The New Robber Barons Read online

  If that weren’t enough to make investors nervous, Jim Chanos, President and founder of Kynikos, told Bloomberg that many large cap shareholders don’t realize that all they have is an operating agreement with mainland companies, not control of hard assets.

  China has loaded itself up with debt. Unfortunately for Chinese citizens, China also down-loaded the “killer app” of socializing credit risk. Bank deposits are low yielding and the borrowing rate is either very low or negative which encourages explosive loan growth, also known as a debt bubble. (“China Financial Markets: Time to relax credit?” by Michael Pettis, Guanghua School of Management, Peking University, October 31, 2011.)

  As for China’s official growth figures, one has to be suspicious of government numbers when ministers have already shown they will try to bulldoze over horrific facts. Discovery of the truth takes a miracle.

  When Will Strain Lead to a Crash?

  China is on track for making as much of a muddle of its economy as many countries in the West have done. While being a fast-growing creditor country helps mitigate the consequences of its folly, the consequences are catching up with China. Are these problems overstated? That’s impossible to tell without reliable numbers. The question to answer is how quickly and to what degree will China’s problems affect its economy? After all, one wants to be able to get in a good short trade just before it all falls apart, if that is where this is headed.

  Dylan Grice points out that anecdotal evidence can be misleading and China may “keep the plates spinning for a few more years.” (“Popular Delusions: On China’s swindles: how big is the bezzle?” by Dylan Grice, Societe Generale Cross Asset Research, November 4, 2011.)

  It would be useful to come up with a measurement that indicates when things are just about to fall apart. Based on my own anecdotal experience in Iran, one cannot predict the timing of a collapse with certainty, but a good leading indicator is when rats start leaving the sinking ship in droves.

  Chanos (“China Chaos”) Derivatives

  Grice provides a clue for the timing of China’s collapse. Since 1990 around 18,000 officials have fled taking an average of around $7 million per flight. Special purpose credit derivatives (perhaps you prefer the term “discredited” derivatives) are a leading indicator for China’s hard landing. I call these “China chaos” derivatives, or “Chanos” derivatives.

  If the rate of change of public officials fleeing the country, df/dt > x, where x is yet to be defined, or the acceleration in fleers, d2f/dt2 > y, where y has yet to be defined, or the rate of change of the average amount of loot dl/dt > z, where z is yet to be defined, then conditions of the Chanos Equilibrium have been violated and destabilization will occur.

  Stated differently, when you see the absolute amount of embezzled wealth fleeing the country suddenly increase, or when you see a sudden increase in the absolute number of Chinese officials leaving the country on “holiday,” or when you see an acceleration in the number of officials leaving the country in a stealthier way, you’ll know China is sinking.

  China 2012: The Year of the Bull (Rogers) or the Bear (Chanos)?

  January 9, 2012

  When I think of a China bull and a China bear, I think of the legendary dueling Jims: Jim Rogers and Jim Chanos. In response to investors bearish on China, Jim Rogers famously said: “I find it interesting that people who couldn’t spell China 10 years ago are now experts.” Jim Chanos famously said that China’s real estate market is “Dubai times 1,000 — or worse.” He’s been saying that for over two years. Chanos points to a credit bubble, and says he’s early and sticking with his short positions. Rogers insists “China is not in a [credit] bubble,” rather it’s been in a price bubble in urban, coastal real estate, and to compare China to Dubai is a false analogy. Jim Rogers is bullish on China’s long term prospects: “China is going to have many serious problems along the way as it rises, but ‘Dubai 1000 times over’?!”

  Jim Rogers: China Bull

  James B. Rogers made his fortune as a hedge fund trader and then took off to see the world. If you have a business degree and you’ve never read his books Adventure Capitalist, Hot Commodities, and A Bull in China, then you’ve had an incomplete education.1 In his world travels, Roger exposes bridge-to-nowhere investments by world organizations like the International Monetary Fund and corrupt governments and waste. He also points out areas of potential sound investments and areas to avoid or short. He’s been short India for over a year. He does his own research and observes that celebrity economists often lump India and China together. “It shows a profound lack of understanding of both.”

  China’s Big Picture

  According to Rogers, China will have many set-backs as it grows, as did the U.K. and the U.S. He notes “the U.S.’s many Depressions in the 19th century, a devastating civil war, periodic massacres in the streets, and little rule of law, few human rights, and several military governments. As recently as 1907 the whole system collapsed just as the U.S. was on the verge of becoming the greatest success of the 20th century. Yet the U.S. did a good job for a long time.”

  What are China’s true growth figures? Rogers doesn’t trust any government’s numbers. He assumes they’re all lying. Yet China’s growth is faster than that of developed countries. A pullback in the West will affect China, but China will be hurt less. The CIA estimates 2010 exports at only 16% of China’s 10 trillion dollar GDP with growth of 10.3% (adjusting the fiat exchange rate for purchasing power parity).

  China’s high household savings rate relative to the U.S. and reserves give it more of a buffer in a downturn. China is feeling the effects of the developed world’s problems and is experiencing inflation, but Rogers says it will suffer less than the developed world. China is a creditor nation and the United States is a debtor nation. (See also: “Clear and Present Danger,” TSF, October 31, 2011.)

  A global slowdown will affect China along with the countries with which it does business. Rogers views the global economy in both absolute and relative terms: “Saying ‘I was right on China’ when the rest of the world is suffering more is embarrassing at least to me. The rest of the world is repeatedly knocking on China’s door to help, since China continues to do better than others.”

  Trouble is Opportunity

  Rogers won’t live in any of his favorite cities in Mainland China, because pollution levels make them unsafe for his family’s health. Some estimates say that by U.S. standards, only 20% of Chinese cities have satisfactory air quality. But Chinese officials say 80% of the cities are satisfactory and improving versus last year. That’s hard to believe. The U.S. Embassy called Beijing’s pollution “crazy bad.” In December, 2011, cancer-causing fine particulate pollution caused a shutdown of the busiest airport in Asia, Beijing’s Capital Airport. Rogers sees money making opportunities for companies that can clean up and control pollution.

  Rogers acknowledged before Jim Chanos that there are localized real estate bubbles in China. In 2009, he warned about the urban, coastal real estate bubble. The government took action to quell speculation. Rogers believes China’s real estate problem is a price bubble more than a credit bubble due to lower leverage in the system.

  Chinese borrowers had to have good credit, make a substantial down payment on even a first home—many paid 100% in cash—and make an even larger down payment on a second home. Leverage through toxic securitizations never took off in China. Chinese real estate developers in some cities will collapse, but strong Chinese economic growth comes from various sources. In the U.S., many borrowers bought houses with no deposit and no job and sometimes more than one. Bankers leveraged bad loans many times over. The scale of the U.S. credit bubble was much bigger.

  The Chinese economy is much more than just real estate. Even as some of the real estate market collapses, other parts of China are doing well and will continue to do well. If Shanghai real estate speculators lose their shirts, other Chinese will profit in investments in solving China’s water problems, air pollution treatment,
agriculture, raw materials, and energy.

  Long Term Outlook: Speaking the Language

  Rogers moved his family from New York to Singapore, where the government is committed to making Mandarin the city-state’s mother tongue within two generations. He’s committed to making it happen now for his daughters.

  In 2009, his daughters participated in a promotional video for Singapore’s “Speak Mandarin Campaign.” (Official languages include English, Malay, Mandarin and Tamil.) His older daughter, Happy, spoke fluent Mandarin as she instructed Baby Bee, her responsive then one-year old sister sitting on Paige Parker’s (Jim’s wife and the mother of his children) lap, to clap, clasp her hands in a Chinese New Year ritual, and then point to a light. Rogers’ latest book is A Gift to My Children.

  Explosive Demand

  China will experience speed-bumps and pullbacks, but even in a slowing economy market share for specific items can continue to grow. China is experiencing what looks like explosive durable consumer demand, and there is both immediate and long term profit potential.

  McDonald’s started in China 15 years ago, and it took 10 years to breakeven. McDonald’s foreign franchise sales were up 7% in 2011. McDonald’s won’t release the numbers for China but says sales in China—its fastest global growth area—are up much more in 2011 versus 2010. McDonald’s is over the moon about finally catching on in China. McDonald’s announced it would increase from 1,300 franchises to 2,000 by 2013, its largest expansion so far in China. In 2011, McDonald’s was a top performing large cap stock partly due to the earnings boost from its franchises in China.

  According to Bloomberg, Yum! Brands, Inc. is thrilled with its KFC restaurant chains’ success in China. Its success swamps that of McDonalds. In 2011, revenues from China outstripped earnings from Yum’s various restaurant chains in the U.S. for the first time.

  Rogers’ Bull Trades

  Rogers’ bullishness is justified in his areas of focus. He has studied China’s issues with food production and consumption and its long term needs for raw materials based on global supply and demand for commodities. He favors all commodities over the rest of the decade, but especially suggests looking at the ones still depressed on a historic basis.

  The central banks of the world seem determined to print their way out of their problems and destroy the value of their currencies through inflation. That should boost the prices of real assets. Rogers is generally short global equities and owns real assets and producing agricultural land.

  Jim Chanos: China Bear

  James S. Chanos, President and founder of Kynikos Associates, L.P., made his reputation with a series of notable short calls spanning three decades including the bankruptcies of Baldwin United in the 1980s and Enron at the beginning of this century.

  The trenchant critic of fraud and hypocrisy is president of the board of trustees at the Browning School, a trustee of The Nightingale Bamford School, and a trustee of The New-York (sic) Historical Society.2 Chanos is a visiting lecturer of a well-received course at Yale: “Financial Fraud throughout History: A Forensic Approach.”

  Yet the cynical divorcee reportedly unwittingly gave his house keys to a prostitute he met in a nightclub and invited to parties—sloppy due diligence? Eliot Spitzer’s career as Governor of New York ended in March 2008, when he allegedly purchased the same prostitute’s sexual services at a Washington hotel.

  In the wake of the Spitzer scandal, Chanos said he was unaware of his house sitter’s illegal activities, and his own relationship was innocuous. Chanos frequents nightclubs in New York and Miami and is the “target” of multiple wayward Russians. He’s an inspiration for skeptics.

  The churlish bear’s most famous current shorts are related to the Chinese real estate market. He’s never been to China—his retort to critics is that he never worked at Enron—but his analysts have. His data points to localized housing bubbles. Chanos is short suppliers of materials such as iron ore, cement, steel and coal. His disclosed longs (a hedge) include Macau gambling establishments. According to Chanos, he’s “long corruption, short property.”

  The thing about corruption is that one can never trust where it ends. As “corruption” goes, gambling is legal in Macau. Money laundering, drug-trafficking, prostitution, and cooking the books are another story. Casinos are usually profitable because they enjoy the house odds. Yet I wonder if the books can be trusted to be any more accurate than Chinese reverse merger companies. (For an earlier discussion on swindles, corruption, and opaque government debt see: “Chanos Crash: Timing China’s Financial Meltdown,” TSF, December 6, 2010.) The shares of Macau casinos may get killed for reasons that make the trade ineffective as the long leg of his hedge…or not. When it comes to being long corruption, Chanos may have done his due diligence.

  Debt and China’s Housing Price Crash

  A housing price crash causes distress even to unleveraged homeowners. To the individual homeowner and individual property developer, it matters very much. Many Chinese home buyers pay cash, but others make high down payments. Some first time home-buyers put down as little as 30%; high by U.S. “standards,” but still painful when housing prices drop 30%. Second homes require at least 50% down, and third homes (where allowed) require all cash. Some investors have bought multiple properties. Even if a borrower pays upfront in full, a housing price decline has a huge impact on how wealthy investors feel.

  Home prices in some areas of China are sliding fast. Some analysts say the “tipping point” started in September and expect it to get much worse. Chinese newspapers reported riots in Shanghai after developers slashed prices to dump inventory. Contracted home buyers saw prices cut 25%. Some property developments in Beijing have had price cuts of 20-30 percent. China’s empty “ghost cities” are seeing price discounts of 30 percent for upfront cash payments. Mainstream U.S. financial media is now reporting possible housing price declines of 20-30 percent for major Chinese cities next year.

  Nothing creates a hard landing—at least locally—better than a housing collapse. Property construction accounts for more than 13% of China’s GDP up from around 3% of GDP in 1999 according to the China National Bureau of Statistics. Local Chinese governments have mounting debt to fund infrastructure projects of 10.7 trillion Yuan ($1.7 trillion) and depend on land sales to fund payments. According to investment management company GMO, debt in Local Government Funding Vehicles amounts to around 1/3 of China’s GDP. The projected slowdown in land sales will pose a huge problem, no matter whose numbers one uses.

  No one knows the size of local government debt obscured by off-balance sheet vehicles. Hidden national government debt includes “support” such as the stated support for the $330 billion and rising debt of the railroad. A variety of other guarantees have ballooned China’s real debt.

  Then there are the obvious problems with undercapitalized banks. According to Jim Antos, an analyst at Mizuho Securities in Asia, loan growth has slowed to 15% from 30%. Antos believes there’s a credit bubble. He asserts debt is “unsustainable” as the current level of bank loans stands at $6,500 per capita in 2010. Gross domestic product per capita is $4,400, according to Antos. (The CIA estimates 2010 adjusted GDP per capita at $7,600 on a purchasing power adjusted basis.)

  On a scale of one to ten, Antos rates China’s debt problem an eight and Greece’s debt problem a ten. Chanos told me: “China should be thanking Greece,” for deflecting attention from China’s debts. Critics say the Yuan isn’t yet a freely convertible currency, but it’s made progress in that direction. China’s growth in areas unrelated to real estate, and the high household savings rate, and reserves suggest a very different economic outcome for China.

  GMO reports that Fitch estimates that 35% of bank loans are directly or indirectly tied to the Chinese property market, and UBS estimates it at 40-50% of outstanding loans. No matter which is correct, a pullback will be brutal. (“Between Errors of Optimism and Pessimism,” by Edward Chancellor, GMO, September 2011, and “China Real Estate—Final Destinati
on,” UBS, August 25, 2011.) “Dubai times 1,000—or worse,” however, sounds like Chanos talking his book.

  The Wukan Rebellion

  Slowing property development in selected areas will mean less local revenue from land sales, and that will translate to more non-performing loans. Yet, even if the government eases, and property developers quickly recover; local citizens may be unwilling to sell arable land, because food prices are soaring.

  Odd things happen when people feel they’re not getting the straight story, and local government officials are stealing their land and money. In 2011, Wukan’s 20,000 citizens drove party officials out of town. Residents of the large fishing village balked when officials tried to illegally sell valuable land to property developers. Inflating food prices meant that people wanted the land to grow more food.

  Armed police were unable to retake Wukan. The provincial governor flew in and negotiated an agreement that included ousting corrupt local officials.