Is China the Biggest Malinvestment Case of All Time?

September 19, 2012
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Malinvestment is one of the most useful concepts in Austrian economics.

As Wikipedia puts it, malinvestment refers to

investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.”

Here is a typical chain of events (as laid out by yours truly):

1) Stimulative monetary policy creates falsely optimistic market signals.
 
2) Private investment firms act aggressively on these false signals.
 
3) As a result, the private sector “malinvests,” i.e. allocates badly. 
 
4) Capacity is increased prematurely, supply ramped up excessively, etc.
 
5) When the stimulus wears off, the economy is in worse shape than before.
 
6) Overhang of excess debt, capacity, supply etc. serves as a dead weight.
 
7) Struggling to ignite growth, the authorities order more stimulus.
 
8) A speculative bubble ignites instead, furthering the malinvestment.
 
9) Yet more excess capacity, debt, supply etc. is accumulated.
 
10) The additional stimulus wears off…
 
11) Repeat the process until you get full-on economic collapse. 

The really vicious thing about the cycle as described above is this: The collapse at the end is virtually preordained!

Why? Because each round of additional stimulus (and the economic distortions it feeds) leads to more malinvestment, which in turn creates a greater problem, to which stimulus is seen as the answer… as time goes by the merry-go-round spins faster and faster until finally the economy in question is hurled from its horse and thrown violently to the ground.

This phenomenon is dangerously present in modern markets – and particularly in China, where the miracle of +8% growth has been artificially sustained at all costs, stretching to greater and greater heights of danger.

For more on the subject of Austrian economics prophecies, false trends, and stimulus-driven booms and busts, see the following pieces:

Which brings us back to China… we are beginning to wonder if China is perhaps the biggest, grandest, most absolutely stunning case of malinvestment in the history of mankind.

Thanks to central bank stimulus, the West certainly has its own malinvestment problems. But at least a quasi-free market acts as a brake.

In China, the authoritarian structure in which the commanding heights are run from Beijing makes for capital misallocation (malinvestment) on a scale of the Great Wall.

For example: China bulls have long feted the country’s top down authoritarian structure as being able to “get things done.”

And this is very true. If you want, say, a highway or a dam built in China, then boy howdy, it will get done, regardless of whether five thousand or five hundred thousand people need to be forcibly displaced from their homes.

What this means is that Beijing can approve mass infrastructure projects at the snap of a finger.

What it also means is that, within the context of a rigid and opaque governing system, China has greater ability to do economic damage to itself (through epic malinvestment) than perhaps any Western democracy that has ever existed.

Quite frankly, we are mystified how staunch free market advocates (ahem, Jim Rogers, cough cough) can talk fire and brimstone regarding Western Central banks on one hand, and yet speak of China glowingly on the other hand.

If the Federal-Reserve-induced manipulation and misallocation is toxic — and you bet it is — a system in which free market capital allocation hardly even exists is far, far worse.

To the extent that Western monetary policy is channeled and driven by compromised central banks, the West suffers serious long term consequences. Of that there is no doubt.

But again, and this is not to make apologies for the West but instead to point out partially mitigating factors, at least a quasi free-market exists where rational capital allocators channel large investment sums.

In China, in contrast, there is barely a free market to speak of – with a majority of public companies owned outright by the government!

Consider the following (rather lengthy) excerpt from Foreign Policy, “Why China will never have a Wall Street:”

Since 1992, the MSCI China Index, the most broadly referenced indicator of Chinese market performance, is down over 40 percent, while the Shanghai Composite Index has risen only a meager 180 percent. During the same period, China’s GDP has rocketed 1,700 percent. This suggests that China’s listed companies have not been significant drivers of the country’s fantastic growth, and that the capital they have received from investors — some $950 billion from the Hong Kong and domestic markets over the last 20 years — has been seriously misallocated.

The underperformance of China’s listed companies is a direct consequence of Beijing’s deliberately awkward adaptation of Western-style stock markets to a command-type economy. Despite the country’s increasingly first-rate infrastructure and all the other trappings (bankers, investors, regulators, scandals) of development, China’s markets only superficially resemble markets elsewhere. A market is where the ownership of a commodity or service is exchanged, not just where securities can be traded on a daily basis. Chinese stock markets do the latter extremely well, but have nothing to do with the exchange of ownership. At a fundamental level, China’s markets do not price companies and their businesses because its listed companies are not for sale, and never have been. As Liu Hongru, the first head of the securities regulator and the godfather of China’s markets, said in 1992, “The shareholding system is not privatization.”

Beijing created its stock markets in the early 1990s because of concern with the poor performance of its state-owned enterprises (SOEs). During the 1980s, private enterprise growth far exceeded that of the SOEs. The government became convinced that adopting the Western capital markets model — diversifying ownership, creating clear corporate structures, and establishing professional legal and audit industries and strong market regulators — would improve SOE management and help them become more competitive both domestically and internationally.

What happened instead was that Beijing excluded non-state companies from the markets and required that absolute ownership control (at least 51 percent) of SOEs remain firmly in the state’s hands. As a result, the stock markets have always been the near-exclusive preserve of the state and its own enterprises (the very recent opening in 2009 of the Shenzhen Exchange to private enterprises notwithstanding). This means that only a minority of a company’s shares trade. The negative repercussions of this arrangement have reverberated far beyond the markets themselves.

Because the state dominates the markets (which it manages and regulates on behalf of companies it owns as the controlling investor), it can channel capital as it likes: An initial public offering (IPO) is fundamentally a bank loan from a state-controlled bank, not the result of a business owner selling a stake in his company to outside investors seeking the highest return on their capital, as we think of in the West. The Chinese government has used this control to create oligopolies and monopolies — the so-called national champions — run by high-ranking political appointees.

In real markets, companies’ attempts to raise capital, as a result, can fail. Not in China! There the government literally sets the price of new shares based on how much funding it needs to raise, then directs other government-controlled entities to invest. Roughly 40 percent of the $9 billion raised in the Shanghai market for the July 2010 IPO of the Agricultural Bank of China, for instance came from other SOEs. This, combined with the more than $13 billion raised on the Hong Kong exchange, helped the bank’s IPO to become on the face of it the largest in the history on any market globally. Another first for China.

That’s not how equity markets are supposed to work. Substituting the state for market forces eliminates the fundamental valuation function of the market, turning it into an arena for speculation where the value of a share reflects market liquidity and investor expectations driven by government policy and the latest rumor or suggestion of government intervention, subsidy, or stimulus. Faith in a business strategy, product innovation or the quality of corporate management is secondary to what investors think the government wants. As a result, China’s investors, retail or institutional, lack the capacity to value companies: There is no need. Nor have China’s investment banks (or, for that matter, the government) developed the core competency of analyzing a company and its industry as the basis for equity valuation. The likelihood that a Steve Jobs could raise significant amounts of capital in such markets would depend almost completely on his relationship with the government and not on his innovative vision. China’s premier economist, Wu Jinglian, famously called China’s stock markets “casinos” and a major source of “crony capitalism.” If anything, he was too gentle.

Hmm… remind us again as to the main purpose of public exchanges in the context of a free market economy?

We submit the purpose of publicly traded markets is to allocate investment capital (accumulated savings) in as productive a manner as possible, via the invisible hand of rational incentives (as opposed to the “visible fist” of government, as Bill Gross likes to call it)…

Centuries of Western failures and successes have taught us much, if we are willing to learn, about how the free market works and why it works.

On a fundamental level, the free market works better than any central planning mechanism because it allows millions of self-interested decision makers to carry out logical decisions at a boots-on-the-ground level, without the distortion of political motive.

When Western economies stray from the essentials of the free market model, they suffer at the margins. This also makes perfect sense, as government entities are not incentivized to make decisions on a profit-and-loss basis.

What fails to make sense here and now is how China has been given a free pass (by optimistic bulls) in respect to all the above.

If anything, the natural lessons of history – plus growing evidence of trouble at local levels – suggests China could be headed not just for a hard landing, but something worse.

From the always excellent Michael Pettis, a local observer and finance professor at Peking University’s Guanghua School of Management, in a prediction that hard commodity prices will have collapsed by 2015 (emphasis ours):

The consensus on expected economic growth among Chinese and foreign economists living in China has already declined sharply in the past few years. From 8-10% just two years ago, the consensus for average growth rates in China over the next decade has dropped to 5-7%. But the historical precedents suggest we should be wary even of these lower estimates. Throughout the last 100 years countries that have enjoyed investment-driven growth miracles have always had much more difficult adjustments than even the greatest skeptics had predicted.

Re, reasons for extreme China pessimism, we are further reminded of an argument Hugh Hendry made some years back. Call it “death by capacity.”

As we know, China’s response to the political challenge of maintaining full employment (and keeping GDP up) has been to massively expand its infrastructure capacity, beyond anything like present needs (and possibly well beyond future needs too).

Similarly, China may have geared its export industry for a massively expanded projection of its Western export customer base. Here is Hendry (via FT interview a few years back):

Now if you go back to 1989 in Tokyo, at the height of the bubble, and you looked at the projection of nominal GDP moving forward, it was a continuation of 5 or 6pc per annum in perpetuity. The reality, however, owing to the post bubble difficulty, is that nominal GDP expanded at 1pc per annum. And it created an enormous surplus capacity which has destroyed the profits of the corporate sector – and everything else within Japan.

Now that’s my fear. My fear is that China and its contemporaries have built productive capacity not only to service a $14 trillion dollar US economy, but to service an economy and an America that they believed would be $20 trillion dollars in seven years time. My fear is that it could be closer to $15 trillion dollars.

So I see China today as a deep out-of-the-money call option on America. Yeah? China  only has a chance of succeeding if the American economy proves to be vigorous and bounces back. And I don’t see the prospects of that happening suddenly imminent.

Note that Europe slowdown, too, is a major pain point relative to China’s export outlook.

The likelihood of the West growing less rapidly – perhaps far less rapidly – than the planners in all their wisdom predicted means that, in addition to all those nutty empty highways, roads and bridges, China could be looking at vast swathes of state-directed export capacity simply becoming dead weight (i.e. major malinvestment).

Bottom line: Given the weight of economic history, the case for China hard landing, or even outright economic collapse, is compelling…

The four most dangerous words to investors, as the old saw goes, are “This time it’s different.” Those who argue China will be okay (like Stephen Roach for example) are essentially arguing the dragon is different, in much the same way pre-2007 housing bulls — who bet the farm on the notion that home prices could never decline – thought the housing bubble was “different.”

Adding kerosene to the fire, China has seemingly replicated many of the gross mistakes of the West along the way. Shadow banking, subprime, bad loans, mountains of inventory… it’s all there.

If theory and the lessons of history are not enough, consider the following empirical evidence:

FedEx CEO Fred Smith on China (via BI / Cullen Roche). “…as the big economies in Europe and the U.S. have grown or contracted — grown at a far lesser rate or, in the case of certain European countries, have contracted, that’s reflected in the numbers in China. And you can’t escape that. I’ve been somewhat amused watching some of the China observers, I think, completely underestimate the effects of the slower exports on the overall China economy.”

China hit by demands of oversupply (Financial Times). [Here is that malinvestment result - JS] “Like thousands of Chinese companies from property developers to car manufacturers, Li Ning is sitting on a mountain of unsold products. Whether they can whittle down these bulging inventories is the single most important question facing corporate China and arguably the economy as a whole…”

In Vietnam, Growing Fears of an Economic Meltdown (New York Times). [How different are Vietnam's communist leaders from China's? - JS] “In Vietnam’s major cities, a once-booming property market has come crashing down. Hundreds of abandoned construction sites are the most obvious signs of a sickly economy… “I can say this is the same as the crisis in Thailand in 1997,” said Hua Ngoc Thuan, the vice chairman of the People’s Committee of Ho Chi Minh City, the city’s top executive body. “Property investors pushed the prices so high. They bought for speculation — not for use.”

China’s steel traders expose banks bad debt (Reuters). [Malinvestment galore - JS] “The battle between the banks and steel traders also exposes flaws in the 4 trillion ($629 billion) stimulus round in 2008, and offers a warning to those calling for pumping more money into the system. At that time, Chinese banks threw money at the steel trade – a crucial cog in supplying the country’s massive construction and infrastructure growth. But those steel loans, after offering a quick fix, became excessive, poorly managed, or a combination of the two. Government officials insisted more money was needed to prop up the industry. Steel executives said the money flow was too heavy, and they had to put the money to work in real estate and the stock market.”After the financial crisis, when the government released its stimulus, banks begged us to borrow money we didn’t need,” Li Huanhan, the owner of Shanghai Shunze Steel Trading, told a judge at a recent hearing. “We had nothing to do with the money, so we turned to other investments, like real estate.”

China’s answer to subprime bets (Reuters). [How long before we hear from a Chinese official that "subprime is contained?" - JS]  “Golden Elephant No. 38 is one of thousands of “wealth-management products”, instruments aimed at monied investors, which have shown phenomenal growth over the last five years. Sales of them soared 43 percent in the first half of 2012 to 12.14 trillion yuan ($1.90 trillion), according to a report by CN Benefit, a Chinese wealth-management consultancy. They are usually created in China’s “shadow banking” system – non-banking institutions that are not subject to the same regulations as banks – which has grown to account for around a fifth of all new financing in China. Like the subprime-debt lending spree in the United States that helped spark the 2008 financial crisis, the products are often opaque, and usually dependent on high-risk underlying assets, such as the Taihe housing project…”

China’s ghost towns and phantom malls (BBC). [Malinvestment on anabolic steroids! - JS] “In Chenggong, there are more than 100,000 new apartments with no occupants,” according to the World Bank’s Holly Krambeck… Matteo Damiani, an Italian journalist who worked for seven years in Kunming, has visited Chenggong several times, photographing empty tower blocks that loom over gigantic plazas, peopled only by enormous works of art. He found a small community of students, workers and security guards but nobody else. “The suburbs and even the city centre are empty,” he says. “You can find a big stadium, shopping malls and hundreds of buildings finished but abandoned.”

Shadow Bankers Vanishing Leave China Victims Seeing Scams (Bloomberg). [Does China have its very own AIG, one wonders? Or thousands of miniature AIGs? - JS] “The shadow bankers are now disappearing, committing suicide or reneging on agreements, leaving thousands of victims in their wake. In the first half of the year, more than 58,000 lawsuits involving disputes over 28.4 billion yuan in private lending were filed in Zhejiang province, where Wenzhou is located, up 27 percent from the same period in 2011 and the most in five years, according to the provincial supreme court. One-fifth of the cases were in Wenzhou, where authorities have set up a special court to handle the surge.”

As if all of the above were not enough, China is now fighting off a trade dispute with the United States – and threatening multiple kinds of war, trade and otherwise, with Japan:

  • US launches auto case against China, Beijing fires back (Reuters)
  • Beijing hints at bond attack on Japan (Telegraph)
  • Why China’s dispute with Japan is more dangerous than you think (Foreign Policy)
  • Chinese General: Prepare for Combat (Washington Free Beacon)

One must wonder – why all the saber-rattling now? Why elevate the Senkaku Islands dispute now?

Could it be that heated protests flaring up all across China (some 85 cities at last count) are seen by the authorities as a useful distraction from increasingly severe economic problems?

How far will China go to distract the world (and the local populace) from its pending malinvestment-fueled implosion?

And none of this really touches on the rampant corruption factors present all throughout China’s financial and political system, as John Hempton of Bronte Capital has argued via The Macroeconomics of Chinese Kleptocracy:

I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:

(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been tomake Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation…

The top down investing and trading implications here are massive, to put it mildly, starting with greatly increased probability that Michael Pettis’ excellently reasoned argument for a soon-to-come collapse in hard commodity prices is on target.

If there is a credible counter-case as to how China will evade all the lessons of history, slip past its egregious mistakes unscathed, mimic the worst sins of the West while paying no penalties, and turn the essential tenets of free market economics upside down in doing so, we would love to hear what it is.

JS (jack@mercenarytrader.com)

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