital is being poorly allocated, for instance in the case of substandard housing that is destroyed relatively soon after being built, what does that say about historical GDP and capital accumulation?  Put another way, if capital is being consumed or is idle rather than deployed into productive purposes, this has the net effect of raising past GDP while depressing current or future GDP.

Let me build on the simple example from earlier about two guys digging and filling in holes.  Now let’s assume the first guy builds a house and sells it to the second guy who takes out a 30 year mortgage to pay for it.  Then after 10 years the house starts falling apart and guy #2 has to move and buy a new house.  There will be a large capital loss by the owner, a developer to purchase the house at market rate to build a new house, or an insurance company.

Consider a second scenario where the house is fine but after 15 years a developer or the city want to tear it down to build bigger, nicer, and newer houses, a very common phenomenon in China.  The developer will have to purchase at near market rate the old house in order to build a new one.  This capital cost will then be passed on to the new purchaser.

This poor allocation or destruction of capital is not limited to real estate but carries over into all other industries.  Over capacity in solar and steel where $500 billion in debt gets you $300 million USD in profits, are the obvious culprits, but under utilization of capital is rampant in China.  According to S&P data, Sinopec and PetroChina pay less than what many governments pay on their debt but also earn an incredibly low rate of return on capital and half of what ExxonMobil earns.  Put another way, in the most capital intensive industry on the planet, Sinopec and PetroChina earn a rate of return on capital that would barely break even for most competitors.

Chinese companies are coming up with ever new and creative ways to hide these capital losses.  The Wall Street Journal is reporting that Chinese banks have devised a plan to sell bad loans to their investment banking arms to try and restructure them.  The bank does not have to report a non-performing loan and receives a higher price for the soured loan than it would on the open market allowing the bank to mask the true picture.

Having lived in China, I can personally attest to the amazing misuse of capital.  Whether it is buildings being torn down ten years after being built or looking out my window and seeing half empty office buildings.  Unfortunately, measuring the “misallocation” of capital is an incredibly hard thing to do

Capital ultimately represents a cash flow, whether that is a machine that makes things or an apartment that someone lives in.  Imagine the losses incurred when you learn that more than 70% of Chinese airports are operating at a loss.  China Railway Corporation announced plans to put together a private investment fund after corruption scandals and losses forced it to give up its status as the Railway Ministry.  The losses it currently sits on are enormous and there is valid concern over its ability to profitably exist without government handouts.  The capital has to receive a stream of cash to pay for the investment or revalue the investment and the cost of the product.

Despite the pictures of gleaming skylines, brand new airports, and bullet trains the cash flows are struggling to pay for the capital used.  Whether through banks, surplus capacity, or a revaluation of the asset and the product, at some point this is going to result in significant losses.