THE TYRANNY OF OPAQUE MARKETS

By the nature of our profession, we are naturally obsessed by what we see daily on our screens. However, in the last several years I have become fascinated by what we do NOT see there. With so much risk capital now captured by the South and the East, unfortunately for us, the opacity of the dealings will only increase. There are three, interrelated reasons for this:
1. East of Istanbul, some 75% of all deals are done in the private market
2. The experience of 2008 led to a breach of trust and much higher dependence on stocks, to the detriment of flows
3. As a result of this obsession of physical inventory control, coupled with low interest rates, contango has evolved in certain commodities, most durably in some metals

Yet, this realization is relatively new. Some three years I traveled from Charlotte NC, where I worked for a multistrat hedge fund, to New York to listen to a number of UBS strategists and analysts. I do not remember the exact date, but this must have taken place sometime between May 2008 when the commodity equities turned sharply down in London and July 2008 when Hank Paulson’s memorable speech reversed long commodity/short financials trade.

The UBS strategist was quite flippant in his dismissal of the weight represented by the emerging markets. He complained about the pressure on him to learn Mandarin and reassured everyone that the proverbial fatso from Costco would have to save the planet as he or she is ultimately irreplaceable. The argument went like this: America with 300m population consumes 11.5 tr worth of goods and services, whereas Europe with twice as many people consumes half of that figure. Japan is a distant third with $4tr worth of consumption and China, well, not in our lifetime shall we see it carrying the weight of responsibility for global growth.

But even if that UBS strategist spoke with a British accent, his view of global economy was strongly embedded in the “consumption” school of thought. In this view, consumption, or end-demand, is what propels this planet around the sun. But then, the end of the world appeared on our Bloomberg screens. Very slowly did we begin to understand that while consumption does matter, consumption on borrowed dime would eventually end in tears.

So what happened since those momentous events three years ago? Closer to home, we dusted off the Austrians. Today angry Congressmen spit out one-liners from Henry Hazlitt’s adorable paperback and Michelle Bachman carries with her a volume penned by von Mieses on a holiday break. And the rest of us? Well, we are all a notch closer to Schumpeter’s view that the way to expand the economic wealth of a nation is not to:
• use fiscal policy and liquidity injections in order to "stimulate demand"
• incur huge fiscal and monetary cost to defend holders of bad debt
• risk long-term slowdown by obstructing the restructuring of excessive debt burdens

No, from a macro perspective, living standards can be increased only in two, but diametrically different ways:
• through capital consumption, i.e. dis-saving and massive borrowing, something we avidly tried (and succeeded) during the Clinton-Bush era, or
• through capital accumulation, i.e. savings and capital investment, a model arduously pursued today by many emerging markets.

We all know that the demand for capital dropped among the developed economies, with FAI/GDP falling from 25% to 18%. At the same time, it has grown in the emerging markets. In India it stands at 33% to GDP and in China 47% and STILL growing at 25% yoy. The question remains, of course, how “productive” (from the Schumpeterian perspective) the growth in the East and the South has been. I believe that the picture there is somewhat mixed. The quality of growth in emerging markets has been uneven and with rising current account deficits and rocketing credit intensity of GDP growth (quadrupling fourthfold in China) may have even deteriorated in the last three years,. But the persistent growth differential between “us and them” is undeniable and should correspondingly affect our thinking about the commodity space across asset classes: the physical, the futures and even the equity.

PHYSICAL COMMODITIES

Commodity professionals, we can give themselves credit that, at least since 2003-04, they have been paying a lot of attention to China. Indeed, I am sometimes amused when I hear about China being “over-dependent” on exports. It was back in 2003 that the leadership of the Chinese Communist Party (CCP) began to question a development model based on exports and on co-opting private entrepreneurs into the Party Congress, a process that had flourished in the late 1990s. 2003-04 was also the time when a decade of Zhu Rongji’s financial reforms had already borne fruit, China had become a WTO member and was in a build-up mode for the Olympic coming out party. In order to bolster the position of the state-owned enterprises, a shift from exports to fixed asset investment became a priority.

A decision was taken that the "pillar" industries, including energy, mining, steel manufacturing, automotive industry and telecom would be dominated by companies under government control. Granted, private enterprise was there to stay, but tolerated only as providers of jobs, foreign exchange and technology. In December 2003, PBOC established Central SAFE investments (Huijin), which later helped recapitalize state-owned banks using foreign exchange reserves, thus entrenching a growth model based on state-owned banks offering loans to SOEs and the same banks coming back to the market every couple of years to recapitalize themselves. The ensuing lending binge unleashed a tsunami of construction activity which durably transformed many commodity markets. In response, Sir Bob Wilson, upon his retirement as Executive Chairman of Rio Tinto, cautioned against commodity markets’ excessive dependence on China.

But dependent we became. The observation of overdependence has been particularly glaring in the commodities that China is net short: metallurgical coal, copper, iron ore, oil, platinum group of metals, soybeans.

We are often victims of our own wishful thinking, expecting the world to become somewhat more Anglo-Saxon, more free-market-ish and more democratic in general. Meanwhile, despite the trappings of (our) modernity, the Chinese Communist Party’s model still has a lot more in common with the Soviet system than with ours. Unlike the pre-Gorbachev Soviet system, which tried hard (and eventually failed) to control the flows and volumes of products, components, subcomponents and commodities throughout the value chain, CCP devised a system in which it controls not the widgets, but the supply of economic factors, and consequently their price. As most of us still remember from the economics class, there are three basic economic factors: land, capital and labor. This is how CCP achieves this in a state-controlled economy with Chinese characteristics:
• land supply control, through state-ownership and land registry at municipal level (I will return to this later),
• capital control, which remains underpriced through capital account controls and distributed through lending quotas,
• labor supply control, with the two-tier population registry (hukou) system: the locals and the migrants and the central guidelines for provincial decisions regarding the minimum wage.

This system may be bursting at its seams now, but it is still firmly under CCP’s control, with the possible exception of underground lending.

Now, if you control all the factors, then regardless of your personal make-up (which may be highly technocratic and pragmatic, rather than ideological), you and your organization will develop a Leninist control culture around it and will be pretty upset if there are ANY inputs whose supply you do NOT control.

The iron ore market is a case in point. China Iron Ore and Steel Association (CISA) is a bureaucratic entity mandated to protect the interests of the country’s steelmakers. If you meet CISA’s officials in Beijing and overcome their initial “we won’t tell you ‘cos you’re a foreigner” (我不告诉你，因为你是外国人) you will soon learn that Western governments, (yes, “governments”) have devised a perverse plot to deprive China of access to iron ore resources and thus to strangle its birthright growth rate.

Much has been said about iron ore market’s high Herfindahl index of supply concentration. However, Sir Bob Wilson was not entirely wrong. Today as much as 25% of global seaborne iron ore of about $1bnt p.a. is destined for just one market: long steel products used in Chinese construction. And when asked about how sustainable this is, most analysts point to the continued “urbanization”.

Contrary to the claims of such reductionist commentators, urbanization itself is NOT a market phenomenon, but a process driven by a confluence of institutional decisions in China, whose sustainability depends largely on the durability of the system based on three pillars:
1. the Constitution of PRC, which turned all land into the property of the State
2. the lopsided structure of provincial budgets, responsible for 77% of expenditure but entitled barely to 46% of federal tax transfers, which turns these budgets dependent on land transfers. As much as 70% of the provincial budget relies on land transfers (leases below cost, sales tax, spec sales).
3. the capacity of local officials to single-handedly transform the value of land by re-allocating land from “rural” (whereby rural land can only accrue value from 30-year leases) to “industrial” or “residential” (where 70-year ‘lease’ is possible).

Urban Development Investment Corporations or UDICs (城市发展投资公司) and other many similar entities (6600 of them nationwide) have been structured to bypass the inability of municipalities to sell bonds directly. The existing products often showcase a glaring mismatch between maturity and revenue generation. However, UDIC bonds (and infrastructure loans) do not have principal payments until years after the communist officials in charge of the province are long gone. Meanwhile, the interest payments are being satisfied with land sale proceeds. Today, the system is saddled with an estimated $RMB11tr (or nearly $2tr) of debt, representing some 42% of China’s GDP. The system’s cheerleaders tend to profess high level of comfort with this number (given the value of assets potentially offsetting this burden), conveniently forgetting that under conditions of uncertainty, the duration of a financial institution’s liabilities shortens and the duration of its assets lengthens.

This process of forced urbanization, embedded in this institutional framework does not affect commodity markets in which China functions as a significant primary producer, e.g. zinc with its global surplus of 256kt this year. But it certainly does matter for iron ore, where the problem is compounded by the dropping exports from India, as illustrated by the recent political and legal wrangle in Karnataka and Orissa. China’s iron ore reserves are of low quality and despite $1bn annual exploration spending, the aggregate reserve depletion is among the fastest on the planet. Looking at the data from US Geological Survey, the 60mt per month importer may run out of domestic sources of iron ore within 9 years.

This is a linear, finite view of the emerging market commodity phenomenon, but cyclicality and seasonality are of equal importance.

SEASONALITY

Since most humans evolve in a climate characterized by regular changes – four seasons in temperate climates, dry and wet seasons in the tropics, near permanent darkness and midnight sun in the Arctic – most of us also come to expect some form of recurrent patterns. Some traditions have even injected such hopes into religious thinking, thus avoiding the eschatological destiny of much of the Western heritage. By the virtue of climate, tradition AND the related credit subcycles, seasonality imposed by the emerging markets has begun to trump such well-respected recurrent references as the US driving season, European winter heating season, US hurricane season or sometimes even northern hemisphere corn planting season. In fact, as we could observe in the last several years, the industrial metal demand dances around the Chinese credit cycle.



The Chinese credit market is directed with an annual, rather than Japanese fiscal or Australian calendar. As the state owned banks have, by government fiat, guaranteed 3% spread loan/savings rate ratio on some $2 trillion worth of savings, they are keen to open their loan books as early as possible after the beginning of the calendar year and earn maximum interest within the official quotas permitted by the regulators for that particular year. Much of that credit goes to builders, contractors and manufacturers. But a lot of this lands with legal, quasi-legal and illegal underground lending system, starting with the commonly tolerated Minjian Jiedai 民间借贷 – or “civil borrowing”, through mutual assistance societies Huzhuhui (互助会), all the way to subterranean loan sharks Gaolidai (高利贷), who would later use this liquidity throughout the year at interest rates we can only remember from Vito Corleone movies.

As a result, the builders are in a position to contract new projects and the commodity import machine is set in motion, with the concomitant impact on the seasonality in China’s current account. Every year, depending on when exactly the Spring Festival falls, sometime between February and April it becomes fashionable for a wave of Western analysts (and some politicians) to express a collective sigh of relief that “Chinese surplus is shrinking and the problem of undervalued renminbi will soon go away”. Consequently, it would be highly improper, impertinent and uncivil of us to dub the Chinese government as a “currency manipulator”. And so it goes. China continues to intervene in forex markets at $1.4bn a day, and Chinese trade surplus is indeed shrinking (from $295bn in 2008 to $183bn last year), but not necessarily in terms of bilateral exchanges with the US as our soybeans exports (even coupled this year with our corn exports) prove insufficient to quench Chinese thirst for inputs, much of which remains very seasonal.

NO PERPETUM MOBILE

The law of structural dynamics means that every self-reinforcing loop will eventually encounter sufficient constraints to slow down the process. Such constraints are already present in the Chinese economy. Robert Mundell was right. If you do not want to realign your prices in relative terms through exchange rate, you will sooner or later pay for this with real price adjustment. This is exactly what happened in China with 87% increase in M2 over the last three years. It is now frequently quoted that this is a country with a third of US GDP and a monetary mass 30% higher than the US. I find it intriguing to compare China of today not with the US of today, but with the Nixon era. The 1970s show how long the lag could be between the M2 avalanche and the onset of inflation.



However, too many of us get carried away by this obsession with inflation and commodities. Not even gold, a financial product par excellence, is perfectly correlated with inflation. Others argue that the value of gold is simply a mirror image of the trade-weighted dollar, but this conveniently dismisses the fact that most other currencies are also losing their purchasing power, not in terms of CPI-related indexes, but in terms of their capacity to acquire assets. As real buying of gold occurs also outside of the USD currency zones, gold represents a useful yardstick of value for all of those currencies, not just the dollar.

No, where gold truly reacts against the extremes, it is in terms of how we connect future and present prices. And we do it via interest rates, in real terms. Gold perfoms well when the expectations become entrenched that real yields will crawl in the gutter for a while. The main exception is the period 1994-95, marked by a Greenspan interest rate hike that panicked the bond market.

FUTURES

Let us move now to the impact on the futures market. Here too, the institutional framework in the emerging markets, and particularly in China is actively shaping the global marketplace.



A critical juncture came in 2008, when the ultra-capital intensive system designed by the Chinese Communist Party and described above was severely tested and then further enhanced. Half a decade into the fixed asset investment binge that made China a linchpin for all the commodity markets with the exception of oil, the 800 pound gorilla trader was still sitting on a 19th trading infrastructure. As China slowly integrated into the world economy, the letter of credit (LOC) system remained key element in its dealings with overseas trade partners. The growth was extraordinary. By 2007, almost 70% of China’s exports were financed with LOCs. But on the import side, so vital for supplying China with raw materials, letters of credit were practically the only avenue for trade financing. It is understandable (at least for sinologists) that pre-payment schemes are not very “Chinese” culturally speaking, but Beijing failed to develop alternatives to the LOC system, which are necessary to keep the trade flowing during periods of credit stress. Factoring could have been one way to deal with the issue. It is astounding that in an economy of 1.3 billion people, the Chinese government issued only two import factoring licenses over the 30 years of reforms.

As many remember, the sudden collapse of China’s LOC system in late 2008 led to a catastrophic slump in most commodity prices. One day I could be sitting with a CFO of a mid-size Australian iron ore company, who professed his confidence in the future, and the next day his panamax vessels were floating idly in Southwest Pacific in search of a willing customer. What did this lesson mean for the buyers? Do not trust the flows, trust only the stocks. So a quarter of a century after the Just in Time system thinned out the value chains, upstream commodity business went in the opposite direction as if we were all in perpetual preparation for a war or, at the very least, for a collision with a large asteroid. China’s Strategic Reserve Bureau began its frenetic buying spree: becoming the world's top importer of copper, soybeans, iron ore, cotton and natural rubber and among the largest buyers of coal, vegetable oil, sugar and potash. Importantly, this hoarding behavior coincided with record low interest rates globally, and it was no different in China.

Two years into the great credit-lubricated party, inflation expectations had become so pervasive that multiple increases in reserve requirement ratios proved insufficient to cool the economy. In October 2010 China officially entered the “tightening mode”. On that day, commodities blipped, but nobody remembers that. By the second hike in December 2010, the commodity market shrugged it off completely. Although some argue that any increase in domestic interest rate exposes its central bank to sterilization losses, the PBOC is not really an independent policy bank. Rather, it is a ministry subjected to the decisions of the State Council, where so-called “stability” is paramount and the commercial considerations secondary. Yet this is a ‘stability’ where food price inflation is in double digits and rents in Beijing shoot up 100% yoy. Someone got scared and the screw had to be tightened.

For the rest of us, the story that has unfolded since then is one of copper.

In January this year a friend announced to me: “this year I am going to short gold and go long copper”. I asked ‘why would you do that?’. Well, “gold is a bubble, but copper has real demand, Chinese really buy it”. I asked: do you know what they do with this when they buy it? He was not interested: “supply and demand”.

In fact, all we usually know about demand in China is the so-called “apparent demand”, i.e. production plus net imports plus/minus changes in Shanghai exchange stocks. When in 2009, Chinese net imports rocketed from 1.360 million to 3.112 million tonnes, it was hard not to see the hidden hand of hoarders: legitimate commercial restocking, strategic moves by SRB, and speculative stockpiling. Conversely, strong end-use and low apparent demand in 2010 pointed to destocking.

By comparison, what has happened since the tightening of interest rates at the end of 2010? Since then, Chinese copper importers have become… bankers. Unfortunately for my buddy the investor, they did not import copper to consume it. And the difference matters. They exploited the system to obtain – and provide - renminbi.

With new official loans in the first five months of this year falling 12% to 3.55 trillion renminbi ($549 billion), it was only a matter of time till the loophole was filled with typically Chinese ingenuity. Already in 2010, letters of credit issued by Hong Kong-listed Chinese banks jumped 70 percent, faster than the nation’s overall trade growth of about 25 percent.

It is useful to review the cat and mouse game between the importers and the regulators and to see what the impact on copper market has been, especially in Asia.

Companies could apply for a 90-day or a six-month dollar-denominated letter of credit to import refined copper, but not really to consume it. The only price was a requirement to put down 20 percent of the value of the imports as a deposit to the bank for the LOCs.

First, copper was imported into China by speculative investors for resale in China. They would sell the metal domestically once it arrived and lend out the earned (renminbi) cash at higher (unofficial) rates before repaying the letter of credit at maturity.

However, because Chinese copper prices have maintained discounts (up to nearly $200/t) to the London Metal Exchange prices since 2010, it forced the speculators to put contracted imports into bonded warehouses, most of which are located in Shanghai area. By March 2011 this shadow stockpile reached a reported 1mt. From here on, there were two ways to obtain renminbi. Investors could either:
1. use the bonded inventory to borrow collateralized loans at 90% or even 100% of the stored material and most frequently re-lend this capital at higher interest rates, or
2. re-export the copper.

Why would re-exports be of interest to investors? First, remember that in an economy with the closed capital account, exporters have to exchange their dollar inflows into renminbi. Secondly, following some successful lobbying by importers, the regulators scrapped the rule whereby these stocks had to pay 17% VAT in order to be re-exported.

However, last April, the Chinese authorities tightened rules on repatriating foreign currency from re-exports. Now, the Chinese firms were required to leave such foreign currency earnings in pending accounts and were not allowed to convert them into renminbi until they received receipts of import payments and re-export incomes. Financial intermediaries also had to cut their advance payments from foreign importers and delayed payments to exporters to 20 percent of the total foreign exchange they sold or bought over the past year. That naturally affected all those who carried several outstanding letters of credit at the same time.
But the demand for renminbi credit continued to outstrip the official lending quotas and the cat-and-mouse game continued. Enter offshore renminbi. To much fanfare, some 20 months ago Beijing had opened up Hong Kong as an offshore venue for investors willing to gain access to renminbi-denominated assets, allowing foreign companies and banks to raise funds in Chinese currency for cross-border trade and investment. Some 67,000 Chinese companies were allowed to participate in the offshore renminbi business. Now, investors trying to resell their bonded copper overseas began to ask foreign buyers to settle trades in the “offshore” renminbi (CNH), remitted from offshore banks in Hong Kong. This summer, however, PBOC moved to tighten the screws on offshore trading and notice No. 145 stressed that the onshore market had not been liberalized and the capital account remained closed. Widespread CNH selling has intensified since and continues to date (late September 2011).

More importantly for the copper market, it soon became possible to deliver the material from the bonded warehouses against Shanghai Futures Exchange contracts. Previously, imports were subject to VAT payments in advance of the delivery against exchange contracts. There are two consequences of this change. First, it removed one hurdle to trading the arbitrage between the Shanghai bourse and the London Metal Exchange. Secondly, in case backwardation appeared in Shanghai, you could now deliver physical against it. For futures traders it could be a way for the shorts to cover their exposure, instead of buying back shorts. The outcome would be reduced volatility.

What does this opening mean for the copper curve? A copper-collateralized loan costs an importer 6 to 8 percent, but the renminbi obtained this way is then re-lent in the “underground” market at rates 3x that much! What is the significance of this? It’s an alchemist’s dream. We turn copper into gold.

One of the reasons why the cost of borrowing base metals, such as copper were generally higher than prevailing interest rates (i.e. µ<λ) was that unlike gold, they usually responded strongly to physical supply-and demand fundamentals. When demand was strong, inventories were depleted and the metal came at premium, putting an even greater upward pressure on prices. As the metal prices rose, the lease rates rose as well in response to the scarcity of the metal. Similarly, when the demand was weak, inventories would build up, making the metal more abundant and pushing prices lower. Not surprisingly, high lease rates were associated with high spot prices and low lease rates with low prices.

However, as long as µ>λ there is an implied rate of return (interest rate less lending rate) on holding the metal. Gold usually provided such an implied rate of return, but base metals did not. Global gold inventory does not matter because the metal is plentiful. In fact, this is how Indian jewelers finance their gold inventory, through gold lease rates, thus avoiding currency risk. And even though gold lease rates generally have a negative correlation with spot prices, the calculated base rates do not ultimately matter.

Gold may have been in contango since Lucy left Olduvai Gorge, but in the case of Chinese copper, if 民间借贷 or 互助会 interest rates remain above the LOC interest rates, then we end up with gold-like characteristics:



Not surprisingly, contango appeared in Shanghai despite all we know about the tightness of copper concentrate, labor activism in Chile, winters in Atacama desert, strikes at Grasberg, low TC/RCs and high merchant premia. This contango would be here to stay, if the futures market in Shanghai was not so jittery about the maze of potential regulatory changes concerning:
• LOCs deposit, interest rates and associated currency exchanges
• offshore renminbi repatriation
• bonded warehouse taxing

Indeed, State Administration of Foreign Exchange has introduced rules to make it harder to use the metal as collateral and in late August People’s Bank of China required banks to place a part of the original collateral held against LOC in low yielding reserve accounts, instead of using it to make further loans. That means that it is going to become more expensive to issue the LOC.

Interestingly enough, the dearth of renminbi credit led not only Chinese investors and merchants to use dollar-denominated LOCs. Even Chinese producers of semi-finished copper products have begun to use letters of credit to purchase USD-priced bonded copper in Shanghai, rather than in the CNY-denominated spot market, for which they do not have cash. Bonded metal in Shanghai can be delivered to buyers in two days after stock owners pay the VAT. Banks in Jiangsu and Zhejiang have been advised not to issue LOCs to purchase bonded copper from Shanghai warehouses, arguing that these only applied to imports and not to the metal already stored in the country. But local banks would continue to provide credits if their bonded copper purchases are resold in the domestic market, rather than re-exported.

Assuming the symmetry in terms of CNY/USD preference, the above pyramid build on copper (or soybeans, or any other) collateral could potentially crumble the moment capital flees towards USD, as it is commonly the case during the episodes of global liquidity stress. This could explain some of the vicious Chinese selling of metals (including copper) throughout most of last week. But more ominous signs could be just around the corner. There are reports of letters of credit refused for imports. The sensitivity of Chinese trade to global credit woes has not diminished.

FINAL WORD

It is time we abandoned the dream that global markets, including financial markets, will somehow lead to homogenization of the world exchanges. Capital and goods move freely precisely BECAUSE of differences between localities, their institutions and their cultures. It’s Asia’s fears that drive its demand for gold, its quest for liquidity and fresh credit or the taste for the control of the physical inventory.

At a conference in Oxford 10 days ago someone was stunned that a decade of global growth delivered a zero return in the US stock market. I find this tunnel vision baffling. It is irrational to expect that Asians would put their wealth in pension funds which, in turn, will efficiently allocate capital to underpriced US stocks. What do we know about their economic behavior, obsession with land ownership, real asset control, inter-generational wealth transfers, seasonal consumption patterns and underground lending structures indicates that commodities, thanks to their fungibility, still remain the best bet we have in the public markets to participate somehow in the waves triggered by China’s and India’s fears.

GREENSPAN 'MADE A MISTAKE', BUT CHINA IS CREATING ONE NOW

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.

URBANIZATION WITH CHINESE CHARACTERISTICS
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.



URBAN GORILLA
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.



REAL ESTATE MARKET
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.



BANKING
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).



DEBT AVERSION LIMITS THE BUBBLE’S TOXICITY
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.

BEGGAR THY BARBARIAN

CHINA AND THE WORLD IN CRISIS
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.

THE END OF THE CHINESE BUBBLE
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).



HOW DO WE KNOW THAT CHINA IS SLOWING?
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.



HOW IS IT POSSIBLE THAT THE WORLD IS CHANGING ITS VIEW ON CHINA SO QUICKLY?
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?



NOT ONLY CHINESE PROBLEM
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”.



CERTAIN THINGS NEVER CHANGE
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.



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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.

CHINA: AFTER THE PARTY

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.



END OF LABOR ARBITRAGE MODEL
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 MIDDLE CLASS
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.

IRRATIONAL OPTIMISM
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.

CHINESE NATIONALISM. THE TIMES OF GLORY (part 6)

"China has stood up"
Mao Tse Tung (Chinese dictator and poet)

Last night, during the opening ceremony of the Olymipic Games in BJ, China stood up many times. And then it crouched. And then it stood up again. The martial order of the show was somewhat intimidating in size, but this must have been more than an artistic accident. And so, the symbolic cheap Chinese labor kept standing up and kept crouching in celebration of 2008 years since the birth of Jesus Christ, you would naturally be forced to think. There were 2008 stood-uppers and 2008 crouchers, 2008 dancers and 2008 tai-chi masters in white pajamas. Christians around the world can be proud of China’s final acknowledgment of the superiority of Christian tradition and Christian calendar. Because for the revolutionary China it is barely 60 years of recurrent ups and downs.

A friend of mine who lives in one stunningly beautiful corner of Europe has recently complained to me. “Why all the focus on China’s human rights, all this menace spewed from the media? It’s enough. It’s not nearly as threatening as al-Qaeda, is it?”

I suppose that as of recent the Western media have, indeed, been saturated with alarming images from both seasoned and overnight “China experts”. The reason is simple. With the (telling) exception of Tibet, foreign journalists are, temporarily, allowed to travel outside Beijing and engage in interviews with the local people. This is an exciting prospect, given that just about all the people that the regime wanted to remove from the capital have, indeed, been sent away. Some of them are, apparently, holed up in ‘re-education camps’ and therefore not accessible at all. But the very concept of freedom to explore the ‘other’ China without a special permit must be thrilling for Chinese speaking foreign journalists. But don’t you worry – the special permits will be introduced back again once the Olympic gala is over. Hence the sudden media focus on the brutal and self-destructive aspects of China’s changes. Some of the testimonies from the locals are revelatory, as for example one registered by an FT journalist yesterday: “China has been invaded and bullied by you too much. Much of our wealth was robbed by Americans and Japanese (…). We Chinese are very friendly”.

Still, the question whether rabid nationalism numbering hundreds of millions of souls in the Far East is more, or less ‘dangerous’ than religious nihilism of 10’000 potential terrorists with their ideological roots in the Middle East is an intriguing one.



Since 2001, the Western world has been obsessed with the terrorist threat emanating from the Middle East and in particular the Manichean branch of aggressive neo-Wahhabism. Large boreal and eucalyptus forests have been chopped down to exhibit, on paper, various putative hypotheses for the rise of religious extremism in the Muslim world. Less space has been devoted to equally bigoted, though arguably less immediately destructive rise of fanaticist Christian, Hindu or Judaic movements and to their political influence. In direct or indirect consequence of their ‘preachings’, lobbying and communal activism, much destruction has been wrought on innocent populations of Iraq, Gujarat or West Bank. Muslims, rather than Islamist terrorists, have often become the victims of these tragic spillovers. But nearly seven years since the telegenic drama between West Street and Church Street of Downtown Manhattan, it is the Muslims who have born the brunt of murderous actions spurred by pseudo-religious indoctrination, which had laced this monotheistic creed with alien theses of Evil Incarnate and perverted versions of Jihad.

This is not to say that the extremist Sunni no longer pose a threat to the world peace. The drift in Iraq and Guantanamo has certainly contributed to the rise a new generation susceptible to fall under the spell of eschatological fanaticism. John Cloonan, an FBI expert recently confirmed in his testimony to the US Congress that a catastrophic ‘revenge’ against the US was, in fact, “coming”.

Terrorist threats do not exhaust the litany of fundamental cultural, behavioral and economic differences between the theocentric Muslim and secularized Western societies. And, with oil prices remaining stubbornly above $100 per barrel, it is very possible that the Middle Eastern wealth will allow the rulers to marry their non-Western lifestyles and dress codes with ultra-modern, if superficial, urbanism and addiction to luxury.

In which, they will eventually join the Chinese exceptionalism.

Whether the Middle Eastern countries mount a geo-strategic challenge to the Western set of values – spelled out in the sacrosanct rule of law, free flow of information, freedom of association, self-determination and electoral or direct democracy – will depend on how adept they are at pushing the button of self-victimhood. Defining their collective identity in terms of “rights” inherited from the suffering of previous generations does little more than feed a sense of grievance and appetite for revenge. But it blocks successfully the attractiveness of the “values” as defined above.

One can shrug off small nations’ claims to real or imaginary past of persecution. But when large nations or former empires fall victim to such destructive propaganda, the world should listen. When Soviet Union was falling apart in 1991, a Moscovite I knew tried hard to rationalize what Mr Putin later famously labeled as the “greatest catastrophe of the 20th century”. Galina stuck to her conviction that the empire continued to exist in the imaginary borders of Stalin’s expansionism. Painstakingly, she went to great lengths trying to explain to me that there were still no borders between Russia and Kazkakhstan or between Russia and Ukraine. And indeed, Ukraine was, in her words, but a borderland, a nation on the fringe of the great Mother Russia, not a separate nation.



Lack of political will to redefine Russia’s place on the world’s map from a neo-imperialistic entity jealous of its “spheres of influence” into a modern nation embedded within a functioning network of partnerships is, as I am writing this, beginning to claim lives in what is quickly becoming the first international military conflict in Europe since 1945. Despite a complex ethnic and political situation in South Ossetia, the Russian Goliath should not expect much sympathy from the West, nor will it receive any from Postjudice.

Russian intervention in Georgia illustrates that the cherished illusions of national victimhood and imperial nostalgia bring little more than human tragedies. The affluent West has learned this lesson - from the Dutch obstructionism in Indonesia to the French brutality in Algeria. But contrary to the claims of anti-Orientalists and their left-wing aficionados, imperialism has not been an exclusively Western phenomenon. What has kept the Russian and Chinese imperialism different and in many ways more durable was their unwillingness or incapacity to project seaborne military power. Instead, the Russians and Chinese states forcefully co-opted and then populated the vast swaths inhabited by very distinct populations. In both cases, they could not help looking down on the exotic populace, labelling the locals, respectively, as inorodtsy (“those born different”) or yemanren (“the wild ones”). With a sense of racial and cultural superiority, actual military might and an economic surplus that facilitated extraordinary fertility of the dominant ethnic group, Russian and Chinese states crawled outward and remained more resilient than any of the “colonial” empires built by the Western nations. The so-called Russian Far East – the only part of East Asia durably colonized by the white man, and the Chinese rule in Turkic and Tibetan parts of Central Asia are the main remnants of that past expansionism, long ripe for an overdue historical correction.

The danger that my European friend severely underestimates is that the last sentence of the previous paragraph will generate an instant reaction in the arteries of a nationalistic Russian or Chinese reader. His or her adrenal glands, located just above the ‘Chinese’ or ‘Russian’ kidneys will have instantly released hormones into the bloodstream, potentially deregulating the bodily electrolyte balance. Their limbic system, which originally evolved to evaluate smells, will have been activated and their indoctrinated minds will create an absurd wall of emotional rejection. “It is ours!”, exclaimed angrily a Korean friend of mine a decade ago, referring to a disputed rocky outcrop somewhere between Korea and Japan. “Tibet is part of China”. “Crimea is part of Russia”. The imaginary walls of nationhood flare up easily, but are doused with utmost difficulty.

Self-victimhood, nationalist nostalgia and theories of humiliation are historically selective and have to overcome many contradictory historical facts and counterfacts. This is true of nationalisms everywhere. Many Israelis prefer to claim that the first two Aliyas brought their ancestors to what was then an “empty” land. Hindutva nationalists would selectively extend the historicity of their claims beyond the Vedic culture into the Indus Valley’s pre-history, even though it bears no relation to the Sanskritic heritage and defies the claims to indigenous sufficiency of the “Hindu” culture. Serbian leaders plunged their subjects into a national tragedy by trying to overcome the contradiction between the populist claims (Serbia is where Serbs live, e.g. Bosnia) with historical grievances (Serbia is where Serbia once historically was, e.g. Kosovo). Interestingly, all these nationalists emote for the past humiliations and the officialdom often glorifies them. Serbs actually lost the much celebrated battle of Kosovo in 1389. Russians celebrate the overthrow of “Latin” (i.e. Polish) rule in Moscow – an episode (1610-1612) virtually unknown elsewhere and hardly meaningful in light of the horrors that Russian and Soviet expansionism wrought on various nations of Europe, Caucasus and Asia in the following centuries. And in China, there is even a special National Humiliation Day, not yet explicitly referring to any specific failure, with some hesitation between commemorating the Opium War (1840-42) and Japan’s invasion of Manchuria in 1931.



Since the Tienanmen massacre, revanchist nationalism has been the Chinese Communists’ favorite bulwark against the insidious influence of Western values. Young Chinese are now more aware of the historic “humiliations” and are quick to list a myriad of grievances encapsulated in the self-serving term bainian guochi (“100 years of national humiliation”). Anything that does not conform to the nationalist dogmatism will “hurt the feelings of the Chinese people” – be it a foreign movie, a comment by a foreign newscaster, an athlete wearing a protective mask in Beijing, a company employing a film star critical of China's support for the Sudanese regime. This thirst for respect is open-ended as so are the continued demands for expressions of guilt. Both desires can never be fully satisfied and are easily frustrated. The paranoia over China’s “rightful place” cannot be easily reversed. Regrettably, historic parallels indicate that there are only two ways out of this cul de sac – large scale re-education or a national calamity. The former is impractical for the current regime and could undermine its own position. The latter is simply too apocalyptic to muse on it here.

Both groups - Chinese nationalists, who suffer from this unattainable aspiration to superiority, and poor madrassa kids, whose intellectual horizon will be confined to Qur’an, Hadith and Sirah, remain inherently insecure in their own self-image. Both groups are oversensitive to any semblance of slight and are prone to overreaction. Their ultimate goals may be diametrically opposed – hyper-materialist in one case, escapist in the other. But the relative success of both is steadily eroding the outreach and influence of the “Western” values, generating a genuine dilemma for the decision makers of the free world. Especially for those decision-makers who see beyond their immediate commercial interest and have decided not to sweat like pigs in 90 degrees Fahrenheit among the stands of an otherwise grandiose Beijing stadium.