While all eyes have been focused on Europe lately, China has quietly been falling apart. In a normal environment, I believe that much more attention would be focused on the looming banking and local government debt crisis in China. Fortunately for them, the train wreck that is Europe is too engrossing for financial markets to tear their eyes away. (By the way, the train went off the rails in Germany last week too. The denouement is at hand. Read this brief article for the summary).
Change "Life" in the next sentence to "China" and Shakespeare's Macbeth soliloquy (Act 5, Scene 5 for those that slept through 11th grade English) looks mighty fitting:
Life's [China's] but a walking shadow, a poor player
That struts and frets his hour upon the stage
And then is heard no more: it is a tale
Told by an idiot, full of sound and fury,
How can I say that one of the world's largest economies, the one that is going to replace America as the global growth engine, the one to which we are losing jobs and profits, the one that owns large amounts of our debt, and on and on, signifies nothing? It's actually quite simple – because the "Chinese Miracle" is based on tremendous amounts of bad loans made by state-controlled banks to state-controlled entities, usually run by politically connected members of the Communist Party's families or the People's Liberation Army (PLA). Those loans will not be paid back. The money that hasn't been siphoned off by the ruling parties families (read this extremely interesting article in the Wall Street Journal about the children of Party members driving Ferraris to pick up their dates and buying $32 million homes in Australia) has been invested in companies that have no return hurdles or expectations for return on capital – in fact, return OF capital itself will be a miracle. Why? Again, it's simple: Character, or lack thereof.
Put bluntly, the Chinese as a whole, as a country, lack character. For those that don't "get" the Chinese moral code, read this article on a recent event in China in which a little 2 year old girl was hit by a truck and 18 people simply walked by and did nothing, leaving her bleeding in the street. If you can stomach it, watch the video, but it's heart-wrenching. The levels of fraud, lying, and stealing that occurs in China is mind-boggling to the western world, which presumes a certain level of trust and honesty in business dealings between strangers. Not so in China. Zinch China, a consulting company that advises American colleges and universities about China, last year published a report based on interviews with 250 Beijing high school students bound for the United States, their parents, and a dozen agents and admissions consultants. The company concluded that 90 percent of Chinese applicants submit false recommendations, 70 percent have other people write their personal essays, 50 percent have forged high school transcripts and 10 percent list academic awards and other achievements they did not receive. The "tide of application fraud," the report predicted, will likely only worsen as more students go to America.
Chinese companies are also, for the most part, morally bankrupt. They have no problem misdirecting government funds (via bank loans) to their cronies in the PLA and Communist Party. In countries that do not respect the rule of law and property rights, eventually foreign companies (some sooner than others) will refuse to invest there and will refuse to partner there. Right now the only way to operate a business in China is to partner with a local company (government owned) that will own a majority stake. The naïve business leaders you see smiling and shaking hands there today will quickly learn what apple growers in Washington State learned about 10 years ago: if you teach the Chinese how to make what you make, eventually they will undercut your prices and put you out of business. Chinese apples (granted, laced with pesticides) are now so much cheaper than Washington apples that the orchards that haven't already been ripped out are simply letting the fruit hang unpicked since the cost of harvesting them is more than they will realize in stores. This followed an "educational exchange" in which a delegation from China learned advanced apple farming techniques from the same orchardists they put out of business 5 years later. This naiveté has been repeated numerous times, from General Motors (GM) to Yahoo! (YHOO) to many others, who assumed that a "partnership" in China will somehow yield actual net cash long-term to the foreign partner. Once the intellectual property has been learned and copied, the foreign partner is squeezed out or the JV is left to fend for itself in the "free market" versus a "new" competitor. American companies seem to finally be catching on, as complaints about intellectual property theft are becoming more vociferous, but until they learn that doing business there is a lose-lose situation, they will continue to have their technology stolen and their products mimicked cheaply.
However, despite blatantly stealing intellectual property from all over the world, China is still apparently hitting the wall at home, and fairly quickly. According to Andy Lees at UBS (who usually has some very interesting data in his daily notes):
"We saw today that 80% of Chinese construction firms say developers are now behind on payments (late cash flow), and that consequently land purchases are already 42% down y/y (slowing local authority cash flow). We also heard that pricing controls means that utility companies no longer have the cash flow to afford vital imports. Q3 corporate cash flow was down 27%.
This decline is also despite massive amounts of money being lent by banks and local governments. According to an excellent Wall Street Journal article by Joseph Sternberg (click here for the full article):
The stimulus opened a credit floodgate that so far has proven impossible to turn off. "There is a misconception that it was only limited to six months," says Charlene Chu, an analyst at Fitch Ratings here and one of the few people outside the government who seems to understand what's going on at China's banks. "But in reality the credit boom lasted a full two years." Fitch estimates that new financing for 2011 will hit 17.5 trillion-18 trillion yuan ($2.7 trillion-$2.8 trillion), equivalent to 37% or more of China's GDP. Financing expanded by an amount equal to 42% of GDP in both 2009 and 2010.
As a proportion of the economy's size, "that's like having $6 trillion in new credit in one year in the U.S., but for two years running," Ms. Chu points out. "In most countries, when banks encounter a difficult economic environment they pull back credit. They've learned over time that you do not want to increase your exposure in a worsening environment. Here, they like to do the exact opposite."
Beijing essentially did what it has done all along—heavy investments in infrastructure and fixed assets—only more so. But the marginal returns on this strategy are rapidly diminishing. In 2006, one yuan in credit expansion yielded 0.76 yuan in GDP growth, according to Fitch. In 2007 and 2008, that one yuan of credit continued to create at least 0.70 yuan in growth. But in 2009, as the credit stimulus got under way in earnest, one yuan of new stimulus credit created a paltry 0.18 yuan in additional GDP. That has improved somewhat since then, but for 2011 one yuan of credit still is expected to create only 0.42 yuan in GDP.
Finally, the government of China is morally bankrupt. It exerts control over information through an extensive system of censorship and control of the state media. From Tiananmen Square to its recent problems with Google, the Party does not want a free and open flow of ideas. Where ideas cannot be openly stated and debated, creativity will die. Recently, after a period of (relative) openness in the 1980s, the Communist Party in China has begun cracking down on artistic freedoms and cultural expression again. For an interesting article on this from a Chinese professor at Claremont McKenna, click here. State control of information and capital allocation is not a recipe for long-term success, despite the laudatory words being heaped on China by our press. Buyer beware…
J.P. Morgan once famously said "A man I do not trust could not get money from me on all bonds in Christendom." Also, in testimony before a House committee that was investigating his economic dominance over America, J.P. Morgan was asked whether commercial credit was based more on money or property. Morgan replied, "The first thing is character…before money or anything else. Money cannot buy it."
If he was alive today, I'm highly certain J.P. Morgan wouldn't be lending any money to China…
Markets for the Upcoming Week
All eyes continue to focus on Europe and the slow-motion train wreck that is their debt crisis. When it was Iceland, then Ireland, then Portugal, Greece, etc blowing up, it was interesting but not terribly distressing. When it was Italy and Spain, people sat up and took notice. Now that Germany failed to sell all its bonds at auction last week (and really, did they expect anything different?), who can buy the debt of ANY Euro using country right now, when the various governments feel free to change the rules at any time it suits them? "Voluntary haircuts" on Greek debt have turned into "voluntary absences" from bond markets. What politicians always forget is that the private buyers are fairly smart and don't have to buy anything – take away my protections and change the rules of the game, and I have the option of just not playing. So while they can try to think of all sorts of new and novel EFSF leveraged structures that will entice in private market buyers, what they don't realize is that the game is already over. Private buyers have gone home and are going to watch this one from the sidelines. Enjoy the game fellas, you're on your own now.
Market Levels this week (all values are for the S&P 500 futures, SPX):
We ended the week right on the support at 1158/1160 (closed at 1158.67 – good enough for government work). From here, support remains at 1158/1160, follow by a very big line in the sand at 1120/1125. If we break that, its kinda game over. There is weak support at 1100 and again around 1050, but those are over a year old and unfortunately, unlike wine, support levels don't get better with age. If we break 1120, grab Auntie Em, Uncle Henry and Toto, and head for the cellar. When it gets all nice and quiet, don't open the door, you're just in the center of the storm.
Resistance is 1185/1190, followed by serious overhead supply at 1215/1220, a little at 1230, and then decent resistance at 1245/1250.
In the words of Sargent Phil Esterhaus, "Let's be careful out there".