Some Thoughts on the Shanghai Free Trade Zone

The latest hot topic in Chinese economic reform that people are seizing on a saving the hallowed 7.5% growth rate is the Shanghai Free Trade Zone (FTZ).  It has been called a “game changer”.  Like many of the so called recent reforms, the Shanghai FTZ is little more than a retread of previous experiments that have not fared so well and ignore the primary problems.

The direct and near term economic impact is likely to be minimal, especially for the overall Chinese economy.  The Shanghai area and surrounding counties are not large enough to impact the Chinese economy as a whole and as Shanghai is already one of the wealthiest areas in China, its marginal impact (i.e. above beyond the already significant benefits Shanghai has) are not likely to be large, especially in the short to medium term.

There are three additional reasons to believe the impact will be minimal.  First, the size of the free trade zone is minimal at only 29 sq kms  out of a Chinese landmass of 9.8 million square kms.  To put that size in perspective, it is less than one-fifth the size of Washington DC and one-third the size of Manhattan.  The Shanghai FTZ is too small to matter.  Second, other FTZ have been tried here in Shenzhen, with little impact.  Third, Shanghai was one of only two provinces in China to report GDP growth less than the national average.  If this is the “game changer” China is hoping for, it might not be the type of game changer Beijing is hoping for.

With that said, the indirect impact and what this may signal have the potential to be enormous.  There are three specific points here.  First, Beijing has a long term strategy to reduce the influence and dependence of China on Hong Kong for finance and shipping specifically.  This is another example of Beijing trying to reduce the influence of Hong Kong while increasing the profile and influence of Shanghai.

Second, Beijing is hoping to foster higher value added industries around Shanghai and move a higher amount of trade through Shanghai rather than the lower value added manufacturing and assembly that currently dominates the Pearl River Delta around Hong Kong.  If the long term result is to foster greater creativity, entrepreneurship, and higher value added industries that are less reliant on fixed asset investment and low value added manufacturing, then the Shanghai Free trade Zone will be a success.  Call me skeptical, but I doubt that a small FTZ will accomplish that and if it does it will take a long time to bear fruit.

Third, the Shanghai free trade zone is a classic example of a Beijing experiment to see if they want to expand similar policies throughout the country.  Though details about what exactly the FTZ in Shanghai will mean, rumor and news reports appear to indicate it will be quite bold.  As an example, Facebook and Twitter will be allowed as will easier RMB trading, which for China are all enormous shifts if true.  Given the uncertainty about future economic policy and reforms, if this becomes the foundation for future policy it would be quite a signal.  So far, the recent stabilization of the Chinese economy has depended on SOE’s and fixed asset investment, rather than economic reform that will promote consumption which is not encouraging.  However, if the Shanghai FTZ takes hold shifts a new direction in policy, it could herald quite positive things.

What is more difficult to ascertain is where this hastily announced FTZ fits within a long term policy plan or the more recent economic downturn.  While there is a long term strategy to emphasize Shanghai at the expense of Hong Kong, this has the appearance of a hastily created plan.  Given the size and haste, it is unlikely the Shanghai FTZ will have an impact on the current economic problems but will provide a good PR boost for those clinging to the reform led turnaround story.  If I was to speculate, I would guess it was a plan probably floating in the background that received extra focus given economic struggles.

The primary impact of the FTZ will be if this is a test policy for nationwide changes and reforms of economic policy.  If it is strictly limited to Shanghai and not even extended to surrounding provinces or the country, its impact could be quite minimal.  If this is used as a test or ground work for greater nationwide reforms, it’s impact could be quite significant.  The Chinese government is feeling a lot of discontent within China and this is a way for them to test different policies.  As a Chinese commenter noted once, why are we, North Korea, and Iran the only countries without Facebook.  Nor is it any secret that economic freedom in China is about the same level of Facebook access.  If these reforms take hold in Shanghai and spread, it could be enormous.  I’m not holding my breath though.

Conversations Considering Whether China is Doing Well

In the past week or two, I have been able to talk with a variety of people who are well positioned to provide well informed thoughts on the Chinese economy.  The common consensus appears to be that while the economy isn’t collapsing, it is none the less quite weak.

Despite Chinese Premier Li Keqiang and GoldmanSachs both touting the Chinese growth story, the story from business sounds much weaker on the ground and after considering what is driving the turn around.

In conversations with the Chairman of a listed Chinese firm who though confident in his businesses prospects, said middle single digit growth was expected this year with other firms in his region who did not have a unique technology like he did faring much worse.  He specifically singled out lower value manufacturing as getting decimated.

Another senior executive for a major technology multi-national with mostly Chinese clients gave guidance also in the mid to low single digit revenue growth range.  He relayed that in his interactions with outside firms, such as clients and suppliers, this seemed to be a pretty common refrain.

While the Chinese economy and finances may not be on the verge of imminent collapse and even rebounding somewhat, the mid-range prospects over the next 6 months remain worrisome with longer range risks even higher.

Infrastructure investment is growing at 30% annually with steel production expanding at close to 20%.  This is as usual being driven by large growth in credit.  While formal bank loan volume continues to decline, the expansion of credit continues unabated at more than 20% year over year.  As the Financial Times citing Capital Economics note, “the omens for the short term are good, but at the cost of making the economy’s structural problems worse.”

Chinese banks however are in no position to expand lending and are probably driving the expansion in off balance sheet credit.  They are lining up to tap international credit markets, though it has yet to be seen if international investors in Hong Kong have the risk appetite.  Given that Chinese banks listed in Hong Kong face a $50 billion USD capital short fall, hedge funds buying at a discount might be the only buyers willing to buy a Chinese loan portfolio in the current environment.

Even JP Morgan in a recent research report said their long term outlook on Chinese banks is negative given questionable asset quality and their projection of growth falling under 7%.  With some banks having near 50% of their wealth management products in non-standard credit assets, the potential for enormous levels of unrecognized risks on balance sheet remains high.

Despite all the talk of reforms, rebalancing, and the rise of the Chinese consumer, nothing has changed.  Chinese growth numbers are being driven by credit growth, fixed asset investment, avoiding any real change. China has managed to keep the growth numbers up, but that doesn’t make the mid to longer term outlook any better.

The Real CPF Scam

Let me pose a not-so-hypothetical.  I am an investment manager and you have money for retirement savings you want to invest.  Like any informed consumer you ask me how much I will charge you to be the investment manager.  I reply, if you invest your money with me, I will keep most of the money you make and if I lose money, well you lose.  Would you invest your hard earned money with anyone who gave you that sales pitch?

If this one-sided deal sounds too absurd to believe then look no further than Temasek Holdings and GIC.  While there are valid unanswered questions about the returns of Temasek which have been written about in great detail, all Temasek money belongs to the citizens of Singapore not the government, executives, or other special parties.

Public surpluses and CPF capital saved by the citizens of Singapore is used to fund Temasek and GIC.  Yet, the government of Singapore only pays savers 2.5-4% despite claims of earning 7 and 17% respectively between GIC and Temasek.  That claimed 7%  earned by GIC in USD belongs to CPF savers and the people of Singapore.  The claimed 17% earned by Temasek in SGD belongs to the people of Singapore who provided the public surpluses and capital investment to build companies.

CPF contributions are borrowed to finance investment.  The CPF saver receives a guaranteed 2.5-4% while the borrowing party, GIC or Temasek receive all returns in excess of 2.5-4%.  The government via GIC and Temasek is confiscating returns that belong to CPF savers and taxpayers.

This is not an insignificant amount of money that the government of Singapore via CPF contributions is confiscating for its own use.  As I estimated here, an average Singaporean earning an average wage with CPF contributions and CPF interest would have approximately $537,000 at the end of their working career.  However, if we took those contributions and they earned GIC interest, they would now have $799,000.  If they earned the Temasek rate of return the average Singaporean would have $4 million SGD in the bank after a career of hard work.

That means that if the average Singaporean was not confined to earning below market returns in CPF savings, they would be $300,000-3,500,000 richer!  Put another way, the Singaporean government is keeping all money in excess of the 2.5-4% CPF return from your savings.  Put yet another way, this is an implicit wealth tax on the average Singaporean worker amounting to $7,500 annually or more than 10% of per capita GDP.

The most important point is this: CPF is your money and investment returns are the investment returns of hard working Singaporean savers.  The investment returns from CPF capital and public surpluses do not belong to the government, the PAP, Temasek, or GIC but to the Singaporean people.

CPF, GIC, and Temasek returns are not the governments money.  They belong to the savers and tax payers of Singapore who have made it a great country.  Remember: this is your money.

The Chinese Economic Public Relations Machine

The markets are overjoyed because Goldman Sachs and the Chinese Premier Li Keqiang have pronounced the Chinese economy sound based upon improved GDP data.  Let’s ignore that Premier Keqiang has been quoted as saying GDP is a man made invention in China and just focus on how fraudulent we know Chinese GDP to be.  Not surprisingly, official manufacturing data remains decidedly stronger than unofficial reports.

What should be concerning is how weak the Chinese corporate sector is.  Not only is it the operating losses in airlines, debt in steel companies 1,300 times larger than profits, and the financial shenanigans I have already covered but the total weakness of the corporate sector.  Baiju growth is 3% underperforming a consensus 10% expectation.  Additionally, all this optimism also ignores the build up in copper inventories because of the lack of demand.   What makes the excess capacity so much more interesting is that previous demand growth was driven not by consumption demand for say construction, but rather by arbitrage opportunities.

Scratching beneath the surface in banks and real estate reveals nothing but problems.  Despite the pronouncements by Goldman Sachs, even official Chinese outlets are increasing their reporting on the concern over bad loan growth.  The Shenzhen Daily pulled no punches writing “Chinese bank executives signaled concern that bad loans could rise, as earnings continued to slow in the face of declining economic growth.”  Want more evidence of financial weakness?  All of a sudden, banks are racing through regulatory hurdles to approve secondary equity offerings to shore up their capital base.  However, as no secondary offerings have actually taken place, it will be quite telling the future of the Chinese economy what will happen when investors are asked to put money in.

How overheated are housing prices?  According to unofficial data from a real estate company surveying 100 major cities in China, the average per square foot price is $159.  To put that in perspective, only Baltimore, New York City, Los Angeles, and San Francisco had higher per square foot prices of major cities in the United States.  In other words, the average per square foot price for an apartment in 100 major cities in China is higher than almost the entire United States.  The final point, the average price of apartment price growth in these 100 major cities was nearly 9% with major cities growing by nearly 25%.  That to me sounds a lot like a bubble.

Put aside the official pronouncements by the economic propaganda department and look at the underlying data on how corporations and industries are faring and there are a lot more problems.