Friday, January 8, 2010

How to Invest in the Chinese Miracle, where Locals Prosper and Foreign Devils Don’t - Alpha

The biggest economic and financial development of the 21st century is the rise of China. My hypothesis is that well-connected Chinese entrepreneurs and bureaucrats will financially prosper in China over the next few decades, as will the growing middle classes. But foreign investors (ethic non-Chinese) will not make money, as they plunge billions every year buying Brooklyn Bridges (Yangtze Bridges) that will never return them a cent. To wit: foreign direct investment (real investment, not financial instruments) in China between 2001 and 2008 ranged between $26bn to $44bn - not much of that will ever come out to investors. I end the post with ideas on how to get investment exposure to the Chinese miracle by not investing in China (the Gold Rush thesis).

Here are the facts for China's economic growth:
-Population: The largest in the world, with 1.34 billion people, it is mostly a young population (92% below the age of 65) with a low dependency ratio (few dependents for every worker – but this well get worse fast).

-GDP growth: Between 9-13% from 2006 to 2008, and a stunning 8% in 2009 when most of the world went negative. While these stats are probably fudged (esp. at the local level), the high level is generally in the ballpark.

Make no mistake: economic growth rates matter. The US, with an expected 2% GPD growth rate over the next 10 years, will increase its GDP from $13.5trn to $16.5trn. China, with an expected 9% rate, will increase its GDP from $8trn to $18.9trn. While Americans will enjoy fat, sleek, and contented lives with higher GDP per capita (fewer people to share the pie), China will be the world’s largest economy.

The Chinese are the world’s greatest entrepreneurs. Whether you’re in Nairobi, Rome, New York, Sydney, or Buenos Aires, you may notice the small retail shops, restaurants, dry cleaners, and other business run by Chinese small businessmen and women. Southeast Asia is dominated by Chinese entrepreneurs. Some stats:

-60 million Chinese entrepreneurs worldwide.
-Chinese entrepreneurs control 70% of the Southeast Asian economy.
-517 out of 1000 top-ranking companies in Asia are owned by ethnic Chinese.
-50% of foreign direct investment (FDI) inflows to mainland China stem from their own expats worldwide.

-Sound Government (for Economic Policy): More controversially, China has one of the best-run central governments in the world, by economic measures. Kudos to the current Politburo Standing Committee of the Communist Party of China; they’ve done much more for the Chinese middle classes, and to reduce poverty, than either the Bush or Obama administrations have done in the US. Besides the amazing growth rates mentioned above (which put India to shame), China had the largest fiscal stimulus package in the world in 2008 in response to the global crisis, at 14% of its expected 2008 GDP. It led the world in recovery. So much so, that the Carnegie Endowment thought the US should copy China. Chinese tax rates are low, and China is also the world’s largest exporter and saver, making and shipping goods to the rest of the world and saving its surpluses (over $2 trillion in foreign exchange).

More broadly, China has had the greatest reduction of poverty the world has ever seen, from 1980 to 2005.

By political, social, and environmental measures, China does a much worse job. But more on that later.

Today, the hosannas and optimistic melodies on the China story are played aloud. The world has much to be happy for, as a billion richer Chinese people is a good event for human development. Assuming that the Chinese government is smart enough to avoid starting wars or developing an imperial global military presence (ahem), it will do well.

Now for reality. Foreign investors (ethic non-Chinese) are basically gifting their money to Chinese entrepreneurs and bureaucrats when they invest there. Some economists have pointed out that economic growth doesn’t necessarily translate into equity returns (valuations still matter, and China is off the deep end in a bubble today, according to America’s best short seller and a glance at public market P/E ratios). I offer three more conceptual reasons for my hypothesis. First come incentives (agency costs). Second is the lack of basic property, speech, and politico-legal rights. Third is a reading of developing market history, especially 19th century American history.

1) One-sided incentives for China’s entrepreneurs and managers (high agency costs):
China’s entrepreneurs and managers have a strong incentive to take foreign capital and technology (including know-how), build a strong company, and then to sever the foreign partner.

Put yourself in an entrepreneur’s shoes. You speak Mandarin, have all the necessary government and family connections (guanxi) to operate, have sweated for years on the ground (after breaking out of poverty), and there is no restriction against you appropriating a business after you build it. Why share it with the pesky foreign investors, who were born with TVs, cars, and free health care? How many entrepreneurs in Silicon Valley would kick their VCs to the curb, after success, if there were no legal consequences? (Hint: A lot). The economic term for this is agency costs – they are much higher in China than most other countries, but investors aren’t paying attention. To counter agency costs, an investor has to be able to monitor entrepreneurs/managers, and then discipline or remove them if needed. In China? Fuggadaboutit.

For a real life example, consider the French company Groupe Danone’s foray into making yogurt in China. They picked a stellar local entrepreneur, Zong Qinghou, who took Danone’s capital, technology, and know-how to start a joint venture. While managing it, he then set up parallel company to compete with it. Eventually, as Danone realized it would lose everything, it settled with Qinghou for a small sum, and basically lost out any long-term future in the Chinese yogurt markets.

Previous China fads have provided books of material for this. See Beijing Jeep or Mr. China for earlier pipe dreams brought to reality. Sure, there are honest entrepreneurs like BYD’s Wang Chuanfu, but this is a matter of personal character in a system that is both amoral and stacked against foreigners (Note, this guy is so bold that he drinks battery fluid to make a business point).

Sure, this incentive system isn’t fair to foreign investors. But neither was the Western occupation of China for a hundred years, the forced sale of drugs like opium to the Chinese masses, and the crushing of local resistance against the “Foreign Devils” (the Boxer Rebellion). Don’t forget the recent bombing of a Chinese embassy in Kosovo by US planes in 1999 (can you imagine Chinese planes bombing a US embassy anywhere, and what the outcry would be over that – what American wouldn’t want war?). Culturally, most Chinese just don’t care about giving a fair shake to wealthy and imperialistic foreign investors. Have doubts about this? Consider how the Chinese system respects no Western intellectual property (estimated $23bn stolen in 2005), but forces the West to respect Chinese patents. Forget fairness, this is amoral sharp dealing.

2) A lack of lack of basic property, speech, and politico-legal rights in China:
This was the detail I brought up earlier on, when discussing the miracle of Chinese growth. Basically, the question for a foreign investor is, what do you do when a bond issuer fails to pay you, or your equity partner reneges on you like Mr. Qinghou? Answer: nothing. You take it on the muzzle, tuck your tail between your legs, and whimper away. Chinese courts are a mess, the rule of law and corruption are worse than the world average, and the “voice and accountability” of people is one of the lowest in the world (see the World Bank’s Governance matters chart below, which suggests China has become less politically stable and more corrupt in the last decade).

The World Bank on Chinese Governance, Corruption, and Rule of Law

You can go to court to sue your equity partner, but you will lose your case (he likely has a political relationship with the judge). A bondholder can try forcing a Chinese company into bankruptcy, but the odds of success are very low (my banker friends in restructuring departments of global banks tell me the two places in the world they can’t collect from are former Soviet republics, run by ex-Mafia/KGB types, and China). Buying bonds without a clear law of bankruptcy/defaults and an honest system backing it up is just insane.

OK, so the legal system is worthless. What about pressure in the press? Well, that’s tough to do when the press won’t even publicize your problems, because it’s controlled by a government who doesn’t want to scare away other potential foreign investors. It’s not just Chinese dissidents protesting gross human abuses that are muzzled; foreign investors don’t have a chance. No free speech means no chance of protesting to get a fair shake or get your money back. I would go further and argue that for property rights to exist, one must have a fair degree of free speech rights (your right to own property depends on your right to publically argue for why you should keep it).

Put bluntly, the game in China is rigged. Economic Freedom for the average citizen is low, and it’s almost nothing for the foreign investor. The Heritage Foundation, a think tank, puts China at 132 in the world, below Yemen, Rwanda, Columbia, and Niger. This is a game for the House, its croupiers, and other insiders.

3) A reading of developing market history, especially 19th century American history, suggests foreign investors boost economic development but lose much of their money to locals. Throughout the 19th century, the US flourished with an influx of European capital. Foreign bondholders financed railroads, cities, and industrial mining operations. The caveat is that they got wiped out in their railroads investments from 1870-1892 (the single largest use of capital in US for that period), as unscrupulous local entrepreneurs transferred wealth to themselves. Dust out the history books and read about Leland Stanford (yes, the Stanford who was a California Governor and with an eponymous University), Jay Gould, and E.H. Harriman (Maury Klein’s books are a great starting point). Likewise, the foreign bondholders didn’t get much back from US states and municipalities.

Unfortunately, we don’t have any investors from the 1880s alive to tell us their stories today, but consider the "Memoirs of Henry Villard." Mr. Villard fought honestly and bravely for European bondholders to receive something, anything, on their rotten American investments. In one European bond investment in the US, only half of the nominal investment was ever received by the railroad company in Oregon, the rest having dissipated along the way. Generally, much of the management and directors of American railroads (the largest corporations of their time, by far the biggest part of the capital markets) transferred foreign wealth to themselves.

Henry Villard (1835-1900), Protector of European Bondholders Against Crooked American Railroads

In sum, direct investing in China is such a bad idea that your common sense should stop you (but wait, very few institutional investors seem to have common sense). Of course, traders and hedge funds who speculate daily in Chinese stocks (in and out like mosquitoes around buffalo) will survive. But investors, that is, people with locked in capital or holding periods greater than a week or month, enter at their peril. The one counterexample I can think of is Warren Buffett's large Petrochina investment in China for a year, which was a naked bet on cheap oil assets and paid off handsomely. But I doubt even the Standing Committee would want to screw the world's most famous investor (imagine the publicity), and time will tell whether smaller investors get this treatment (odds are they won't).

So what’s a foreign investor to do, to get China exposure?

The Gold Rush Thesis - Buy China through Australia, Canada, and other Exporters: The thesis comes from the California gold rush in the 1840s and 1850s. Very few of the prospectors and miners made money in the mountains and plains, but the ones who did quite well were the merchants who sold to them. For example, the magnates Collis Huntington and Mark Hopkins made their first fortune selling dry goods, mining supplies, and other hardware to miners; they later partnered with Leland Stanford to create a railroad/transportation monopoly.

A Dry Goods Store and Hotel in a Mining Town in Sutter Creek, Circa 1850

For the 21st century, investors should look to prospering Australian and Canadian companies who export into China. Examples include Penn West, Talisman Energy, Suncor Energy, Barrick Gold, Alcan, and Potash Corp. Similarly Australia has some great resource companies like BHP Billiton, Bluescope Steel, and Ashton Mining. For the US and Germany, tech companies with dominant positions, like Cisco, Oracle, Siemens, and Twintec will do well. Generally, China’s largest imports are electrical machinery, oil, metals, scientific instruments, and office machines and equipment. Of course, younger companies who export heavily into China will do even better than the multinationals, but I’m not revealing my list of whom I’m betting on.

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