Four Commentaries from Trip to China

Author: David Kotok, Post Date: November 20, 2007
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Report From Beijing November 6, 2007

It’s early Tuesday morning here and 13 hours ahead of east coast time. The blackberry connection is perfect so we are current on email, telephone messages and have digested the news from Citi and Google. We’ve absorbed Federal Reserve Governor Mishkin’s speech.

The contrasts in Beijing are remarkable. We see that easily when we walk through the vastness of the Forbidden City and absorb its centuries of history of emperors and concubines. Leaving Tiananmen Square and Chairman Mao’s tomb, our eyes see construction cranes and rising buildings in every direction. This place is booming.

Sadly, we note that we cannot experience the full visual effect. The air pollution is so thick you can almost cut it with a knife. The visual side of this city is impaired by this massive, irritating, toxic cloud.

I recall flying into Sao Paolo, Brazil, like Beijing, a city of 20 million people. From the plane in Sao Paolo one sees this mass of urban, modern construction. In Beijing, one can only see it a few long blocks at a time. It’s here. It’s massive. But like the sun which is blocked by the pollution cloud, your visual experience is impaired.

“The smog is awful” said one of my colleagues. Smog is a mixture of man-made polluting smoke and naturally occurring fog; Beijing is not San Francisco. There is no fog component. All this airborne gunk which irritates your eyes and cancerfies your lungs is a by-product of China’s economic growth.

“Chinese like to do things at their own pace” said a central banker. He explained why the People’s Bank of China proceeds with gradualism when implementing changes.

It is hard to grasp an understanding of this Chinese need for gradualism when sitting behind your desk in the United States. It’s more easily understood once you are here. China is not about to be pushed by American protectionist threats impacting trade or by central banker cajolery impacting monetary policy. The sooner we accept that notion the faster we westerners will succeed in negotiations about globalization and China’s role in the new world economic order.

China has four times the population of the United States and one-sixth the number of automobiles. China is absorbing 15 million transplants from rural to urban labor force in each and every year. China’s fledgling stock exchange and evolving monetary policy must be viewed in the same way one would observe teenagers. Likewise, there is a cultural divide which also requires the westerner to be thoughtful and tolerant. One needs great patience in China.

One specific item is intriguing. The Hong Kong dollar is pegged by the Hong Kong monetary authority at a 1 to 1 ratio with the U.S. dollar. The Mainland Chinese currency, the Yuan, is managed by the government and has been gradually strengthening against the U.S. dollar which means it has also been strengthening against the Hong Kong dollar.

Everyone affirms the ongoing Hong Kong dollar peg. Every official articulates the “one country, two systems” approach to the Hong Kong versus Mainland financial structure. The bond market does not believe them. Today, the ten-year U.S. treasury yielded 4.3 percent at the same time the ten-year Hong Kong government bond yielded 3.7 percent. This pricing implies that the Hong Kong – U.S. dollar peg will break in the next few years.

The bond market is pricing that restructuring sometime after the 2008 Olympics have become history.

This Chinese boom is permanent. We need to be thinking about this emerging market economy as an awakening modern giant and not a throwback to the earlier dynasties that inhabited the Forbidden City.

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The Great Wall, November 7, 2007

“They got a wall in China. It’s a thousand miles long. To keep out the foreigners, they made it strong”. Paul Simon.

Thighs burn. These are steep steps and there are so many. 60 years after reading about it in a kindergarten book, the Great Wall looms before me.

We climb onward and upward. Pause. The pulse is high. More pause. The breathe returns. Resume upward. It feels so exciting to climb this ancient and mysterious fortification. Pause again. Look at the foliage in these mountains. Strange trees with bright yellow and red leaves beckon the eyes. Resume upward. “We’ll go as far as that outcropping station and stop.”

Whew! We’re here. No morning mountain chill now. Coats are open; scarves off. Pictures must be taken quickly. We must remember to get back to the bus on time and not keep the others waiting. Now down: different than up but dangerous if you slip on the steep and well worn steps. “Careful! Hold onto the rail.”

Even here the pollution cloud partially blocks the sun. Beijing’s aerial assault on the planet carries to these mountains 50 miles from the center of the city. “How wondrous this would be if the air were clear” I thought. We leave this restored antiquity and contemplate a magnificent ancient barrier and what message can it offer us on this marvelous experiential day.

Walls don’t work.

Modern Chinese know that this great edifice didn’t protect a culture and an Emperor. Walls crumble when forces are destined to breach them. Westerners learned this lesson as children from the story of biblical Joshua. Europeans saw that in Berlin. Walls don’t work. The West and the East could both learn from their history with walls.

But we human dummies still build them. Sometimes on the Rio Grande River. Other times when we are swimming in the economic pool. Another wall exists here; this one is in trade.

Guangdong province announced today that it will officially support any Chinese toy manufacturer wishing to sue Mattel for damages from the lead paint recall. Why do this now? President Bush’s task force is announcing its findings and this distraction is designed to make the Chinese manufacturers stronger when facing US actions. China wants to draw attention away from its problems with internal governance. The US wants agencies like the Food and Drug Administration to announce recalls and warnings at will and to have US inspectors in Chinese facilities.

Beijing is using a media wall. It won’t work. Beijing wants all actions negotiated. It is not going to happen when it comes to product safety and the US. This wall will fall. The risk is backlash. That will fuel the protectionist wall that America’s political fools are building.

There is a financial wall.

“One country, two systems” is the phrase that describes the status of Hong Kong. Maybe so, but only as long as it serves Beijing’s purposes. Remember: This is all sovereign China now. Longing for British colonial status serves no useful purpose.

Beijing faces an issue of huge proportions. Millions of newly successful younger people have savings that found their way into the Mainland stock exchanges. Now these stocks are 50 or 60 times earnings and carry a negative equity risk premium. There is a bubble in progress.

Beijing knows the problem. I was able to clearly affirm that in private meetings. They do not have a solution. They believe that they may be able to find one but in reality they are floundering. They want to shove the problem behind a wall. This time it is a financial wall.

One approach was to form Qualified Domestic Institutional Investor funds (QDII) so that Mainland Chinese could direct their investment monies into vehicles which would allow them to invest outside China’s borders. Hong Kong was planned to be the first outlet. When that was announced the HK market took off like a rocket and moved up by 50% in ten weeks. Global investors poured money into HK in anticipation of Mainland funds following them and bidding up prices in HK to the same lofty levels as exist in Shanghai and Shenzhen. The HK authorities are worried about volatility so they prevailed on Beijing to postpone the transfer of investment funds. That triggered this week’s sell off in HK.

Now the QDII are sitting with billions of US dollars. They await the opportunity to move and are stymied by this delay. They are a financial force and will eventually breach this wall.

In my conversations here it becomes clear that the both the HK market and the Mainland market are now driven by more than fundamentals. These valuations defy normal methodology. They are a result of intense liquidity driven momentum. Officials know it.

The skilled economists and advisers to the government in Beijing don’t know what to do. They will listen to the arguments for opening markets and easing the pressure. They understand the need for action before it gets worse. At decision time they weaken and resort to gradualism and risk aversion when making a decision. The risk they wish to avert is the political upheaval that may occur if millions of fledgling and inexperienced investors suddenly face large losses.

That could happen once the wall with Hong Kong comes down and the arbitrage between these two markets closes to some level. No one knows where that level will be but it could result in a sell off once the issue of valuation returns to the investment decision making process.

But will Beijing act? Or will they wait and watch until the forces that will ultimately break down that wall reach the threshold where they overwhelm it? This is a Chinese puzzle.

The Emperor’s Great Walls didn’t work. Neither will the modern versions of financial walls or trade walls or political walls. This lesson is needed for Westerners and Easterners. In our globalized world, walls just don’t work.

I write this from Beijing on a borrowed computer while my Cumberland associates sleep in the US. Today’s lunch was with travel colleagues in a shopping mall nearby. It teemed with young and affluent Chinese who are enjoying the fruits of this extraordinary experiment in opening an economy. They are the new global stakeholders. Believe me. They don’t want war and they don’t want walls.

Now we must go for a much needed, jet lagged induced afternoon rest and then shower and dress for a celebratory dinner at the Beijing’s famous Peking Duck house. Tomorrow we fly to Shanghai.

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From Shanghai to Yellow Mountain , November 11, 2007

China Mobile’s digital speed allows me to write this from the top of Yellow Mountain. (Google Huangshan Mountain). This is the site of filming “Crouching Tiger and Hidden Dragon.” Earth’s rotation will soon bring the mountain’s soft and fading sunlight to brighten America’s eastern shores.

There are many great gorges and peaks in the world. Metaphors like the Grand Canyon or Yosemite leap to one’s American mind. Here, the foliage adds a unique distinction. The ubiquitous Huangshan pine tree has ferreted out a piece of earth among the rocks and rooted its way into history and artistic beauty.

A cable car takes our group to the mountaintop hotel; the same place where the porters climb by foot. It’s eighty Yuan (about $11) for each of us to ride a round trip of 8 minutes each way. Wealth differential here is as large a chasm as the gorge.

Fifty Yuan is paid to the porter to climb up for 5 hours with a heavy load; three hours down when returning on the 8000 steps. This is considered a good job because a porter can earn the equivalent of about $150 a month and that is more than he can make as farmer. The government will not discount the cable car for the porters. Using the cable car would eliminate jobs and income in a country where the labor force grows by 15 million people a year.

For views of this mystical and misty spot see the movie and use the internet. I attest that what you view is true. Fortunately for us, today was sunny. There’s no pollution here; there’s only majesty and sereneness and a group of smiling Buddhist monks from Malaysia on a pilgrimage.

Now for some observations about Shanghai and markets.

China’s stock markets (including Hong Kong) have reached about 5% of total global stock market capitalization. In part that is due to the soaring markets in Shenzhen and Shanghai. Actually these markets are virtual. The trading floor of the Shanghai Stock Exchange has 1600 seats but the active pit is only about 100 persons. Like the floor of the New York Stock Exchange the digital world has replaced the bustle on the “floor.” Open outcry markets are consigned to history. Global investors who visualize China’s market as less than state-of-the-art technology are wrong.

But what about these stock prices. This market is about 50 times earnings. And many of the stocks that trade are minority portions in state owned companies. That said, the outlook for Shanghai is more likely to be up than down. My friend and an experienced China investor, Don Straszheim thinks 9000 is within reach on this index; it’s now about 5000.

When he and I met last for coffee in Philadelphia’s 30th Street Station between trains, I argued vigorously about valuations and bubble markets. I suggested that 50 P/E is a bubble. I still believe that some day it will be so. But for this moment Don is right and I admit error. This Mainland China stock market has an upside bias. There are clear reasons.

A first hand look here changes one’s view. I have now interviewed some Chinese investors and some business executives. They all own stocks. They all practice a personal allocation between their real estate, bank deposits and the Mainland “A” shares that only they can buy. They seem to have limited interest in going outside although some have put small amounts in the new Qualified Domestic Institutional Investment funds (QDII). When the government says okay, this fund will allow Chinese investors to place money outside the Mainland markets.

I asked each person about their sell discipline. The universal answer is “no.” They do not have one. They only buy. They reenter the market and add to positions on dips. I gleaned that something like a 30 to 35 P/E is believed to be attractive. At a 50 to 60 P/E they seem to hold back and wait. I could not find anyone other than day traders who were sellers. A typical allocation is about 2/3 in a bank deposit at interest and 1/3 stocks. Since these folks have a positive savings rate, the allocation to stocks is constantly growing in the current monetary construction.

Monetary policy is a fundamental reason why this booming economy will sustain what appears to be outrageous stock multiples. The reason is very low interest rates. Investors get less than the rate of inflation on their bank deposits. They are limited in the real estate they can own and they have only had the freedom to own any real estate for eight years. They use mortgages at 7% to buy household real estate that they believe will appreciate at large double-digit rates. This is all they know from personal experience.

As long as the Chinese central bank sustains this monetary stimulus, this economy will be able to grow at 10 or 11 or 12 percent per year. It will have some inflation but that is blunted by very high productivity gains achieved in conjunction with this huge and growing labor force.

Think of it this way. A 10% growth rate with 5% inflation would need to have a mid-teen rate of interest to normalize equilibrium at western standards. In China the government sponsored interest rate is less than half (7.29% on one year loans) and that is after 5 rate hikes this year.

Support for this conclusion is found in the few private lending transactions where a private consortium loan carries a rate of between 15% and 20%. Some of my economist colleagues and I debated this issue but we certainly respect that 15% is representative of an unregulated market and is likely to be close to an equilibrium rate for this economy.

Internal Chinese monetary stimulus is not the only cause of the stock market surge. Shanghai is also bulled by leakage from foreign sources. The border is porous even if the rules say no outsiders without a formal approval.

Consider that the Osaka Stock Exchange (OSE) has launched a Shanghai Index ETF. It consists of 50 stocks. The index is licensed by the Shanghai exchange to Nomura for this purpose. Nomura is a leading ETF sponsor in Japan and this ETF was designed for Japanese investors.

We have yet to find out how the index is arbitraged against the actual stock prices. The prospectus is in Japanese and the security is easily available only to Japanese investors. You need to go through a complex trust in order to buy it as an American. You can track it on Bloomberg on the OSE with number 1309. Note: in Japan they use numbers and not letters for their stock symbols.

The ETF was launched on October 23rd and rose the limit on the first day. It has attracted inflows of about 11 billion yen ($100 million) a week since it was launched. That was net new cash into Shanghai stocks or through derivatives that ended up in Shanghai stocks.

A key question we raised here is about the prospect of Japanese money flows into Chinese markets. This reallocation of assets is potentially huge. Japanese households are holding over 50% of their financial assets in bank and postal deposits. This was rational for them as long as they had deflation. Remember: the buying power of a zero interest rate deposit is rising when the price level is falling. Thus a Japanese investor added wealth by sitting in a zero interest rate cash account.

That is changing in Japan and now these investors will seek alternatives. China is a big one for them. With dollar weakness persisting they are not as attracted to the US. And they understand the nature of a rapidly growing Asian market. They had a similar experience within the last generation.

Japanese investors think there is some time before the China bubble implodes. That means they are an additional potential funding source for this rising China market. We need to watch Japan’s investment flows very carefully for guidance about how to proceed as US based investors.

More thoughts on Shanghai itself.

This 19 million people city is an extraordinary boom town. A night cruise on the Huang Pu River reveals it. Near the shoreline are the illuminated facades of last century and the colonial era. A beauty is the original 1921 building of the Hong Kong Shanghai Bank Corporation (HSBC in today’s world). Behind these edifices stand the skyline of a modern miracle. You think you are seeing a science fiction movie. There are 2900 buildings in this city over 20 stories tall. The architectural eye candy is bewildering. And construction cranes are everywhere.

The TV tower (a space odyssey) dominates a section where a refinery was once was planned. In 1993 the Chinese government wouldn’t let the refinery developers sell any of their production for domestic consumption. They required that everything be exported. Fortunately for the present city, the developers pulled out and left the undeveloped swamp. Now it is a megalopolis.

We could write for another hour but must stop now and watch the sunset colors bathe Yellow Mountain. We will be back in Shanghai tomorrow and then to Hong Kong for a client meeting and a visit with some bankers and investors. We fly 14 hours to Newark on Thursday and drag our jetlagged body to our desk on Friday.

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Hong Kong and Clarence Wong, November 13, 2007

I came to this computer from the “Fish Bar” restaurant on the 7th floor terrace of Hong Kong’s JW Marriott. Dinner was amid and surrounded by Hong Kong’s tall buildings and bright lights. Manager Clarence Wong is a gracious host; tell him I sent you.

6 sweet and succulent oysters (Belons from Australia) and a glass of White Haven (New Zealand) sauvignon blanc were followed by a good old fashioned American style cheeseburger (with yummy, crisp Yankee Doodle fries) washed down by a glass of Chilean Montes Alpha syrah. The latter wine is an old friend; the former, a new one and sure to be repeated if my American wine importer can get it).

The burger was delicious following a week of chop stick cuisine. I love Chinese food but really needed this respite and this globally assembled meal.

In this wonderful interconnected world, HK leaps out at you from the moment you ride across the new bridge while transiting between airport and city center. The city boils and sizzles with life among its 7 million sardinized citizens. Proximate living didn’t dampen the spirit here.

From this vantage point Hong Kong sits in the center of the Asian whirlwind. Will this last? Will the China miracle persist? What about the weak dollar?

We don’t like what we see in some of the world’s central banks.

China is fighting food price inflation by raising bank reserve requirements. Sorry, folks. That won’t work. The Beijing bosses fear civil unrest with good reason. Last weekend a Carrefour store offered a discount on cooking oil. The lines formed starting at 4 AM. When the door opened at 8, a stampede ensued; three people were killed; 31 injured. This time the Chinese press carried the story. They are learning that the internet has suppressed censorship. It also enables mobilizers of demonstrations.

But the Peoples Bank of China will not lower food prices with higher interest rates or larger bank reserve requirements. They need citizens’ incomes to rise so that growing numbers can get into a higher than subsistence standard. You don’t do that by trying to stifle growth.

In the rest of the world the central banks are fretting about the dollar. In Europe the European Central Bank (ECB) will talk about the currency but will allow the marketplace to function.

In the US the Treasury Secretary will talk about the US strong dollar and everyone else will laugh. Fortunately the Fed has not responded by raising interest rates. It cannot and should not and must not do so. The Fed is rightfully worried about a weakening US economy and a housing crisis. It probably will cut rates again.

The Bank of England has their hands full with the run on a bank and its aftermath and inflation above limits such that they cannot cut rates easily. BOE is between a Northern Rock and a hard place.

Japan is going to resist a yen breaking through 110. Hence Japanese rate increases are now on hold for a while. As soon as markets come to terms with this elongated Japanese policy the yen carry trade positioning will resume. This source of global leverage has not ended.

Other central banks are resisting the appreciation of their currencies by doing the dumbest of things. Columbia imposed a penalty on those who brought foreign inflows into their country. They wanted to stem the rise of their currency against the dollar. Instead they socked their own stock market as trading volume declined by 27%. India suffered a loss when it imposed controls. History is replete with examples of failure when controls are used instead of allowing market adjustments.

Alan Greenspan used rate hikes in 1987 to defend the dollar and triggered the stock market crash. That is when America learned its lesson. Ben Bernanke will not repeat it. Foreigners should pay attention.

Global investors now need to be attentive to central bank and foreign government actions that impose controls and restrictions. Interest rates are not the only tool. This is an alternate to raising rates to defend a currency. The fact is that neither of these approaches will work. The loser is always the country that erects the barriers or imposes the higher costs instead of allowing the foreign exchange markets to adjust.

Monetary policy has two structures. The first is managing the tradeoff between inflation and growth. When growth is solid, the central bank fights inflation. When growth is weak, it first must address the weakness. If it persists in fighting inflation, it does so at its peril.

The other trade off is between functioning markets and moral hazard. When markets are clearing and liquid, the central bank can worry about the gambling instinct that encourages folks to ignore risks (the definition of moral hazard). When markets aren’t functioning the central bank must first get them liquid and orderly again.

In the US the Fed is dealing with only partially functioning markets. And it has a weakening economy. That is why Fed policy will remain easy regardless of the US dollar and foreign exchange rates. Other countries will be best served to leave this alone and allow their currencies to adjust.

It’s 10 o’clock in Hong Kong and time for me to get some sleep. Tomorrow we will intersperse meetings with a ferry ride to Kowloon and a trip up the tram for a peek from the peak.

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