Thursday, October 30, 2008


Only several days are left till the final verdict is passed on the relative merits of two finalists in America’s most expensive ever electoral circus. It has been so much fun this time: we have enjoyed a parade including a liberal shrew, a token preacher, a plastic equity guru, a dallying populist, a septuagenarian grouch, a half-black upstart and finally a puck-loving but animal-hating diva.

The onset of the financial crisis messed up the strategies which, amidst fear mongering, would have perkily punted the same “values” message that had brought George W. Bush to power. But the slump in measurable values of homes and pensions has since shifted the rules of the game considerably. So much so that most of the intellectual elite of the country has now embraced a candidate whose official stance on trade would, in other circumstances, make any economically literate voter squeamish.

Will Obama win? The common view is now that the result will hinge on the voting decisions of the independents. Sarah Palin was supposed to rally Hillary’s troops, and she aptly appealed to them in her first public appearance as a vice-presidential nominee. As we now know, the thrust proved short-lived and she instead galvanized the numerically important, yet ideologically isolated minority whose voting record had helped to run the country aground. The independents may be displeased with Obama’s ‘otherness’ as much as with Palin’s increasingly Fascist, ‘shrill, baby, shrill’ wailing tones. Palin’s rallying calls point to an ‘enemy within’, whereby she utilizes sliding signifiers and exploits connotations of fear and alienation. These speeches would make a poor reading as a propaganda piece. But chopped up into an engrossing “call and response” ritual, they confirm the troops in their conviction that someone, somehow must prevent the inevitable.

But is Obama’s win really inevitable? He is close to victory, even though a well-timed video tape from Osama bin Laden could, yet again, help the Republicans and mire the US troops for years to come. Barring such a catastrophic development, the odds against Palin and her presidential running mate are high. Many independents may have now fallen under Obama’s unquestionable personal charm, his calm demeanor, and smooth-as-silk delivery in the otherwise inconclusive debates. Obama’s supporters stress the professionalism of the faultless campaign as a proof of his considerable managerial skills. Yet there are still many others who need another ‘ticking point’ to mark the Obama-Biden slot at the top of the ballot. Will the fear of Obama’s “past associations” trump the genuine fascination with this ambitious young man? Will the scare mongering of a “socialist” tax policy really frighten the middle class?

To be true, the red flag of “socialism” in America is an argument that is just inane and vacuous as Western Europeans’ congenital rejection of “religion” in politics.
Just as Europe’s political ethics is rich in references drawing on religious traditions, so did the US government, on occasion, assume a larger role in the country’s economy than it has been the case since Ronald Reagan’s presidency. As the turbulent Paulson era is now drawing to a close, the battle against “socialism” appears to have been lost without a single shot, regardless of Republican distaste for the ‘Swedish’ solution. Indeed, despite triumphant anti-Americanism on the European left, we may now all be in the same, centrist, boat, whether in America, Sweden or elsewhere. In the third quarter of 2007, the Swedish automaker Volvo received 41000 orders for its trucks. This year, in the corresponding quarter, the same company received barely 115 orders. The collapse of transaction flows in the ‘real economy’ - in America, in Asia and in Europe - should serve as a timely wake-up call against any exploitation of the allegedly contrasting interests of the Wall St and the Main St, la rue, la calle, dajie and die Strasse.

It is the market circumstances, still not fully recognized by the proverbial Joe in the street, that have radically altered the plausibility and feasibility of the grand fiscal plans touted by either party with relation to health care, education and other policies. In an effort to save its financial market, the US government has so far only injected an equivalent of about 6% of GDP. When Japan hit the curb in the early 1990s, the country spent closer to 25% of its GDP to finally put the economy back on track. But Japan’s asset values have never recovered to pre-bubble levels and it might, just as well, take a lot longer than commonly assumed for America to return to the 2007 level of asset wealth.

The comparisons with Japan’s balance sheet recession are ubiquitous, but misinformed. For one, unlike Japan, the US is not a net saver, which will make all the talk of ultimate rescue of its economy reliant on external sources. Japan’s stagnant demography made its growth highly dependent on its trade account and on income from overseas investments. The United States, even at dollar’s low last summer, still had nothing much to export. It will not be able to solve its current conundrum through the turnaround in the current account.

Equally importantly, America does not benefit from the social cohesion that characterizes the racially united and monolingual Japan. Over centuries the Japanese society has perfected a team spirit that only island nations can aspire to (shimaguni konjo). I still recall the shock of the sudden confrontation with homeless people around Shinjuku station and in Ueno Park in Tokyo. Yet at the depth of the economic slump and labor market losses, local shops organized distribution of foodstuffs within 48 hours of expiration. In a country ravaged by periodic natural disasters, a sense of common destiny was just too strong for anyone to remain indifferent.

As I visited poor black neighborhoods in the American South last weekend, the memories of Japan’s deflationary decade loomed again. Persuaded by committed friends, I participated in a last ditch pre-electoral “canvassing” effort. Our role consisted in knocking on doors that we would have otherwise never knocked on. And these were ‘doors’ that barely knew the fruits of America’s economic boom of the last 16 years.

Granted, these are not slums. Many of these modest houses are ‘owned’, which, as we now know means little more than a call option of ownership of the mortgaged property. Many others have been foreclosed. Yet something else struck us when we tried to elicit the response from behind those rickety doors. Many pre-electoral statistics rely on a somewhat automated arithmetic and plug in the numbers of African American population as ‘natural’ Obama’s supporters. They could yet prove mistaken.

Race is a big factor in this election – for better or worse. Many so-called ‘liberals’ (a term curiously referring to left-wingers in the US, but denoting free market apostles in continental Europe) would probably care much less for a Democratic candidate, were it not for the racial symbolic of his rise and a potentially cathartic impact of the election on the depressed black population. Similarly, most, if certainly not all African Americans would rather vote for a black candidate if given a choice. A numerically more important, though less vocal group of white voters may have an issue with a candidate representing a racial or a linguistic minority.

The racial divide remains one of the defining factors of the Democratic Party’s predicament in the Southern United States. Jimmy Carter’s parenthesis notwithstanding, the conservative vote swung away from the Democrats since Lyndon Johnson signed the Anti-Segregation Act in 1964. And whereas before African Americans were not allowed to board the bus through the same door as the whites, today they do not share public buses with white folks at all. The Civil Rights movement may have triumphed. The not so civil economic wrongs could not be so easily unwound.

Walking from door to door and listening to the deeply accented lingo transported directly from the pages of ‘Huckleberry Finn’, I could not escape the feeling that, for many of my accidental interlocutors, an act of voting for an abstract, Washington DC-based position will require an extraordinary personal effort. An effort to switch on the ubiquitous TV blare. An effort to lurch out of the dark bedroom. An effort to leave the familiar neighborhood. An effort to profess a view.

This is not a population accustomed to, or indeed required to make an effort in the first place. We are far, very far from Emersonian self-reliance. As we tried to explain to these half-illiterate people how to mark the ballot, it dawned on me that an act of INDIVIDUAL effort in an abstract (as opposed to physical) task is without precedent in their personal experience. The vote will take place only if and when the organized groups, the local churches, the campaigners or the community organizers provide the necessary assistance to the people who do not, in usual circumstances, take the extraordinary initiative to leave the ghetto.

And then there was hope. A 7-year-old girl opened the door and dragged her mom to the porch. While we were trying to make sure that her mother could understand the intricacies of the arguably confusing presidential, senatorial and gubernatorial ballot, the little girl flourished, flaunting with pride her experience of the ‘vote’ she had already exercised at school. The school game was supposed to prepare the young Americans for their future rights. Flushed, but proud, the little lady confirmed to us that she had ‘voted’ for O-ba-ma. There was no sense of otherness in her scintillating voice. But there was more hope in this statement than in the raucous mass rallies.

Sunday, October 26, 2008


Last week, China announced a number of moves to ease the stress in the real estate market. Down payments have been lowered, interest rates on first home mortgage cut and tax exemption extended. Although these policies should improve home sales in the coming months, they betray the overdependence of the Chinese economy on the government’s continued support for the real estate bubble.

The extraordinary expansion of real estate investment in China created a self-reinforcing loop with accelerated urbanization patterns. Migrations have taken people from Western provinces to Central provinces, from Central provinces to Coastal regions, from Coastal regions to Beijing and Shanghai, and from Beijing and Shanghai to America. Some reverse movement of talent (from US to China’s main cities) and low cost labor (from coastal areas to home provinces) has already begun, but does not yet reverse the overall trend.

The official urbanization rate has reached 43%, growing at 1% every 2 years. The unofficial “target” is 65%, but it could be affected by further trends in FAI and migration policies. Key to understanding the nature of China’s vertiginous growth is not migration, but physical expansion of the cities’ outer rings; much of the statistical “urbanization” took place not through immigration and birth rates, but by swallowing the land around the municipal boundaries, along with the local population. As much as 40% of increase in urban population (120m) has been achieved this way since 1990. In theory, assuming a 2% population growth, the cities could expand by another 350m people (including 240m migrants) by 2025. But that would assume a rate of growth even faster than over the last 18 years, would require funding for health and education services for the migrants who would constitute as much as 40% of urban population.

The population density and wide dispersion of incomes invites comparisons between EU and China. Europe’s 550m inhabitants are but a little less than a third of China’s, but Chinese urbanization plans saw 221 cities of at least 1m population, almost seven times as many as in Europe. However, the same plans see only 170 mass transit systems in China, as compared to 85 in Europe. Clearly, something is just not right.

This process allowed for an unprecedented expansion of wealth in the provinces. Contrary to common misperceptions, it is the local government that retains taxes, subsidizes local industry and licenses retail. Theoretically, during the last four years all the land sales were supposed to proceed through auctions, but in practice much real estate investment was done in hand-to-hand deals (“want to build a clinic in the 4th ringroad? I’ll do it for you. 1m renminbi, please”).

Land in China belongs to “the state”. In rural areas farmers are allowed to own a house, but not their land, which is leased out for 30 years from the state. But in urban areas, leases are for 70 years and people are allowed to “sell” on their apartments as if they owned them. This dichotomy leads to instant profits from land reclassification from “rural” – where no value transfer is possible to “urban” or “industrial”, where long term leases allow the land to accrue commercial value. Since the budgetary de-centralization earlier this decade, such land “reclassification” has constituted an important source of provincial income, ranging from 10% to as much as 40% of the budget, second only to VAT.

Realtors realize that there always is an official and an unofficial price for the land. Although in theory land auctions have been mandatory, there are many ways to go around it. Unlike in Singapore, Chinese bureaucrats are routinely underpaid and this form of ‘urbanization’ has been a very important source of grey income. The worst corruption occurs at the lowest level, where the officials are very poorly paid. It is among this group that one finds full size replicas of the White House and entire Audi fleets. In practice, passive corruption is punishable, but active corruption is not and investors may $cement their guanxi with impunity.

The other main driver of urbanization has been the Dong Qian process of inner city rehabilitation (2004-08). This process has now come to an end in the largest urban centers.

The real estate market is not entirely dependent on immigration as there is still potential demand for housing among existing urbanites, over at least 4 years, should the market conditions remain healthy. Prior to 2006, supply of residential units outstripped demand. The market shot up in 2007, with the average price running up 50%, with some cities registering even higher jumps. So far this year we have seen an average of 60% drop in transaction volume, and 40% fall in price in the main cities. Floor area sales usually improve in summer (Jul-Aug), which was not the case this year.

China’s downcycles usually last between 12 and 18 months, but could last longer if purchasing power deteriorates for some reason. That could be the case if GDP growth contracts considerably. Although household incomes still rose faster in 2007 than house prices, this reflected mean incomes, not median incomes.

Beijing has currently 15 months’ worth of inventory, so it could be surprising that price per sq meter is not falling yet. But the capital is home to an estimated army of 400000 bureaucrats from the central government many of whom are literally maintained by private entrepreneurs in order to keep up good guanxi. Nor is there any other reason for the $1000/night rooms at Ritz Carlton with herds of available girls always ready for the hot shots. The three Chinese status symbols (apartment, car, prostitutes) find a well structured demand in Beijing, making this market less volatile than the coastal areas.

The other reason why Beijing market will hold up better is the prestige and social standing accruing from a family member who moved to the capital and owns an apartment there. Many cousins in the countryside will scrap funds together to be linked, by extension, to such a status symbol. Over the past 7 years, some 0.5m people immigrated into Beijing every year (including the above-mentioned graduates). There is no consensus to what extent this trend may be sustained, but the only natural boundary is formed by the mountain range in Hebei, to the north of the capital.
In Beijing, on the 5th ringroad, a 90 sq m apartment costs around $175k. Usually property developers would target a 6/1 annual income ratio, so a two-person family with an income of $29k pa qualifies easily. That translates into 8300 renminbi per month – right in the middle of the urban middle class bracket. Statistically, some 15 - 20% of Beijing’s population within the 5th ringroad makes this amount of money.

The above figure of 20% would, on paper, clash with the current ownership rate of 80% (in Beijing). However, 80% of available units are purchased by the companies and allocated to their employees (similar to the now defunct Japanese kaisha system). Among the owners, 30% are first time buyers, a further 40% upgrade to larger units (or more appropriate location) and 30% are well-off investors who upgrade even further or hold multiple residences. Although many hold speculative property in expectation of higher prices (apartments are empty, not rented), some are suffering wealth effects (cash is tied up in the stock market and won’t realize losses and are priced out of the market due to liquidity problems).

A 120 sq m (2 bedroom) apartment in central Shanghai costs around $730k. This could appear pricey, but Shanghai and Beijing dominate China in the war for talent. 150’000 graduates from Beijing universities end up staying there after graduation. 28% of Shanghai’s workforce has tertiary education, but there are not enough graduates for 2nd tier cities.

The impact of the US credit crisis has been limited on the big four (state owned) banks as most of them trade only RMB-denominated debt. FX bonds are a tiny (and highly regulated) part of their business.

China’s property bubble should not be understood as a fallout from past credit excesses. In fact, if China does experience an increase in non-performing loans, it will probably be on the manufacturing side, rather than in real estate. Loans to realtors and loans to property owners have been a relatively small portion of banks’ portfolios. Overall, developers’ loans account for only 7% of bank assets and real estate companies’ liability to asset ratio is 73%. This is why the impact from the property slump on overall consumption will be limited (no home equity loans here).
The bubble was pricked by two regulatory moves initiated as far back as September 2007, when the government banned lending for land purchase purposes and land hoarding period was shortened through revised land auction rules. However, due to the huge fiscal boost injected on the occasion of the new 5-year plan, the effects were not immediately apparent in the market. Not surprisingly, after years of heady growth, the realtors were still very cash-rich.

Banks are under guidelines that limit lending to property developers who wish to build profitable (i.e. larger units). However, if the realtor complies with the 70/90 rule and agrees to build smaller units, the bank will release the loan immediately. For all other types of residential property, the realtor will have to be 1 year advanced into the development and post a 30%-40% margin (“equity”, not necessarily cash), which severely limits leverage. Importantly, the recent relaxation of lending quota did not apply to property development.

In the absence of bank lending for property development, realtors turn to wealthy backers. But here the lending costs are very onerous. The bill comes with a 20% interest, plus the cost of protection from renminbi appreciation, and access to 60% of value of the property. Such a “loan” is only extended to those who hold all the 5 property certificates (land, ownership, construction, inspections and – most coveted – sale permit).

The second reason why Chinese property bubble will not transform into a severe credit crunch lies in the economic behavior of investors. The population is generally risk and debt averse. Consumer loan to savings ratio is 24% and 80% of banks’ funding comes from retail deposits. Still, some youngsters who use corporate credit cards are beginning to apply for revolving credit. Remarkably, there has been a credit growth expansion this year (up 5% year on year), with expected loan growth of $0.5tr this year, with total loan portfolio of $4.18tr. The government does not encourage revolving credit. As usual, the expectation is that if something goes wrong, the government will ‘save’ them.

A sizable 3 bedroom house in suburban Shanghai may cost as much as $430k. Debt aversion is so high among Chinese homeowners that when uncertainty grows his/her economic behavior will be exactly the opposite to the American model. Rather than refinancing the mortgage, the Chinese homeowner will accelerate the repayment schedule. Until last week, with a 35% down payment and 5.4% interest rate, it was not uncommon to see these mortgages repaid within 4 or 5 years. Importantly, the price of such a piece of property is still up 80% over the last 5 years, which not only increases labor mobility but also leads to wealth concentration high net worth in the areas determined by school quality, where “emperor moms” tend to congregate.

The buyers of a second unit face steeper hurdles. It is very difficult to obtain a loan for the second apartment. Such buyers need to put 40% down payment and have to pay higher interest premium (7.7%).

The subprime problem is a distant abstraction for the Chinese. Buyers of their first apartment pay a 30% down payment and mortgage is only offered to clients whose income is above $10.5k pa per person (one needs to earn at least 6000 renminbi per month in order to service repayments of 3000 renminbi per month). These figures apply to second tier cities.

Although interest rates were cut by 0.27% in early September and again a month later, the transmission of this measure makes it little more than a symbolic measure and no impact on residential investment. The recent relaxation of lending applies only to a 10bp reduction in reserve requirement among the smaller banks (which account for 40% of the market). Lending quotas were increased by 5%, applying to all state-owned banks and their JVs. The government’s priority is to target small and mid sized enterprises, energy saving businesses, green technology and Sichuan rebuilding, not the property market. The government dissects the prospective loan recipients into 3 categories: “actively promoted” (renewable energy, transportation, grid, rail, ports), “prudently promoted” (health care, power generation), and “restricted” (highly polluting, energy-intensive, overcapacity – like glass, steel, aluminum, cement).

Capital growth could even become negative. Although loan to retail deposit ratio is 57%, as profits are fall and unemployment rises, non performing loans (NPLs) would return as a feature of China’s financial system. An 8% GDP growth (official) translates into 4% NPL. A 6% GDP growth (official) would lead to NPL expansion to 6.8%. Disposable income growth trails GDP growth by 2%, so losses could be made worse.

With asset prices falling (depressing artificial price earnings ratios), price competition will intensify again in the conditions of overcapacity (assuming continued slow demand overseas). Production costs may appear less flexible than in the past (labor, energy, quality control, environmental costs) and capacity utilization rates are bound to fall. Production scale-backs are possible and bankruptcies would spread among small and midsize enterprises with low working capital.

Friday, October 17, 2008


I promised to focus on China's property bubble this week, but other important events are approaching fast and the planned feature will be delayed by several days

When fear and uncertainty spread their repulsive tentacles, many humans react by displacing and even personalizing the elusive object of such emotions. A similar phenomenon of projective blaming is now underway among sections of the American electorate. At a time of unprecedented wealth destruction, many Americans are obsessed with a myth of dark, menacing Otherness. According to the myth’s organizing principle an Indonesian Muslim Communist from a Radical Black Church could actually be a Kenyan Weatherman Arab Terrorist. And yes, the real danger is that this person, with his un-American name, is getting perilously close to be the next President of a country which, until two months ago, was still a beacon of free market capitalism.

The despair runs deep. So deep that these frustrated groups of the American voters have placed their hopes with an occasionally electrifying, though often syntax-challenged personality of an admittedly handsome woman who prides herself with her utter disdain for the intricacies of the global economy and the world affairs. Supreme in her fiery harangues, the Republican VP candidate has been unable to properly construct subordinate clauses when speaking of that country we are in of which one state she is the executive of where Putin rears his head and we send them out to keep an eye on. Ok?

Palin was handpicked by McCain’s entourage to ‘shore up’ his credentials among the powerful Evangelical voters. Although many foreign observers see the Evangelicals’ influence through the prism of their support for Bush’s failed foreign policies or their biblically sealed alliance with Israel’s right wingers, the group’s impact on the quality of American political debate has been much more pervasive and wide-ranging. On talk radio shows earlier this year, John McCain came under assault from Evangelicals who castigated him for opposing torture in Guantanamo. “He is anti-torture”, yelped with high-pitched indignation an obviously deeply religious woman, “but I am pro-torture!” It was not until McCain’s campaign organizers increased the frequency of his interaction with the Evangelical “base” that the sectarian reaction became less strident (“he is one of us”). But some have remained reserved, noting that McCain never quite captured the wisdom of George W. Bush, the wisdom of finding all the right answers in the Scriptures. Astonishing as it might seem, the hapless Mr Bush will be sorely missed by that orphaned 30% of the US electorate and by their allies from one small country in the Middle East.

Palinism is arguably more than a daily fodder for late night comedy show chuckle. The real risk for America’s value system lies in the fact that as many as three Supreme Court judges could be confirmed by the new President. The country’s direction could thus be durably affected by these choices and the fears about the very sustainability of the ‘value crusade’ contribute to the hysterical anti-Obama atmosphere at many of Palin’s rallies. The reactions have become so hostile that some opponents likened Palin to segregationist George Wallace. Suddenly it is the Democrats who had to apologize for the comparison; the organizers of the anti-Obama rallies did not have to. And yet, the emotions among the ignorant mob run high. Calls to “kill him” reflect the fear displacement of small town America. It is bemusing to relive it during interviews with white youngsters from the Deep South, who threaten to “relocate to a Communist country” if Obama wins. I concur that North Korea could actually be good for their eating habits.

Meanwhile, the American media remain puzzled. Accused of uncritical approach to the excesses of Bush’s first term, most mainstream networks find it hard not to betray their pro-Obama sympathies. It leaves the Fox TV as a lone conduit of rather farcical right-wing propaganda. But the spin feels tired and worn out. When four years ago John Kerry won another TV debate against the incumbent, the Fox TV proclaimed that although Kerry was “glib” and probably a better debater, Bush was “a better President”. Four more years of war and trillions of dollars of lost wealth later, that argument is markedly less airborne. Besides, arguing that Palin would make a “better” President could prove risqué outside the avidly sectarian circles.

The spin doctors are, therefore, at pains to turn ignorance into virtue and mediocrity into value. Instead, they have tried to undermine the opponent’s appeal by further stressing his Otherness. After Obama’s triumphal tour of the Middle East and Europe, I received emails with some astonishing accusations of the Democratic candidate’s betrayal of America. According to the slur, Obama proved that he was not truly American because he…. “spoke to 200’000 screaming Germans”. This sticks. After all, Kerry was accused of being fluent in French. Palin’s oversize flag pin, and her sub-Bush distaste for anything foreign plays well with this audience. And, unfortunately for Obama, his daughters are still too young to “proudly serve the nation” in Iraq.

The race card and the anti-Muslim innuendos are a frequent motif in these mailings. In one such email, sporting the picture of Obama’s poor, wrinkled Kenyan grandma, the outraged caption read: “do you want the First Family of the United States of America to look like THAT?” Obama’s absent father’s ethnic roots are also dragged out as a proof of Barack’s own radical leanings

With the economic situation dire and the real life consequences of the financial meltdown too complex for even well informed people to grasp, the “it’s economy, stupid” argument can only drive home the message through anecdotal or better yet first person experience. The 401k checks, which most Americans receive monthly are a home run “free mailing” for the candidate who has crafted a message of ‘change’, even if his program, as much as his opponent’s, will be at pains to incorporate the fiscal and financial constraints within which the future administration will have to operate.

The new inhabitant of the White House will inherit a country diminished abroad after 8 years of shameful unilateralism, and severely hobbled economically after the last 16 years of bubbly hubris. Cleaning up the mess left over by the Clinton/Bush era will be a task of Herculean proportions. The new administration will have to deal with mounting public debts, bad assets and corporate failures. In such circumstances, it will not be easy to re-ignite the nation’s energy without the (tempting) handout of easy credit. Instead, America will have to enter the unpleasant era of deleveraging. And with half a trillion dollar of annual deficits - something will have to give. The unenviable choice will fall somewhere between reflation, tax increases and spending cuts.

Reflation makes one shudder at the thought about the potentially disastrous, long term consequences for the savers. It is difficult to believe that the application of openly reflationary measures would signify a full circle in the economic orthodoxy. Still, your best protection against the potential ravages of debt reflation would be… gold. Purchase of gold should be facilitated by its subpar performance during the initial deflation and aided further by the artificially strong US dollar which depresses the value of the dollar-denominated gold price. Dollar’s strength is ‘artificial’ because it is supported by three, temporary events: European banks’ unwinding of their short dollar positions in the wake of the CDO breakdown, US-based hedge funds’ closing out their dollar-denominated debt after selling their large positions overseas, and US corporations benefiting from IRS tax breaks for repatriation of profit from overseas. The relative weakness of the yellow metal (in dollar terms) could, therefore, provide an excellent entry point to secure future insurance against reflation.

During electoral campaigns, no one’s lips will read “more taxes”. But the unpleasant reality for either candidate is that the deficit will force such increases in some form, as soon as the immediate recession has passed. The proper timing of such fiscal rebalancing will be tricky and, if implemented prematurely, it could suffer from the so-called Hashimoto Effect. Ten years ago, the Japanese Premier managed to smother a recovering economy by showing that low interest rates are a necessary, but insufficient condition to offset the weakness in growth indicators. Regrettably, I have little advice for Americans who are bound to face a heavier tax burden. But one obvious choice would be to swap your US passports for the passports of Burundi, Bhutan or Barbados.

Finally, the most appealing solution of all, i.e. spending cuts. In the last televised debate, both presidential candidates were patently vague as to which public program should be trimmed – health? Education? Social security? Tough to build new America without them. The wars in the Middle East and Central Asia could be one target, but this is not instantly achievable. Should such a pull-out, if implemented for fiscal, rather than strategic reasons, could lead to seriously destabilizing consequences. But you could still make money on it, for example by investing in burqa stocks.

One thing is certain. After the unilateral (and misguided) decision to go into Iraq and the equally unilateral (and misguided) decision to let Lehman Brothers fall, the costs of Washington’s solitary adventures are now more obvious than ever. These expensive blunders have led not only to multibillion losses but also to an extraordinary loss of America’s geopolitical and financial power. This is because much of that power was predicated on counterparties’ and rivals’ critically important perception of power.

All those valuations – from net present value to earnings multiples to cash burn rate to liquidation value - are in fact highly dependent on the thin layer of trust in what constitutes “fundamental value”. Only now do we realize how much of America’s power lied in its addictive optimism. And without optimism, Uncle Sam is worth a lot less.

Yet for as long as America continues to attract talent from around the world and continues to create favorable conditions for hard-working people, the promise of this land of opportunity will tower high above many others. The next four years will be crucial. The challenge to wean the economy of its addiction to credit supported by property values should not be underestimated by even the most skilled motivational speaker of his generation.

Saturday, October 11, 2008


Another week of market panic. Another long, damaging week for all those who borrowed short term liquidity in order to invest or lend in the long term. No end in sight for the unprecedented, convulsive seizing of interbank and money markets. No counterparty is trusted, no credit history adequate. But the worst could be yet to come. And it will come if trade partners refuse to conduct physical transactions with each other. Such a threat, meted out last week by China’s state owned enterprises to one of Australia’s iron ore producers induced Kevin Rudd, Australia’s Mandarin speaking Prime Minister to pick up the phone and call China’s Premier. The necessity for such government interventions illustrate just how fragile the global trading system could be. The unraveling of the hitherto flourishing trade routes could make the recovery of our decimated savings so much more difficult if not entirely impossible.

As the dramatic events of global market meltdowns and banking collapses are unfolding, some commentators are still holding on tight to the hope that the savings accumulated in current account surplus countries will somehow save the planet’s economy. After all, the central banks of Asia and Middle East have for years been gobbling up US Treasuries and agency bonds, helping to suppress US interest rates and facilitating America’s housing bubble. This seemingly unquenchable appetite for the single staple meal of US debt kept afloat the over-leveraged American ‘consumer of last resort’. Some are now hoping that the trillions of dollars worth of US government paper accumulated in the East could be somehow unlocked to unfreeze the clogged LIBOR and see the lending resume globally.

But such a scenario could now prove overoptimistic as the ‘savings-surplus’ economies are slowing down as well. The precipitous drop in the oil prices is draining the wealth of Petrodollar economies at a record pace. Just this week, we have learned that the Russian oligarchs had registered a combined loss of $230bn over only four months. Last week I wrote about China’s exports predicament. With China’s largest export market – Europe – now tipping into recession, further contraction in this sector should be expected. But there are other, even more potent drivers leading to an unpleasant screech in the Chinese brakes. The mid-cycle, downward trend in China’s real estate market, although not directly related to America’s credit problems, is highly worrying. And what makes China’s economic deceleration worse is that all the three endowment factors have over the last year seen coincidental sharp price increases: coastal labor (due to legislation), capital (caused by tight lending quotas) and land (owing to land hoarding and speculation).

When the Chinese government moved to reinvigorate domestic economy back in 2002/2003, much of the internal growth came through unprecedented expansion in fixed asset investment (FAI). As a result, FAI rose to 41% of Chinese GDP. The relative magnitude of this contribution is apparent when compared to the importance of domestic consumption (36%) and net exports (8%). As much as 50% of urban GDP growth comes from FAI. Critically, real estate represents a quarter of fixed asset investment (compared to 30% manufacturing and 11% transport). At its cyclical peak, 10% GDP growth has been associated with 20% FAI growth, translating into unprecedented demand for steel and raw materials. It is in the consumption of energy and basic raw materials that we can now detect just how severe China’s slowdown really is. Year on year rate of growth in fixed asset investment has fallen by 6%, construction output by 10% and residential property by 16%. As of last month, annual decrease in growth was 6.2% in energy, 4.6% in iron ore, 3.5% in cement. Coal consumption growth has fallen 4%. Previous troughs in those subsectors occurred between 2001 and 2005, but did not coincide. This time they do.

Power demand in particular is a good indicator of real GDP numbers, even though the ratio is falling slowly with the phase-out of the most energy intensive industries. In 2000, the ratio of electricity consumption to GDP was 1.5:1, but it is now closer to 1:1. And if so, this particular indicator looks scary; China’s electricity demand growth was barely above 4% in August, and sharply down from spring. Some of this breakdown could be caused by insufficient coal deliveries to power plants and cash flow problems of electricity generators unable to pay for the fuel.

Optimists point to increased infrastructure development, but even if accelerated, it is unlikely to substitute for the material hyper-intensity of real estate development of the recent years.

The realization of just how serious China’s problem is has dawned on us late, very late. Indeed, until my recent trip to China I had been holding out a hope that the negative stream of data could be attributed to several one-time, seasonality-distorting events. “Excuses” for the pause in apparent growth indicators were aplenty. Olympic priorities had apparently trumped the need to keep the economy racing, resulting in large-scale absenteeism in favor of ‘patriotic’ TV screens or the net surfing. Despite the aspirations of traditional numerology, 2008 has been hardly a “lucky” year with its earthquakes, snowstorms, floods and recurrent health scares and, at least officially, “disasters led to the slowdown in the economy”. Year on year comparisons were also complicated by the twin impacts of renminbi appreciation and the introduction of the new, rigid Labor law.

There is little doubt that at least some of these factors added to the economy’s cyclical maturity and weak external environment, but there are more disturbing, structural reasons as well.

The 2005-07 excesses in construction and property investment were caused by low or negative real interest rates, which led to capital misallocation, excessive capital expenditure and speculative investment in stocks and property. Having failed to develop a proper social security system, the government relied on pump-priming to keep the labor-intensive machine going. It is worth remembering that each time the Chinese administration is overhauled on the occasion of a new 5-year plan, fiscal pump-priming boosts fixed asset investment. Such economic stimuli are in China functional equivalents of pre-election spending by incumbent governments in democratic countries. Even though no one gets elected by the Chinese population, the mobs have to be pleased.

Such big fiscal boosts last between 6 and 9 months. Importantly, the last one was introduced in October 2007 and this means that capacity growth in some manufacturing sectors significantly lagged the (falling) demand cycle. Whereas demand peaked late 2007, capacity expansion continued into the second quarter of 2008, further distorting the perceptions of China’s allegedly unstoppable growth.

Finally, there is the stock market. Having lost 67% over the year, Shanghai index is occasionally propped up by the government in effort to re-establish confidence in the market, but the aggregate price to earnings ratios are still at multiples of around 20 times, hardly a bargain for bottom feeders. More ominously, some 30% of the 2007 earnings of the listed companies were in cross-investments. When Ping An Insurance announced its results for the first half of 2008, its losses were 20% higher than its (negative) income, due to additional investment losses.

It is also a good testimony of the magnitude of the slowdown that the typically flow-boosting natural disasters (snowstorm and earthquakes) did little to stimulate the economy. The data on Sichuan reconstruction is curiously sporadic, as if it was another state secret. Or are they all rebuilding their lives with local bamboo?

At the height of China’s property bubble, the cost of construction was about 1/3 of the value of a new house. The remaining 2/3 were divided into the profit, taxes and permitting. The price of land used to constitute 30% of overall costs in 2005, but its share doubled in the last three years. Such supply side constraints led to low concentration of urban construction, absurd valuations and cheap execution. Construction quality is generally very shabby and ‘cutting corners’ was the way for the developers to absorb the costs of land, labor, cement and steel.

The growth of Chinese investment and its role as the marginal consumer of all sorts of raw materials was largely responsible for the huge increase in commodity prices globally. The dragon’s ferocious collapse is now taking a toll on the resource sector of the global economy, pulling in its wake the economies of Latin America, Africa and Australia. Although the liquidity problems of Chinese construction firms and steel producers could be the main reason for the slowdown in physical transactions, we could be at the cusp of something much more ominous. Since the massive market sell-off began, almost a quarter of the global wealth has been wiped out – in savings, assets and other forms of capital. When the extinction of wealth is so widespread, so deep and so fast as this time, cooperation to stem the ravages may be more difficult to achieve. Instead, we are facing the classic dilemma of the tragedy of Commons. And so, for about two weeks now, Chinese customers have been refusing to pay their bills and honor purchase commitments signed with counterparties from India to Indonesia to Australia.

Some ten years ago, I learned this lesson myself. At that time, my firm decided to sign a contract with a Chinese transportation company. We happily returned from Beijing, with a document officially signed by Mr Wang, a senior official of that company. Over weeks and months we found communication with the Chinese partners increasingly difficult and there were no signs of delivery on the contract. When we finally intervened, it turned out that Mr Wang had left the company. Back in Beijing, we eventually managed to see his replacement, Mr Hu. We sat down in oversize armchairs arranged side by side, sipped green tea and exchanged pleasantries. When I finally asked Mr Hu about the contract, he glanced at me with a look of a bored anteater and snapped: “but this paper signed by Mr Wang. Mr Wang no longer work here. You should not think this paper important”.

As the first news came about Chinese state owned enterprises breaking long-term contracts with Australian suppliers, I was reminded of the 18th century letter that the Chinese emperor wrote to King George of Britain. Here’s what he wrote:

“You, O King, live beyond the confines of many seas, nevertheless, impelled by your humble desire to partake of the benefits of our civilization, you have dispatched a mission respectfully bearing your memorial. To show your devotion, you have sent offerings of your country's produce. In consideration of the fact that your Ambassador and his deputy have come a long way with your memorial and tribute, I have shown them high favor and have allowed them to be introduced into my presence.

Swaying the wide world, I have but one aim in view, namely, to maintain a perfect governance and to fulfill the duties of the State: strange and costly objects do not interest me. If I have commanded that the tribute offerings sent by you, O King, are to be accepted, this was solely in consideration for the spirit which prompted you to dispatch them from afar. Our dynasty's majestic virtue has penetrated unto every country under Heaven, and Kings of all nations have offered their costly tribute by land and sea. As your Ambassador can see for himself, we possess all things. I set no value on objects strange or ingenious, and have no use for your country's manufactures. It behoves you, O King, to respect my sentiments and to display even greater devotion and loyalty in future, so that, by perpetual submission to our Throne, you may secure peace and prosperity for your country hereafter”.

As Chinese real estate slump impoverishes realtors, construction companies, cement and steel producers, it can be expected that the losses will be pushed further up the value chain, even if that creates potential legal or diplomatic ripples. With the global depression looming, ‘beggar thy neighbor’ tactics may yet become our daily staple. The age-old traditions of business conduct in China will be of no help in trying to save international, rule-based cooperation. Instead, one should wonder why the Chinese state has not yet embarked on a buying spree of its own. If Russia can purchase Iceland, why couldn’t Australia be sold to PRC? Such a realignment of relative power in the Pacific basin could yet prove to be the ultimate outcome of the free markets’ current seizures.


Next week, I’ll probe the intricacies of the system which underpinned the extraordinary tale of real estate bubble in China and took the global markets for an unprecedented ride.

Saturday, October 4, 2008


It has been an extraordinary week. While the world’s attention focused on the US Congress passing a bill that, by Friday afternoon appeared to be a sad story of too late and too little, the commercial paper market seized up, leaving the companies around the world unable to borrow money for the most basic of transactions. As the markets are scratching their sweaty heads, some observers seek shades of hope in the economies whose liquidity does not depend directly on the smooth functioning of the global finance. But, as the meltdown in Russia’s financial system is now proving, ample foreign reserves are not necessary a bulwark against a global credit crunch.

Nowhere are those hopeful winks more prevalent than in the direction of China, an ever-growing juggernaut that only recently graced the world with nationalistic displays of organizational prowess and tetchy pride. Alas, these hopes will be disappointed because, with perverse timing, the Chinese miracle is now exhausted.

Last week I returned to China after almost a year. For nearly 15 years, I had been visiting the country with unplanned and surprising regularity. As I moved through careers and residencies, people around me always wanted to do business with China, or at the very least collect information about business opportunities in the seemingly unstoppable Middle Kingdom. Their optimistic charts would show various countries’ comparative GDP per capita on the horizontal axis and the same economies’ consumption of applicable good (steel, paper, beef, shoes and, yes, milk) on the vertical axis. Invariably, the business executives drew two conclusions. First, China’s GDP per capita would one day “catch up” with the advanced economies or at the very least with its rich neighbors in Asia. And, secondly, its intensity of consumption of those various goods and services would somehow follow the “natural” pattern of development, traced by Japan, the United States and Europe.

This a priori universalism, enshrined in the “world is flat” ideology, always grated. After all, even among developed economies we all differ in consumption patterns. The Japanese eat less meat, Americans travel less internationally and Europeans spend less on defense. Per capita. Somewhere beyond the awe that China’s undeniably rapid growth generated, there also lurked a suspicion that the country’s socio-political system may find it more difficult to ensure the flexibility required to modernize the economy to the level of a democratic South Korea or a democratic Taiwan. But it is a testimony to Chinese people’s extraordinary devotion to enrichment through personal (and family) effort that, on aggregate, PRC has achieved what it did over the last 30 years. Three decades since the opening of China’s economy, it is time to take stock of this remarkable development. But I would caution against such a ‘stock’ being taken on Shanghai Stock Exchange.

It was the collapsing commodity markets worldwide that drew me to China this time. Certainly, Hank Paulson’s efforts to reverse the “long commodity – short financials” trade in mid-July helped to deflate large fund positions in the former sector. But signals of softening demand for raw materials appeared already in May, when many of the commodity companies hit the all-time high market values, while still trailing their net present value, sometimes by as much as 20%. China – the world’s largest consumer of just about any commodity with the exception of oil – would certainly hold the key to understanding what is happening in the physical market. Admittedly, the notoriously unreliable data from the Middle Kingdom were made even more noisy this year – the extreme winter in much of mainland Asia, the devastating earthquakes in the Southwest and a clamp down on polluting industries and transportation during the Olympic Games have all conspired against a scientific approach to data collection.

There were surely signs of a significant slowdown since the beginning of the year. Between September 2007 and March 2008, the labor costs ran up by 40% in coastal areas, discontinuation of export tax rebates cancelled a further 13% of profits, raw materials added another 5% to costs, fuel and energy jumped up for all but the most shielded operators, and local currency appreciated by 15% against the dollar just when the American consumer felt the first effects of what back then was known as a “subprime” crisis. No wonder that upon their return from Chinese New Year holiday workers found that their Korean bosses in Shandong had simply closed shop. Taiwanese entrepreneurs in the South went even further. Unlike the Korean business owners, who used to rent out operating facilities, many Taiwanese capitalists invested into local assets, land and property. But they too decided to leave, preferring to write off the value of these assets rather than face onerous closure costs.

The exodus of the workforce from coastal China’s export centers back inland was also possible by the reduction in income gap between the coast and inland provinces. For as long as jobs are available in the inland provinces, a 1000 renminbi in Gansu goes much further than 1500 renminbi in Shenzhen and life feels safer in the family cocoon of the hometown, away from mechanistic and sterile dorm conditions of the coast.

The new Labor Law, introduced on January 1 this year broke the camel’s back. The wage pressures, first registered in the summer of 2006, had been eroding the labor arbitrage model for a while, especially among nimbly-fingered female workforce. Credit should be given to the government for realizing early on the dangers of overreliance on foreign demand. Not surprisingly, since at least 2003, Beijing pursued rapid industrialization and infrastructure development around the country. Real estate development blossomed, rendering China’s GDP less obviously reliant on exports, though at the price of exposing it to another form of dependency - on imported materials. However, at 36% of GDP, the post-WTO accession export boom continued to provide the source of coveted foreign exchange reserves, frequently pointed out by westerners as a source of potential trouble, but treated domestically as a war chest ready to shore up the most endangered sectors of the economy (e.g. banking in 2004).

Labor arbitrage is a finite game. China’s labor growth may peak as early as 2010, when it will reach 68% of the population (around 770m). The subsequent shrinking of the workforce will only add to the progressive loss of China’s competitive advantage in basic manufacturing. Already now, a worker in coastal China costs between $120 and $210 per month, compared to only $50 in Cambodia and $10 in parts of coastal India. Some of the production may be shifting inland, but the distance from the coastal export bases often cancels the advantages of lower unit costs.

China will find it problematic to shift from labor arbitrage to higher value added production and branding. 30 years since the opening, there is still no Sony, no Toyota and no Samsung. Corporate practices in China are not based on pursuit of excellence but have for years been developed around personal access to specific opportunities and intimate knowledge of the inner workings of the system. The success of many Chinese companies was made possible by the influence they could exert on the liberalization of specific markets, allowing them to reap rewards of first mover advantage and superior strategic positioning. In such circumstances, it is not entirely surprising that innovation and creativity have not been China’s strength.

The quality of workforce is one area hampering any repositioning of the labor arbitrage model. The pliable and hardworking workforce may be adequate for satisfactory task execution, but is not globally competitive in the context of modern-day organizational management. Only 9m Chinese enter university every year – a pitifully small number in a nation of 1.3bn. And many of these graduates lack communication skills, leadership skills, analytical skills, English, capacity to take initiative and find solutions. Not long ago, my company sought to hire a professional from one of the country’s top engineering school. Several hundred people came to our presentation on Friday afternoon – both students and graduates. Of 150 resumés we received, only about 20 made any sense. Having gone through interviews, we could barely hire one person. The ideal combination of adequate English and analytical skills is so hard to come by that the few people who do offer such highly sought after qualifications command a huge premium on the job market. No wonder that 30 years since the opening, most foreign invested companies still have to staff the top echelons with Hong Kong, Taiwanese and Singaporean professionals.

The educational system and the internal migration patterns have wrought havoc with what was a generation ago a classless society. Today, China can be roughly divided into three strata – with the oft-lauded “middle class” separating the extremes of wealth and poverty. Depending on location, the core of this “middle class” earns between $10.5k and $21k per annum (all such comparisons need to take into account that the cost base in China is still about a third of the world’s largest dollarized economy). And although many college graduates initially earn less than this bracket would indicate, currently some 60% of Beijing households have an income of $12k.

People with incomes of at least around $30k per year are considered “rich”. These are not only entrepreneurs, but also the above-mentioned professionals hired by Western companies and earning sometimes several multiples of this figure. This is a successful, but greedy bunch, expecting a 25% - 30% pay raise each time they switch jobs. In effect, they do little else than arb the market for their ego-asset, shifting between short term owners. And although a 45% income tax applies to this income bracket, the gulf between them and China’s poor has been widening for several years now.

What is astounding is that much of this wealth is concentrated in the hands of young people – between 24 and 31 years old. Their consumer behavior is the single most promising feature of China’s economic life AD 2008. It is also in the naïve optimism of this acquisitive group that a palliative to the economy’s current woes can be sought. More than 2 years ago, Goldman Sachs published a groundbreaking paper on “China becoming old before it becomes rich”. The findings, based on the observation of the unusual demographic pyramid, pointed to a scenario of inevitable slowdown in internal demand, to some degree replicating the pattern exemplified earlier by Japan. Two years later, exactly the opposite is happening.

Amazingly, a youngster earning RMB5000 per month (some $8760 annually) can no only afford a RMB120000 car, but also 90 square meter apartment, which on Beijing’s fifth ringroad would cost around $175k. How is this possible? The demography, and modern China’s family structure provide answers. The youngster in question – invariably a single child - may dispose not only of his own revenue, but also of his (usually working) parents’. S/he may even dip into grandparents’ savings, for whom little is more important than the gratitude offered further down the (thin) bloodline. As a consequence, a young Beijinger would have access to not one but up to seven sources of revenue and savings. A young couple could even double this number. Their spending power is unparalleled among “middle classes” elsewhere. Importantly, it has been entirely shunned from exposure to credit.

But the expectation of “gratitude” that lineage-obsessed elderly Chinese expect – at the very least in the form of prayer for deceased ancestors – may prove a little overoptimistic. These young emperors and empresses are so used to be on the receiving end of family’s attention that reciprocating the favor comes with great difficulty. It is, therefore, not surprising that the divorce rate has skyrocketed in China. The relative scarcity of available women due to the still prevalent infanticide in the late 1970s and in 1980s has created an imbalance that subverts the forces of traditional patriarchalism. Young men are poorly prepared to deal with this challenge, but little in China is sexier than money, a fact that propels many young men to pursue material goals with even greater zeal.

These young people, and especially young women, are hugely optimistic about their future not only thanks to their spending power and exclusive memory of ever improving economic conditions, but also because they are shielded from the negativity that inundates the media in many other countries. Beijing’s full media and internet control ensures not only the ubiquity of ludicrously crass and inane entertainment, but also channels local aspirations into a very selective targets of consumerism – a car (to show off), an apartment (to brag about), and electronic appliances (to boast upon). Conspicuous consumption defines much of the behavior of the converts to born-again materialism.

How different is this experience from Japan’s… I visited my Japanese friends in Tokyo this week to learn that similarly childless society can find itself in an entirely different situation. Japan’s problem is that its society is too healthy. Unlike in China, people here usually eat safe food, breathe clean air and generally enjoy the fruits of their past hard work. But they live too long. Former sarariman accumulated only one revenue per family and usually had more than one child. Retired today, and facing life expectancy of around 80 years, such people have to dip into their savings and do so uncomfortably, with little, if anything to bequeath to the next generation which has been segmented into fairly stable professionals and precarious part-timers. Asset values in Japan have been depressed for almost 2 decades and there is little faith in future increases of the market value. Whereas the Chinese government’s ubiquitous “propaganda of success” convinces people that Beijing would eventually step in to bail out investors, homeowners and consumers, Japanese viewers watch TV news replete with depressing stories of accidents, suicides, rapes and disasters. And while the Chinese people are continually reminded of the nation’s putative greatness by stunts ranging from sports events to space missions, Tokyoites scowl at Mayor Ishihara’s ambitious plans to organize second Olympic Games in the city.

Japan's combination of obsessive pessimism and world record beating life expectancy could appear oxymoronic. Yet it is in contrast with China’s ignorant optimism that the Japanese phenomenon can be understood. During the first three days of my visit to China, 67 people died in 2 separate coal mine accidents in Shaanxi, 8 people died in a typhoon in Guangdong, 8 people were killed and 38 missing after a landslide in Sichuan, 72 youngsters died in the fire of a dance club in Shenzhen, 267 people died in a mudslide in Xiangfen county. The official death toll in the "milk with plastic" scandal was 4, but 53000 infants had been infected. Pessimism and excessive life expectancy are none of China’s worries. For now.