I spent quite a bit of time writing about the Chinese Real-Estate bubble in 2009-2010. Back in 2005, the bubble (based on affordability ratios) was already evident, but post Gov’t stimulus boondoggle, the bubble turned into a super-bubble. Sometime in late 2010, I had written everything that I really had to say about it, and since there’s no equivalent of Chinese-CDS that I could find to buy and make some cash on the impending real-estate meltdown, I could only sit back, think about other things, and wait for the inevitable.

Some of the things I wrote:

• Dec 2009 – China Radio International: Real Estate
• Jan 2010 – Bloomberg Picks Up on China Real Estate Bubble
• Dec 2009 – Real Estate Bubble – Exit Strategy
• Jan 2010 – China Bubble? Jim Rogers “No”. Jim Chanos “Yes”.
• Jan 2010 – Even the Police Dept. is Building Houses
• Jan 2010 – Leverage and the Chinese Property Bubble
• Dec 2009 – Take It From Japan – Bubbles Hurt
• Dec 2009 – Finally an Economist who Understands China

Most interesting notes from two years ago?

This is exactly what China needs to worry about – when the debt is unwound, what will keep the brakes on the descent.

And…

The 2009 “Expand Domestic Consumption” (扩大内需) policy of China has been a newspaper success around the world, however, I’m inclined to think the result will be exactly what was experienced in Japan: “succeeded only in inflating the national debt”.

So here we are. The music has stopped. Let’s see who sits down, and who doesn’t. In the long run, this is a very good thing for the Chinese economy. Every day earlier means less mis-allocated resources to re-allocate.

Conspiracy Theory:

Could the technocrats have planned this all along, as a way to force wealthy Chinese to provide financing to develop new housing for the rest of the nations citizens, and crash the market enabling those less affluent citizens to buy up the houses at effectively subsidized prices?

If you spend any amount of time in any of China’s cities, it will not take long to notice that there are MANY WEALTHY PEOPLE and MORE POOR PEOPLE. China obviously has a massive population – so you get a chance to see more people in a short period of time that almost anywhere else.

Western strategists continually write about Rural vs Urban China, often writing about these in terms of Rich vs Poor China. Then they equate the current rural condition with Mao’s peasant led rebellion that founded the People’s Republic of China back in 1949.

For whatever reason, pundits are always looking at the LAST PROBLEM, and when they don’t have a deep understanding of the situation, pundits like to make analogies to Chinese history.

I have two contentions:

1. WE FOCUS ON THE WRONG GAP: China does have a rich poor gap that must be improved – but it’s not the rural/urban or even the rich/poor gap. It’s the middle class/rich gap.
2. CHINESE HISTORY ISN’T SPECIAL: China’s history is almost meaningless in trying to understand modern China. What’s happening on the ground today in China has as little in common with the Mao era as the Civil War does with modern America.

Today there was an article in StratFor (Strategic Forecasting) that focuses on the gap between China’s rich and poor. The article is titled: China Political Memo: A Growing Gap Between the People and the Elite.

A recent survey conducted at several top universities in China, including Peking University (PKU) and Tsinghua University, shows that the percentage of rural students enrolled at those institutions has dramatically declined over the past two decades. At PKU the percentage dropped from more than 30 percent in the 1990s to about 10 percent today. The numbers are similar at Tsinghua and other more selective Chinese universities. The most obvious reasons for this decline include China’s rapid rate of urbanization and the increasing number of job opportunities available to the rural population. Still, the decline is a worrisome sign that opportunities for China’s rural population to attain higher social status may be narrowing. The survey findings also reinforce an already evident trend: that social mobility in China is not as fluid as the country’s economic development might suggest.

Good. We’re focused on social mobility. Educational institutions are a big part of social mobility – especially access to the most elite institutions.

You can read the original China Daily article: Rural Students Deserve Better.

The rural Chinese population has been experiencing severe brain-drain for the last 30 years. In 1982, China was 20% urban, and only 26% urban by 1990. Today, China is over 50% urban. By 2035, it’s expected to be 70% urban.

Based on the numbers given in 1990 and today – the admission numbers should probably be closer to 15%. But that’s without factoring in the “brain drain” that has already happened in the country side. The smartest, the most ambitious, the most motivated have long since left this pre-industrial farming communities, and the ones that are born onto these farms try to get out as fast as possible.

So – it’s not a black and white issue – from an efficiency standpoint – to say that more farm students should be enrolled then are already being enrolled.

On the other hand, unrelated changes such as improving the legal system, tax system, and real estate market would probably do more to strengthen the country. How much does the unreliable legal system do to keep people from working with those outside of their network?

In any society, even an ideal one, social stratification is inevitable. But for a modern society to prosper and grow it must minimize barriers to economic advancement. Otherwise, gaps will widen among the social strata, creating potential resentment and instability at the lower levels. In China, the traditional path to a better life was the imperial examination system (ke ju), which began in the 7th century during the Sui dynasty and was open to anyone who demonstrated sufficient intelligence and drive, regardless of social status. Ke ju selected the most promising administrators for the state bureaucracy. As such, it served for centuries as a portal through which smart and hard-working youth could become part of China’s political class. This transformation could greatly change the life not only of the individual aspirant, but also his entire family. Cancellation of the imperial examination system in 1905, during the Qing dynasty, cut off this mode of access. In the 1950s, the division between the people and the ruling elite was reinforced with the introduction of the hukou system, a resident-identification program that created an official division between rural and urban dwellers.

This is a typical example of bias #2 – Chinese History isn’t special. What does the “imperial examination system” have to do with modern China? The exams could be taken by male adults, and the last exam was given in 1905 – meaning that the test taker had to be born before 1890. The imperial exams were a test. “Gaokao” was a test. The SAT is also a test. Why would we assume that “Gaokao” has more connection to the imperial exams than it does to the SAT?

The biggest beneficiaries of the system have been urban dwellers, who have greater access to employment, social welfare, education, medical care and housing than their rural counterparts. Despite years of campaigning by the state for hukou reform and a more equitable distribution of benefits, little has been achieved. If anything the disparity seems to be widening, which makes the findings of the recent university survey all the more troubling.

Of course the industrialized (ie. urban dwellers) are the beneficiaries of modern China – because they are more productive in the urban environment. Their farming jobs are easily replaced with the capital equipment used on American farms – equipment that allows 1% of Americans to work in agriculture.

One of the few portals left for upwardly mobile youth in China is the college entrance examinations (known as gao kao). The gao kao system is intensely competitive, allowing qualified applicants regardless of pedigree an opportunity to enter a university (usually in an urban area), earn a degree and find a well-paying job. While the system falls short in many ways — stipulating, for example, lower quotas for rural applicants than their urban counterparts and thereby further widening the gap — it remains the most efficient path toward the elite class, both politically and economically. And this, much like the imperial examinations once did, helps to anchor stability and, to some extent, secures the power of the elite class. While an expanding educational system was once seen as a great leveler of modern China, a growing imbalance in the distribution of resources between the country’s rising middle class and their less privileged rural counterparts is making it harder for rural youth to move upward. College tuition and fees are becoming less affordable. Many of the top universities choose students based on their acquired specialties — for example, music or technology — which wealthy students are better able to develop. This hurts rural students, who are more likely to have attained high scores through hard work. Meanwhile, many selections are based on personal networks, which further impedes poor students. The result is a narrowing of options for rural youth, the brightest of whom may not have enough money or the right connections to get into the top schools. Barriers are also being raised by the increasingly close connections between China’s political elite and business elite, both urban based. As it becomes harder for China’s rural population to break through these barriers, it could lead to growing grievances over inequality and intensifying social unrest — Beijing’s greatest fear. Therefore, Beijing may need to work to increase access, creating opportunities for the country’s massive rural population.

Yes, it’s sad anytime someone is under-utilized. In 1982, 75% of Mainland Chinese were subsistence farmers. Today it’s less than 50%. Seems reasonable to believe that the 50% that are still subsistence farmers are probably not much better off than they were in 1982 – because they are no more productive than they were in 1982. However, if they want, then can go get a job in an urban area. They can work in the factory, and their kids can get a shot at really integrating into that urban area. Unless the government makes a mess of inflation – there was 100% inflation leading up to the 1989/6/4 incident – the farmers will be fine. They know their future awaits them in the city when their time comes. If not them personally, their children or grandchildren.

The bigger problem is that the wealthy/elite are very entrenched, and getting more entrenched by the second. The far more interesting survey for Tsinghua and PKU would be: what is your parents net worth? or what bureaucracy do your parents run?Knowing how relationships and favors work throughout China, I would be very pleasantly surprised if these numbers were anything like a representative (meritocratic) representation of urban China.

The Chinese Middle class has average incomes around $10,000 USD/year. Meanwhile, China has more than 1.11 MILLION households with net worth over $1,000,000 USD. Houses in most urban areas of China can not be purchased by the “middle class” with the current middle class income:home price ratio.

It’s not the barrier between the poor and the middle class that China needs to worry about – this is a barrier that the motivated can easily overcome. It’s the barrier between middle class and wealthy that they need to worry about — because the smart, ambitious, but frustrated — those are the ones you’ve got to worry about.

Interesting SeekingAlpha article pointing out credit expansion as an often overlooked factor in developing market growth, and that when credit expansion stops, developing markets may stop developing.

It is almost taken for granted that many emerging markets will continue to experience higher growth rates than more established countries including the United States, the U.K., and most of the countries in Western Europe. However, it is usually assumed to be the result of a superior educational system, a more coherent set of cultural values, high population growth, vast natural resources, and numerous other factors–all of which are almost completely irrelevant to the issue of economic vibrancy. Let’s focus on the single most important feature of emerging markets, which is the availability of credit. Developed markets have enjoyed relatively easy and plentiful access to credit in numerous forms for decades or longer–mortgages, credit cards, auto loans, installment payments, low money down payments, government-guaranteed borrowing, and numerous related institutions. In sharp contrast, much of the rest of the world was on a cash-only basis until just twenty or thirty years ago (or even less, in some ‘frontier’ countries including Colombia, Mongolia, and Uganda). If you live in an all-cash economy which suddenly begins to use credit, there will be an immediate surge in spending–and which will create a domino expansionary effect. When someone borrows money, that money quickly finds its way into the real economy. Over time, as that loan has to be repaid, this will have a gradual drag on the economy over a period of several years or more. However, the immediate impact is invariably positive. In any nation where most of the GDP growth is caused through the expansion of local businesses, as in China and India, the fact that many millions of people will suddenly have access to credit will almost certainly create double-digit increases in annual revenue for many sectors of the economy. This higher rate of growth can only continue as long as credit continues to become more readily available to an ever-increasing segment of the total population. Eventually, as in the developed world, a point of saturation begins to be approached. There are still those who do not have access to credit, but they will eventually consist primarily of those who are not creditworthy due to their limited personal circumstances, or the minority of those who simply refuse to borrow money under any circumstances. Once this saturation point is reached, further credit expansion slows dramatically. This has the immediate effect of causing lower rates of economic growth. In the longer run, the reality of widespread loans having to be repaid will have an even more negative effect on the economy, especially during times of recession when assets become less valuable, while loans are not diminished in magnitude. In relative terms, then, the loan-to-asset ratio of much of the population will dangerously increase.

The author makes a good point, especially scary if you consider many emerging markets drastically (100%!) under report their public debt numbers, but credit expansion isn’t the only reason for growth in Asia. The more important, and more real story is productivity growth.

China has a good educational system, stable government, and talented, hard working citizens. No reason Chinese labor should be priced at 20% of USA labor, especially when Chinese blue collar labor is MORE PRODUCTIVE than US blue collar labor in many situations (environmental regulations, employee obedience).

Real-estate prices in China are already adjusted for 10-20 years from now when those prices hit parity, but still many medium/long businesses opportunities selling to the chinese consumer, particularly: Agriculture, Finance, Retail, Medicine, Health & Fitness.

In the USA, when you first interact with someone, you assume you are relatively trustworthy and that they are who they say they are, unless they give you some reason to be suspicious. In China, the default stance is that you are always suspicious and you only believe someone is who they say they are, and can deliver what they say they can deliver after they’ve given you reason to believe them. In other words:

• In the USA, innocent until proven guilty
• In China, guilty until proven innocent

China is an extremely low trust environment. As Fukuyama argues, Trust is an economic lubricant, reducing the cost of transactions and enabling cooperation.

Yet, in this ultra low trust environment, companies still have to offer financing terms to their business partners. The result, is that collecting the outstanding cash is very difficult, many payments are unable to be collected, and companies are often uncertain of their overall financial position. From Dec 1st until Chinese New Year, many Chinese companies are focused on collecting outstanding accounts. Books are typically closed on (Lunar) Chinese New Year.

They don’t have much penetration yet, but Dun & Bradstreet (DNB) has partnered with Huaxia Bank to expand into China. (Huaxia is 20% owned by Deutsche Bank).

Every Chinese company having a D&B number would be a big step forward for businesses, and with Web 2.0 technologies, D&B should be able to leverage the Chinese business community to get an early read on which companies are growing, which are struggling, and who you can trust to pay on time – if ever.

Note the D&B/Huaxia JV started in Dec 2006, more than a year after Deutsche Bank acquired a 20% stake in Huaxia, yet it doesn’t seem to be getting a lot of traction yet. Probably not ideal to structure this sort of thing as a JV – since it’s not in the business of actually granting credit, just acting as an information service, and since D&B is a strong global brand that can quickly earn trust in China, it’s probably better structured as just a Foreign Enterprise, ideally selling stakes in that enterprise to each of the biggest Chinese banks. That way you’ve got government support, access to proprietary government information, but you have the free market incentives necessary to succeed anywhere.

It’s already been nearly 4 years, and the JV may need to be restructured, but D&B has the potential to have a huge impact on China – an impact on society far beyond what consumer goods companies can hope for.

Price is what you pay. Value is what you get.

—Warren Buffet

Beijing regularly complains about the “safety of it’s dollar reserves”. This political posturing makes for nice headlines and helps aggregate soft power, but your response should just be to laugh at Beijing’s naiveté and move on to the next story.

Beijing should keep some foreign currency reserves, which help to stabilize the domestic currency and encourage foreign investment. However, if Beijing did not manipulate the value of the Yuan, Beijing’s dollar reserves would not have risen to the ridiculous levels that we see now.

Today, the Chinese economy is structured to do one thing very well: make products for export. Manufacturing is a notoriously cost conscious business, and as costs in China rise, the government doesn’t want to see factories relocate en-masse to Vietnam, the Philippines, or other lower cost regions. Under normal circumstances, currencies trade a lot like stocks, prices go up and down relative to each other every day. However, every day the Chinese Yuan is worth the same amount of US Dollars. For almost 2 years, it’s been pegged at about $1.00 USD = ¥6.83 Yuan.

Trading Dollars for Yuan.

China didn’t pass a law saying that each dollar is worth 6.83 Yuan. Nobody will be tortured, jailed or executed for trading Dollars for Yuan at another rate. Instead, China’s central bank, The People’s Bank of China (PBoC), has created a policy that no matter what, they will sell you ¥6.83 Yuan for each $1.00 USD. The value of the Yuan is less than ¥6.83. Perhaps the value is ¥6.8, perhaps it’s ¥6.0, it might even be ¥5.0 or ¥4.0 for each $1 USD. However, since the PBoC is willing to sell Yuan at such a discounted price, they have a monopoly on the market. There’s no free exchange market for the Yuan, so nobody, including the PBoC can figure out exactly what the value of the Yuan should be, but the price is set by the PBoC.

Trading Yuan for Dollars

Selling Yuan is a little different story. If you have Yuan, and you want to sell them for Dollars, the PBoC doesn’t make life easy for you. Yuan sellers have to register with the PBoC and request foreign exchange. The PBoC has the choice on whether or not the Yuan sale will be permitted. For anyone investing in China, this is a very important fact to be aware of – one that I expect will bite a lot of foreign investors if the Chinese Real-Estate market bubble were to pop.

Since the PBoC is willing to give you such a great price when you sell dollars and buy Yuan, there is automatically an inward flow into Yuan, in spite of the risk that the PBoC may not let you convert Yuan back into dollars when you want to take your money back out.

If you torture the data long enough, it will confess.

–Ronald Coase

The Big Pile of Dollars

As long as the PBoC keeps the peg, all of the dollar reserves that are acquired are valued by the PBoC at the price that the PBoC paid, even though the value is less than the price paid. Everybody knows that the PBoC is selling Yuan very cheap, so even more people buy Yuan (or other Chinese assets) with the intention of selling them back as soon as the price of the Yuan rises to match it’s value. Combine this with the fact that the Chinese economy is designed to produce exports, and you’ve got a recipe to up with a lot of dollars.

The PBoC has an account full of dollars corresponding to all of the Yuan, Yuan valued exports, and Yuan assets that China has sold to the rest of the world. This pile of dollars is massive and grows quickly. Since some interest on this money is better than no interest at all, the PBoC lends a lot of these dollars back to the US Federal Government, helping to finance both annual deficits and the overall debt, and pushing down interest rates.

Losses: Real or Realized

If the actual value of the Yuan in dollar terms was ¥6.70, but the PBoC’s currently pegged rate were ¥6.80, then every single time the PBoC trades a Dollar for a Yuan, it would be loosing ¥0.10 Yuan for every dollar traded. The bigger the gap between the rate that the PBoC is willing to pay for Dollars, and the the value of the Yuan, the bigger the loss on each trade. Central Banks are funded by Tax payers, so money loosing policies like this are not unheard of.

Every day for several years, the PBoC has been paying top dollar to buy dollars, even though the Dollar has been going down relative to other currencies (Euro, Yen).

(In case you didn’t notice, the flat line, least changed against the dollar, is the Chinese Yuan)

The PBoC re-values the Yuan, either by allow it’s price to be set by the market, just like the Dollar, the Euro and the Yen, or by raising the price the PBoC sells Yuan (perhaps only 6.0 Yuan for each dollar instead of 6.8 today).

THE CATCH, is that even though the PBoC is loosing money every time it buys dollars, from an accounting perspective it doesn’t look like a loss. It’s not until the price of the Yuan increases, the loss will finally look like a loss, a huge loss, to every accountant on the planet.

After the smoke clears

Someday, the PBoC will stop operating as the discount Yuan seller, thereby slowing down their accumulation of dollars, and correspondingly reducing demand for interest payments on their big pile of dollars. Less demand for dollar interest, means that the price of financing debt is going to go up. You’re not going to have many more chances to get a 30-year fixed mortgage at 5% — it was 12% in 1985.

The rising Yuan could be extremely dangerous for the Chinese economy, because there isn’t any other sector that could replace China’s manufacturing jobs. Though there are many well educated and talented Chinese entrepreneurs, the unpredictable regulatory and legal framework make investment in any R&D very high risk. Without further political reform, China appears to be stuck at the bottom of the value chain, in the Manufacturing department.

BBC put together an interesting review of Internet stock bubble, that ended on March 10, 2000.

February 2000:

David: If your not a media stock, dot-com stock or a telecom stock, valuations are very low.

BBC: So what you’re saying David is that it’s really the result of this asset bubble. In other words, the actual stock market value of these companies was way out of line, compared to their potential to earn money.

David: Right, and I think that was fairly widely known. In our consciousness, it was just way out of whack. But, every day you heeded it, or you got left behind. These things were going up by the day, they were going up by the rate of warp seed, regardless of whether they had earnings or not.

BBC: Though you though it was all a bit ridiculous, you still felt you had to keep recommending these dot-com shares to your clients.

David: Looks, this seems kinda ridiculous, maybe we should look at pulling back on the aggressiveness of your styles, because they had all of the proof they needed – in their track record. It was fabulous. And it was very difficult to convince them of any other type of approach to what they were doing. I think it was quite difficult to tell clients to pull back, when every month they were making another 5-10%.

The Internet stock bubble was a classic stock market speculative bubble. The 2007 subprime crisis is a bubble in credit and the price of money. The discussions people were having about Internet Stocks in February 2000 sure sound a lot like discussions about the Chinese Real-Estate market.

They had all of the proof they needed – in their track record.

Gordon Chang, author of “The Coming Collapse of China“, published in 2001. The book predicted the China would collapse by around 2005, or perhaps as late as 2010. He predicts that widespread unemployment, government corruption, inefficient state owned enterprises, and a lack of leadership would lead to the undoing. Publishers Weekly comments:

His invocations of the “power of the Chinese people,” or of an imaginary individual who will one day “end the Chinese state as it now exists,” read more like political soap opera than judicious analyses.

One of the Amazon commenters summarized Mr Chang’s POV as:

“The Coming Collapse of China” is an angry book written by the son of a man who “left China before the end of the Second World War and [the son] grew up hearing him say that Mao Zedong’s regime would have to fall.” The son returned to China to work as a lawyer in Shanghai. When he wrote this book – his first – it was a polemic in which he pounded away at the evils of Communism and predicted that Jiang Zemin’s regime would have to fall.

The Christian Science Monitor published Mr Chang’s “China: the world’s next great economic crash” article in the Opinion section this week. The truth is probably somewhere in between the current China Euphoria (rise of China is story of decade) and Mr. Chang’s China Collapse POV. For the record, I’m optimistic that China will be in a very strong position by 2050, with living standards in the largest cities (Beijing, Shanghai, Guangzhou) at parity with Taipei and Hong Kong. However there is a massive asset bubble in China that is hurting all but the wealthiest 0.5% (85% of families can’t afford basic housing). 40% of local gov’t revenues come from land sales (Professor Chovanec) and current GDP growth is fueled by real estate development.

The following is an [objective?] look at the current China situation:

Beijing, ignoring advice from Washington and other capitals, did not in the boom times try to restructure its economy to favor consumption. Instead, the Chinese government sought to take maximum advantage of then-surging foreign demand. The role of consumption, therefore declined – falling from a historical average of 60 percent of the economy to about 30 percent last year. No country has a lower rate.

To make up for slumping demand abroad and sluggish consumer spending at home, the State Council, the central government’s cabinet, announced a stimulus plan in November 2008. Beijing originally said it would spend $586 billion through 2010. In the first full year of the program however, it has directly and through state banks disbursed about $1.1 trillion in stimulus funds.

The plan, not surprisingly, is creating gross domestic product, but growth is an artificial “sugar high.” For one thing, Beijing’s stimulus spending last year was around a quarter of the total economy. Now, perhaps as much as 95 percent of China’s growth is attributable to state investment, as a Chinese analyst noted recently.

Despite the massive state spending, the country’s economy is not particularly robust. Power consumption statistics, a crucial indicator of economic activity, show the economy expanding at only two-thirds the announced rate.

Moreover, essentially flat consumer prices last year belie official reports of roaring retail sales. So does the full-year 11.2 percent decline in imports, another sign of sluggish domestic demand. And if the economy is really growing by double digits, why is Beijing insisting on continuing its stimulus?

New York Times columnist Thomas Friedman, however, thinks none of this will be a problem. Arguing that China is not the next Enron, he gives this advice to Mr. Chanos: “Never short a country with $2 trillion in foreign currency reserves.”

Yet Beijing’s record-setting reserves – now $2.4 trillion – are essentially unusable for this purpose. Why? China’s leaders need local currency, the renminbi, to deal with domestic needs. If they convert reserves into renminbi, they will cause the currency to zoom up in value and choke off the critical export sector. Foreign reserves have only limited uses in domestic crises.

Second, the state’s stimulus plan is taking the nation in the wrong direction. It is favoring large state enterprises over small and medium-sized private firms, and state financial institutions are diverting credit to state-sponsored infrastructure. Over the past three decades, China’s economy has expanded at an average annual rate of 9.9 percent because of the private sector, but now Beijing is renationalizing the economy with state cash.

Third, Beijing’s flooding of state enterprises with government cash will undermine their competitiveness, as a similar tide of money severely damaged Japan’s corporations during the bubble years.

Japanese managers discovered they could make more money managing cash than from anything else, and they therefore neglected their underlying businesses. Essentially the same thing is happening in China.

Jeffrey Frankel, of Harvard University wrote “On the Renminbi”, concerning the RMB/USD peg as the view looked from 2005, just after the first minor devaluation (2.1%) of the RMB. When one currency is pegged to another, the value will typically be pegged too high, or too low. If pegged too high, there will be a run on the currency, just like an old fashioned bank run, but in this case it’s the nations central bank. If pegged too low, the currency will be undervalued. Hot money will arrive in anticipation of the eventual revaluation. Central Bankers must try to get the excess cash out of the system, primarily through Sterilization Bonds.

We have already mentioned that a balance of payments surplus implies that the reserve component of the monetary base is increasing. Some expansion in the monetary policy may be entirely appropriate, especially in an economy with strong long-term growth. But in an economy that is in danger of overheating, the central bank may wish to sterilize the inflow, so as to prevent expansion in the overall money supply.

If the money supply expands, you will create inflation and may also create asset bubbles which [mis]allocate resources from productive efficient. Recently these misallocations have expanded global housing markets and propped up global stock markets.

Sterilization can be a good response to an inflow, for a period of time. It can help the country maintain its exchange rate target without abandoning a target for the money supply or interest rate. But it can become increasingly difficult over time, especially if traditional barriers to capital flows have been gradually eroded. One problem is that it just prolongs the balance of payments disequilibrium, because it by-passes the automatic mechanism of adjustment that reserve flows provide under the monetary approach to the balance of payments. Another potential problem is the quasi-fiscal deficit: if the central bank has to pay high interest rates to get domestic residents voluntarily to absorb “sterilization bonds,” while receiving low interest rates on its reserves of US treasury securities, then it is running a deficit.

Under normal circumstances, Sterilization Bonds would require chinese state banks to purchase bonds from the government, reducing the size of the money supply (because money is handed back to the government). However, in China all foreign currencies collected at state banks are immediately surrendered to the central bank. I believe this policy removes the typical need for “Sterilization”.

Some governments are able to force their bonds down the throats of their banks without paying market interest rates, a form of financial repression; but this just weakens the balance sheets of banks and raises the odds of a banking crisis somewhere down the road.

With the banks all being owned by the Gov’t, this is the case here…

One disadvantage of a balance of payments surplus, on the other hand, is that the reserves, which are typically held in the form of US Treasury bills and bonds and other dollar securities, pay a low rate of return. Interest rates on US treasury bills are low because the market is so liquid and because default is assumed to be very unlikely — and also, during the period 2001-2004, because the Federal Reserve has held short-term interest rates well below normal historical levels. The Chinese authorities have evidently already diversified out of Treasury bills, into agency bonds and other longer term securities, which will probably help the yield somewhat. But it is more likely than not that the dollar will depreciate over the next ten years (not necessarily in the short run), in light of the large US trade deficit, which would reduce even further the return to holding dollar securities. (Diversification into the euro or other currencies has evidently not yet gone far.)

The low interest rates associated with this giant pool of money helped sow the seeds for the global financial crisis. Basically, there is too much money in RMB and not enough good USD investments, yet the Fed set interest rates too low. The result was Chinese bankers buying Fannie, Freddie and boatloads of mortgaged backed securities.

These points are drawn largely from the experience of emerging markets such as Colombia and Korea in the early 1990s. Those countries were able to sterilize capital inflows only for a year or two, before it became too difficult, due to high interest rates on the sterilization bonds and the prolongation of strong capital inflows (as in standard macro models). Chinese officials may be correct that their case is somewhat different, due to a financial system that is less open and less market-oriented.

See the “surrender” policy for dealing with foreign currency.

The capital inflow has consisted largely of Chinese citizens bringing capital flight money back home, speculating on a revaluation, and so far the authorities have not had to pay high interest rates locally to sterilize it. But they may find it increasingly difficult to sterilize further inflows.

The “inflows” are all the Chinese expatriate class returning home story was probably true when this story started, however the size of the bubble today and “Rise of China” being the most read story of the decade indicate the story has been stretched quite a ways now. Interesting that speculators always have a million reasons why it’s different this time and how other people are speculating, but not them and it’s not widespread.

Either way, if this gap is real, better to address it through appreciation than inflation.

But I doubt this is the policy that the CCP will peruse, despite how logical it may be and how much it may benefit the average citizen.

Caing reported that it’s going online. Now, the guys at google have decided to stop self-censoring, even if it means pulling their operations out of China! Full source (blocked by GFW)

These attacks and the surveillance they have uncovered–combined with the attempts over the past year to further limit free speech on the web–have led us to conclude that we should review the feasibility of our business operations in China. We have decided we are no longer willing to continue censoring our results on Google.cn, and so over the next few weeks we will be discussing with the Chinese government the basis on which we could operate an unfiltered search engine within the law, if at all. We recognize that this may well mean having to shut down Google.cn, and potentially our offices in China.

In Mainland Chinese culture, the person with slightly more authority in a situation routinely strong-arms the weaker party, and the weaker party generally goes along with the situation, saying “没办法 – No [other] method”. Google is another recent example 1st worlders of saying “No, are civilized and don’t agree with mafia negociation tactics”. Great job guys! Hope to see an explosion of cases like this in 2010!

The CCP has been using 8% annual GDP growth as the metric of success for years, but has lost sight of WHY 8% GDP growth has been the objective – and the bureaucrats have figured out how to manipulate GDP growth during the bubble years, the same way managers in American firms figured out how to manipulate stock prices in the 60s/70s. The resulting american conglomerate boom didn’t create long term shareholder value any more than the central planners focus on unproductive GDP will create long term financial benefit.

Deng Xiaoping made massive steps forward in Chinese reform by simply getting the gov’t out of the way, and with his support Zhao Ziyang and Zhu Rongji were able to go further. Chinese reform has been in exercise in gradualism, and this gradualism has avoid many undoable mistakes. However, we are left asking who are the reformers today? Wen Jiabao seems to generally came deeply about the welfare of the people, but without a free press and an independent judiciary, I think corruption will eat away at the efficiency of the Chinese economy and prevent mainlanders from reaching living standards of their brethren in Taiwan and Hong Kong.

The mainstream financial press has recently started picking up on the idea of weather or not “China” is a bubble. Longtime China bull Jim Rogers is quoted as saying: “I find it interesting that people who couldn’t spell China 10 years ago are now experts on China… China is not in a bubble.”

Rogers’ partner George Soros got famous shorting sterling. Meanwhile, Jim Chanos got famous shorting Enron. Chanos noticed that Enron had a very low return on Capital Investment (only 6-7%/year) and is seeing the same low return on invested capital here in China.

The first day I ever came to Shanghai, it was for a lunch invitation with Rogers. I fell in love with the place, and though it took a few months to get here, I plan to stay in Shanghai. Bubble or not. That first day in Shanghai, standing with Rogers on top of the Ritz Carlton, he explained to me the madness of the Shanghai real-estate bubble, and moreover, the world wide real-estate bubble. So there you go: “Rogers, China real-estate Bubble: Yes”.

Listen, Rogers is saying that “There is no commodities bubble”. Rogers has a huge amount invested in this, and if central banks keep printing money, they keep proving Rogers right. When China’s real-estate bubble pops, some commodities will take a short term hit, but the macro trend is that the USD is being devalued.

Chanos isn’t saying that he doesn’t think that China has a bright future, he is said the GDP numbers are “massively inflated by under-depreciating a very, very, very shaky capital asset base.” Chanos’ critics say that China’s different because there’s no leverage here, but that’s not true. The market is leverage by multiple layers of ownership each using existing property as collateral. Not unlike the structured leverage in Dubai, but completely different from the leveraging the the US property market.

Most interesting is that many in the US are vehemently opposed to government involvement in the economy, yet those same people are bullish on the China market because the Chinese Technocrats can “fine tune” the economy at their will. These are the same all powerful technocrats that drop dead regularly bingeing with the hostesses at KTV.

Here’s the relevant China situation, as it stands today, summed up quickly: 1. Everybody in China was dirt poor from 1949-1977 because the gov’t prevented private enterprise (basically the same as North Korea today) 2. In 1977, Deng Xiaoping created the first Special Economic Zone in Shenzhen, beginning the growth of China. 3. In the late 90s, Clinton arranged for China to enter the WTO, speeding up foreign direct investment 4. More investment more, higher efficiency factories and foreign exchange reserves soared 5. The gov’t invested (25%?) these foreign exchange reserves into infrastructure, creating hopes of a modern, industrialized, first world China at some point in the future. 6. The owners of the factories, the beneficiaries of the infrastructure projects earned private profits, and had to invest these profits – due to lack of investment options, most chose to invest in luxury real-estate, pushing up prices to current levels. 7. In ’07, the Global Economic Crisis came and China still had enough foreign reserves to weather the crisis, not only offsetting the drop in exports, but preserving the lucky “8%” GDP “growth”. 8. Throughout ’08/’09, Due to high real-estate prices and weakened global trade and investment options, even more money has been poured into Chinese Real-Estate

Things to remember. The Technocrat “Central Planners” have never had a good track record. We’re all aware of the disasters of Communist Central Planning of Russia, Cuba and the Closed China. In the 80s though, American’s talked about the magic of the METI (Ministry of Economy, Trade and Industry) explaining how America couldn’t compete with Japan’s centrally planned capitalism. That infatuation ended around when American’s bought Rockefeller Center back from Japanese investors for half the price.

Personally, I’m very long on the Chinese entrepreneurs and the Chinese people. In the next 50 years, I hope that most of them are able to join us Americans, and our allies in Japan and Europe in first world living standards – they’ve already done so in Hong Kong and Taiwan and it seems to be a great thing for all of us. Meanwhile, I’m very bearish on bureaucrats everywhere, and nowhere more so than where the bureaucrats are living in a giant bubble – and feeding the bubble for their own benefit.

Hu Shuli 胡舒立, founder of Caijing Magazine stepped down back in November. Hu Shuli is known to have backing from the CCP Standing Committee, enabling her to safely report on policy, corruption, law and human rights from a relatively independent perspective. Her situation is quite unique in China.

In September last year, Hu Shuli started stepping away from Caijing due to editorial constraints that were starting to impact the magazine. The scope of coverage started tightening in July, not due to editorial, but due to the magazine’s chief investor (Wang Boming 王波明) calling for caution. The All-China Federation of Industry and Commerce/中华全国工商业联合会, the party-led organization of businessmen that holds the magazine’s publishing license. Desk editors told reporters they wouldn’t be running any politically controversial stories — indefinitely. The move was related to the general restrictions of all forms surrounding the Oct 1st, 60 year anniversary of the CCP.

There are some things that even Caijing would have never been able to report on…

The untouchables are known among foreign media as “the three T’s and one F”: Tiananmen, Tibet, Taiwan, and the Falun Gong. Jeremy Goldkorn, who runs a Web site about Chinese media called Danwei.org, adds, “You don’t directly criticize central government and top leaders, and you don’t question their legitimacy. You can criticize lower-down officials, specific actions, and talk about local problems.”

Our worries seem to be over. This wasn’t a long term crackdown on transparency. It was only only an admission of frailty in preparation for the 60th anniversary military parade.

Hu Shuli 胡舒立 is back in action at Caing 新世纪周刊! Here’s the post at Caing: 胡舒立的团队和新闻职业共同体

A “bubble” is a sustained but temporary major misalignment between perceptions of value (momentarily reflected in market prices) and actual underlying value (eventually reflected in actual cash flows over time). In this sense, it is primarily a psychological phenomenon, caused by unrealistically high expectations of profit and/or underestimation of risk. I stress the words “sustained” and “major” because minor misalignments are taking place — and being corrected — constantly, which is what markets are all about. If all of us knew what returns would actually be over time, we wouldn’t even need markets — or entrepreneurs — in the first place. But there are times — we call them bubbles — when these misalignments persist and feed on themselves until, somewhere down the road, the market loses faith and valuations suddenly come crashing back to reality in one fell blow.

Some economic bubbles that we’ve experienced:

• Tulip Mania, Netherlands, 1637
• South Sea Company Bubble, UK, 1720
• Compagnie d’Occident / Mississippi Company, France, 1720. (Leveraged)
• Railway Mania, UK, 1840s
• Canal Mania, UK, 1790s
• Stock Market Bubble, US, 1920s (Leveraged)
• Japan Real-Estate and Stock Bubble, Japan, 1986-1990 (Leveraged)
• Internet – Dot Com Bubble, US, 1998-2000
• Housing Bubble, Worldwide, 2000-2006 (Leveraged)

Non-leveraged bubbles are still bubbles, but fortunately their ends are not as dramatic and there effects are not as long lasting as leveraged (credit boom) bubbles. Frederic Mishkin pointed out this distinction in the Financial Times (Not all bubbles present a risk to the economy [FT subscription required]).

Like the start of the Internet Industry, there were also bubbles at the start of the Automotive, Radio and Television revolutions. Each one changed our life. Each time, too much speculative capital chases too few good assets. Additionally, the excess supply of capital creates an excess supply of assets that can be purchased.

The common thread in these three bubbles is over-excited investors putting money into a relatively new product, financial scheme, or industry that seems, given its limited track record, to offer a sure-fire path to riches but whose real risks and rewards they do not yet fully comprehend. Funding those investments via debt is not a necessary ingredient.

I have not yet been able to find a lot of 3rd party sources covering real-estate leverage in China, for now I’ll quote Prof. Chovanec on the subject (Leverage and China’s Property Market).

According to current rules, Chinese developers must use their own capital to secure land. Once they do so, banks will lend them 65% of the money they need for construction and related development costs, with the land pledged as collateral. But saying developers must use “their own capital” to buy the land is a bit misleading.

Residential Sector: Developers build and offload projects rapidly to buyers, half of whom are paying cash.

• Many developers do raise such funds by listing on the domestic or Hong Kong stock exchanges
• Many bring in private equity investors.
• I’ve also seem them raise it in the form of debt
  • Parent company take out loans and then inject the funds as capital into a real estate subsidiary. (most common)
  • Issuing high-yield bonds (if they’re listed)
  • By taking on loans at multiple layers of holding companies, a developer can leverage up considerably to cover his “capital” commitment to the banks.
  • It’s very hard to quantify the extent of this exposure, due to the indirect way many of these loans were raised and channeled into real estate.
• Approximately 50% of all residential purchases in China today are financed with mortgages
• China’s mortgage market is relatively small — about 10% of GDP, compared to 48% for Hong Kong.

Commercial sector, developers are building properties mainly to hold and lease. That means they are raising debt — both from banks and subordinated creditors — and they are not deleveraging.

• Many commercial buildings sit nearly or completely empty
• Where does the cashflow to pay the loans on the property come from?
  • Does the bank care, or is it happy rolling over the loan because the (supposed) value of the collateral has risen?
• This is the Dubai story all over again — multiple layers of leverage, no tenants, no cash flow.

Credit vs Collateral

• In the West, banks usually make commercial loans to businesses based on an evaluation of their expected profits and cash flows — will they earn enough to repay?
• In China, as in many developing markets where banks’ technical skills are not so sophisticated, most business loans are made on the basis of collateral — are there assets the bank can seize if the loan goes bad?
  • Asset Chinese banks like most as collateral is real estate
  • Therefore SOEs enjoy both preferential access to land AND lion’s share of bank loans in China
• Nobody is really arguing that Chinese banks are over-leveraged.
• It’s their clients, the developers and SOEs, that are leveraged up on real estate.
• It’s loans to those clients, should property take a tumble, that would hit the banks as losses.

Cash Rich SOEs Pushing Real Estate Bubble Ever Higher

The National Audit Office data shows that 25 central ministries are involved in real estate violations, worth billions of yuan. Among them, unlisted assets of 51.6917 million yuan from the Ministry of Foreign Affairs have gone into purchasing real estate. The Ministry of Agriculture has developed commercial housing, acting beyond its authority, and has submitted false reports on housing subsidies. In 2008, a real estate rental service center under the Ministry of Finance took in rental income of 5.3193 million yuan. The Ministry of Public Security has approved construction projects worth 422 million yuan, utterly exceeding its authority. Other data show that among 136 central enterprises under the State-owned Assets Supervision Administration Commission, about 70% of the companies are involved in real estate, among which 16 firms are primarily based in the property industry, including Poly, Sino-Ocean, and China Resources, while more than 80 outside firms have business in real estate. Among the top ten highest priced land purchases in major cities in the first half of this year, 60% were gobbled up by SOEs.

Yes, that is 25 central ministries that have been caught speculating in the real-estate market.

• What is the Ministry of Agriculture doing building houses?
• And the Police Department (called “Public Security” here) is in the construction business too?

The government here is just as “asleep at the wheel” as the OFHEO was when regulating Fannie-May and Freedie-Mac.

The Office of Federal Housing Enterprise Oversight (OFHEO) was an agency within the Department of Housing and Urban Development. It was charged with ensuring the capital adequacy and financial safety and soundness of two government sponsored enterprises — the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).

Ignoring the Dubai Crisis and Bubble Concerns, Chinese SOEs Continue Playing “Land King”

Another 19 real estate companies also showed interest in the land bought by Sino Ocean, among them Gemdale Group, a private real estate company. It didn’t bother to bid, though, as prices were too high and a huge challenge for a private company. In the current environment, SOEs are able to take significantly greater risks than private enterprises.

My closest friend in Shanghai is also a land developer (房地产开发商) and I’ve heard the exact same story from him. Every time they try to bid on a project, some SOE backed business comes in at a higher price. No matter how much you are willing to offer, the SOE backed group raise the bid until they get the property.

Do SOE’s have a secret for generating better ROI than experienced, well managed, privately held developers? If they do, they should start a training academy teaching their “post-market economics efficiency”. Most likely this will be a lesson in buying high and selling low.

Zhang Shuguang, chairman of Unirule Institute of Economics, says, “Real estate policy next year is a choice among contradictions and big changes may not take place. Tightening policies will cause the real estate bubble to burst, resulting in economic problems, while excessive stimulus will bring a bigger bubble and greater risks.”

You’ve got a bubble on your hands. Choices I’m aware of are a) soft landing or b) hard landing. Sounds like the Chinese plan is to “manage the bubble”. Good luck with that.

The dilemma is more obvious for local governments. Zhang Shuguang says that half of local government income is real estate-related, and local real estate policies will not see big changes. Preferential policies may be fine-tuned instead of cancelled.

In case you want to know “why” the bureaucrats what to “manage the bubble” instead of fixing the economy? Because the bubble is putting money in their budgets. The bigger the budget, the bigger the kickback.

Can we bring Zhu Rongji back the way Deng Xiaoping was brought back? He’s ceased to exist as a public figure since 2003 – just about the time the economy started going way off track.

Zhu tackled the problems of an excessive money supply, rising prices, and a chaotic financial market stemming, in large measure, from runaway investments in fixed assets. After four years of successful macro-economic controls with curbing inflation as the primary task, an overheated Chinese economy cooled down to a “soft landing”.

Unfortunately, he’s not likely to be restored because:

Zhu has a reputation for being a strong, strict administrator, intolerant of flunkeyism, nepotism, and a dilatory style of work. For his hard work ethic and general truthful and transparent attitude, he is generally considered one of the most popular Communist officials in mainland China.

The New York Times put together an excellent story about the struggle against chinese real-estate speculation here in Beijing. The article is called “Chinese Businesses Resist Eviction by Developers“.

The company that bought the land that included her restaurant for $700 million — a huge parcel a few minutes from the Olympic stadium — was already busily clearing the block for another glittering mega-development. The sooner it broke ground, the sooner it could capitalize on property values that spiked more than 30 percent this year in Beijing and a handful of other cities.

The only thing in the company’s way was a squat row of buildings that included the Fish Castle Restaurant, a decidedly modest Sichuan-style seafood joint that Ms. Qin and her boyfriend opened just before the 2008 Summer Olympics. The couple, the very picture of modern Chinese entrepreneurial bravado, had signed a three-year lease, poured their extended families’ life savings into fixing up the space, and then learned in August that they had only two months to get out.

Chinese newspapers are filled with stories of battles involving so-called nail houses, the properties whose owners and occupants are like deeply embedded spikes that refuse to give way to redevelopment juggernauts. As an unceasing real-estate boom has swept the nation, much of it orchestrated by the local governments that benefit from soaring land values, property owners and occupants often protest unfair compensation.

SOEs are becoming an ever larger portion of the Chinese economy, bidding up prices and pushing out private entrepreneurs. Long term, I have zero faith that the “central planners” in any country can create long term growth better than innovative entrepreneurs.