Quietly this week, China has crossed yet another milestone in its evolution as
the new economic superpower for the 21st and 22nd centuries. Four of the top 10
companies by market capitalization globally are Chinese, compared to only three
in the United States (the other three are European). This is a stunning
achievement, and one that deserves kudos from around the world.
I don't really care that this victory came about due to the unraveling of the
financial legerdemain of US banks such as Citigroup and Bank of America, both
of which fell below the top 10 this week. This kind of price adjustment to
unexpected write-offs
may strike some as an over-reaction, but not people like me who have been
arguing for a long time that US and European banks depend on Asia for bailouts
anyway [1].
To be sure, I am fully confident that US banks will claw their way back, if for
nothing else because they work in the unforgiving realm of market capitalism
[2]. That is not to say though that they will necessarily exceed the market
values of Chinese banks in the near term, because many financial chiefs now
acknowledge that it will take more than three quarters for these banks to put
their subprime problems behind them.
The other point that doesn't worry me is that Chinese companies (and Asian
companies in general) trade at lofty price-earnings ratio multiples (PER in the
equity investors' parlance) especially relative to the US and European
companies. Well, what do you expect when one economy is growing at well over
10% while others are stuck in the 1 to 2% growth range? When adjusted for
underlying growth, Chinese ratios do not look expensive. That's why I don't
really care that billionaire investment guru Warren Buffett sold his stake in
PetroChina recently; his record of being a successful stock market investor is
anyway overstated by a large margin (but that's a topic for another article).
The factors that do worry me are not usually discussed in Asian newspapers or
indeed the wider financial media, which is why readers here will do well to
keep them in mind: these include unsustainable levels of money growth, the
implied protection of equity values that has caused excessive investor
confidence, poor standards of corporate governance, and lastly the legacy of
state control that leaves much to be desired in terms of free capital
transfers. In the following paragraphs, each of these four factors are examined
in turn.
Too much money
The most important reason for the growth in Chinese stock markets is the
unsustainable money growth unleashed by the government's decision to keep the
yuan pegged to the US dollar [3]. By adopting gradual appreciation against the
US dollar against a larger one-off movement, the government has effectively
shot its own central bank, the People's Bank of China, in the foot by
disallowing price stability.
The new Great Wall of Money in China has effectively corralled its stock and
property markets into a web of rapid price rises, protecting the markets from
externally-induced price adjustments, for example because of any changes in
global economic growth expectations.
This is good as far as it goes, but when money growth goes into reverse at some
point when China realizes its mistake and allows the yuan to float (as I have
long argued it must), the Wall will disappear overnight, and leave the stock
and property markets at the mercy of speculators who can easily topple the
values of all the large companies in China today.
Implied protection
Declines in the stock market wouldn't be a problem but for the unique nature of
China's markets. Ever since the fiasco with the trust and investment companies
(ITIC) sector in the late 1990s [4], Chinese authorities have been very
cautious about understanding exactly what public expectations are with respect
to any investment.
Thus, they clarified the position of the big four "policy" commercial banks -
Bank of China, Agricultural Bank of China, Industrial and Commercial Bank of
China and China Construction Bank - relative to smaller banks around the
country. Similarly, when property markets appeared to get out of hand in
Shanghai, then president Jiang Zemin moved to dismiss the local mayor and
ensure that the property market did not get too hot.
Unfortunately, and thanks to the government's obduracy on the yuan highlighted
above, the stock market has gone to dizzying heights, propelled by every
student, housewife and street corner geriatric imaginable. The stunning growth
of brokerage accounts - over 100,000 per day earlier this year, has pushed
money out of bank accounts into the stock market, where it chases "cannot fail"
companies.
This logic is flawed because while no one expects the likes of Bank of China to
fail, that doesn't mean the stock price will stay where it is now! Investors in
China’s local markets simply do not appreciate the difference between the
safety of a bank deposit and that of a share, and herein lies a big fault line
for the government to cross.
This is why the central bank and concerned officials talk the market down from
time to time. Their words go unheeded, and that in turn may force a sharper
reaction at some point - because about the last thing the government wants now
is for a million shareholders to come on to the streets and demand compensation
for stock market losses.
Poor corporate governance
The third major problem with Chinese companies is the abysmal corporate
governance standards in place. Granted, there is no real comparable "gold"
standard in Asia today - think for example about accounting standards of
Japanese companies - but there is still a lot of room for improvement.
Dodgy accounting is certainly something that has recently caught Americans with
their pants down, but it is my hope - not my belief - that Chinese companies
will do better. A casual analysis of some financial statements shows
substantial levels of income from unexplained sources, like investments. While
that is all right for investment companies, I am less clear why telecom and
steel companies should have a large portion of their annual earnings being
derived from gains on the stock market.
This is a dangerous game to play, as the Japanese companies found out in the
1990s. With a large number of cross shareholding and direct market bets helping
to boost the Japanese firms' own earnings, the first decline in stock markets
soon produced massive earnings write-offs from companies that had really no
business being in stock market investments, like retail stores and tire
manufacturers. That in turn perpetuated the stock market decline in Japan,
leading to the country's permanent state of recession since then.
State control
The last troubling bit, and by no means the least, is the significant extent of
state control on Chinese companies. This produces multiple distortions.
Firstly, the number of shares actually traded is lower than what is available
to trade. As market capitalization of US companies almost always covers free
floating shares, their values are more believable than those of Chinese
companies where more than 50% of large companies' stocks do not actually trade
at all because they are owned by the government. In turn, this produces the
phenomenon of too much money chasing too few stocks, known in the markets as
the "Dot Con" phenomenon.
The second element of distortion brought by state control is the lack of
professional management that could force companies to indulge in sub-optimal
behavior. Thus, while a petroleum refiner may or may not choose to deal with
Sudan based on commercial interests, the element of state control makes it more
likely that the decision is politically tainted, and therefore eventually
dangerous for shareholders.
The sector with the biggest risks on this score is obviously the commercial
banks. With state-directed lending and government-influenced investments on the
rise (for example by a Beijing investment company in the rescue effort of a US
investment bank), it is clear that the seeds of further problems are being sown
today. For example, there is a lot of talk that US Treasury Secretary Hank
Paulson has requested direct assistance from Chinese banks for the problems of
the structured investment vehicles sector. With even US banks shying from this
proposal, it is very likely that Chinese banks will be left holding the baby of
unexpected losses for years to come, should they comply with the request
because of government pressure.
Conclusion
Reading all these four factors together, it is clear to me that China's victory
parade must be put on ice for a while. The government should let the currency
float and remove excessive money growth as well as sell off its own stakes in
these companies in order to get the right market levels. Chinese investors must
be better educated about the outcomes of investing in stock markets, and not
expect any government bailout.
Without all these factors in play, investors could very well look back in two
years time at what went on this year as the seeds of a Ponzi [5] scheme that
eventually collapsed under its own weight. There is time yet, but too many
things can go wrong for China's future for authorities to remain hands-off in
the current situation. It is time to act now.
Notes
1. Asia and the
vicious cycle of bank bailouts Asia Times Online, August 11, 2007.
2. Off with
their heads Asia Times Online, November 6, 2007.
3. Deja Wu: Why
China must revalue Asia Times Online, June 30, 2007.
4. Attempting to trim the power of Guangdong provincial officials, the
authorties shut down the operations of Guangdong ITIC or GITIC, in turn causing
a panic withdrawal of deposits from all other ITICs in the country. Only the
Beijing-based China ITIC (CITIC) survived, leaving bondholders in other ITICs
nursing their wounds for years to come.
5. A Ponzi scheme is a fraudulent investment operation that involves paying
abnormally high returns ("profits") to investors out of the money paid in by
subsequent investors, rather than from net revenues generated by any real
business. It is named after Charles Ponzi. Wikipedia
entry.
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