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.

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