Chinese Government Policy

The Sweet Smell of Success — One Chinese County’s Dominant Role in Global Garlic Industry

Ming dynasty bowl from China First Capital blog post

Anyone who has enjoyed Chinese food in China will discover, by aroma as well as by taste, that garlic is the most widely-used flavoring agent of all, after salt. It’s detectable – in fact visible – in just about every stir-fried or stewed dish, in such large quantities to leave most outsiders breathless. Which, of course, is just as well. 

A simple stir-fried dish will often have 3-4 whole cloves of chopped or sliced garlic. Many dishes have far more. One of my favorites, Lazi Jiding, is a Sichuan dish of small chunks of chicken, chili peppers, and often several heads’ worth of garlic cloves all deep-fried together.

Garlic turns up everywhere, at all times of the day. This morning at the breakfast buffet of the hotel where I was staying in Fujian, there was a dish of simple stir-fried cabbage that had at least 25 cloves of garlic in it. I stopped counting long enough to spoon some onto my plate, and move onto the next garlic-laced Chinese breakfast treat.  

I lived a lot in Italy,  the other country famed for its use of garlic. There, adding more than one clove to a dish is usually considered excessive, even uncouth. You will likely eat more garlic in a day in China than a month spent eating in Italy. 

In the US, garlic has become a far more common part of the diet than when I was a child.  I began noticing several years ago that all the garlic I bought in LA was imported from China. That always struck me as odd, since very little fresh food is imported from China, and California has a town, Gilroy, that’s famed as one of the world’s largest producers of garlic. 

The Made-in-China garlic I’ve bought is always fresh, crisp and cheap – usually no more than a dollar a pound. I never figured out how anyone could make any money shipping it from so far and selling it for so cheap. 

I assumed that the US’s ever-increasing appetite for garlic was emptying China of its favorite flavoring. Since moving to China, however, I’ve seen that wasn’t the case, that there was more than enough to satisfy China’s far larger appetite. So, then my question became: where is all this garlic being produced? From all the garlic in circulation, you’d think half of China’s arable land must be used to cultivate it. Yet, I’ve never seen any in the ground. I’ve asked friends, farmers, chefs, but never got a clear answer to where all this garlic was coming from. 

Now I know at least one place. Jinxiang County in Shandong Province is the largest garlic-producing area in China. This little-known area in Shandong’s southwest corner is not far from Qufu, Confucius’s birthplace. Jinxiang  is also now one of the centers of worldwide commodity speculation. The price of Jinxiang-grown garlic has spiked recently, rising more than fifty-fold from its low a year ago. As the China Daily reports, “Garlic trading has created a handful of new millionaires overnight in Jinxiang county.” 

I couldn’t find a figure for Jinxiang’s total garlic output. But, last year Jinxiang produced 70% of China’s garlic for export, over one million tons last year. That means that Jinxiang produced half all the garlic eaten outside China. At current pace and current export price of around $1,000 a ton, Shandong will export over $1 billion of garlic in next 12 months. 

China has no strong natural advantage in garlic-production. It’s not particularly labor-intensive, nor does it grow best in climate like China’s. Garlic, after all, is a member of the onion family, and so grows pretty well all over the world. Jinxiang must be the world’s leading garlic producer for other reasons that highlight a part of China’s economic strength that is often not emphasized: regions with intensive focus on particular industries (in this case, growing garlic for home and export market)  and a developed infrastructure to move goods quickly and efficiently to market. 

China has one other advantage that helps explain its dominance in global garlic-production. The whole plant can be sold for good money, not just the bulb. Chinese also eat prodigious quantities of the green garlic shoots that grow above ground. This vegetable, called jiu cai (韭菜)in Chinese, is served on its own, as a stir-fried dish, or added to many other staples, including dumplings. Like a skilful butcher carving a hog,  garlic farmers in Jinxiang know how to extract every morsel of profit, and leave nothing to waste. 

I’m determined now to go to Jinxiang. Partly, it’s because I love garlic. But, I also want to see (and smell) this region for myself, how farms are organized, what else is grown or manufactured there. I want to find out more how one place became so big and so successful selling one agricultural product that (unlike, say, tobacco or ginseng) grows just about anywhere. 

My company is lucky enough to have two clients in Shandong. I’ve already worked out how far these companies are from Jinxiang, and will go there at first opportunity.  I’m pretty certain over the last 20 years, to satiate my love of garlic, more of my money has ended up in Jinxiang than just about anywhere else in China.  


Yiwu: China’s Little Known Capital of Commerce

Lacquer box, from China First Capital blog post

 

What is the most international city in China? Shanghai? Beijing? Surely, it must be Hong Kong? No, the most international city in China is one most people outside China have never heard of: Yiwu, in Zhejiang Province. 

Yiwu is about three hours southwest of Shanghai, with no sites of any importance, and a somewhat rundown city center. Few international tourists will ever set foot there. And yet, at this very moment, there are more foreigners thronging there than anywhere else in China. 

Yiwu, you see, is where the Third World comes to shop. In the last ten years, it’s become the nexus of a large, complicated global trade route, the main supply depot for tens of thousands of shops all across the world. Yiwu’s streets and hotels are filled everyday with thousands of traders from Africa, Russia and the Middle East. They come there to make money, which they do by buying goods by the container load in Yiwu to ship back and sell in their home countries.  

This is petty capitalism on a grand scale: thousands of foreign small businessmen buying from thousands of Yiwu merchants, who rent stalls in the huge market centers spread across the center of Yiwu. At a guess, there must be over 15,000 stalls in these market centers, each staffed by a local, each catering mainly to the foreigners who spend most of their days bargain hunting. 

Mainly, the stuff for sale caters to the taste of this foreign market. Little if any of it would find buyers in US, Western Europe or, increasingly, China itself. Indeed, from what I could tell, more of the world’s hideous clothing ends up for sale in Yiwu than anywhere else. There is enough polyester and other petrochemical-derived materials on display to power the world’s ocean shipping fleet for generations.

Besides clothing, there are a large number of stalls selling other basics of poorer economies, like printed plastic bags, cheap carpets, plastic jewelry, lighting and other house wares. If you wanted to know how people dress and furnish their homes in Isfahan, Aleppo, Izmir, Rostock or Accra, you could get a decent impression by walking through the market centers of Yiwu. 

How and why Yiwu became the center of this multi-billion dollar trade remains a mystery to me. Yiwu has no natural advantages of any kind: it’s far from main transports hubs, hemmed in by mountains, and never developed much of an industrial base. The main export ports of Ningbo and Shanghai are both over three hours away by truck.

Clearly, there was no central government diktat saying Yiwu would be China’s “window on the Third World”. It seems to have happened spontaneously. To accommodate all the foreign traders, basic English is much more widely spoken than anywhere else in China. Even the lady at the ticket booth in the Yiwu bus station can use English to sell a one-way bus ticket to Guangzhou to an African on his way home. 

The English is not always correct. Outside one of the many shops selling sex toys, I saw a sign reading  “Aduit uppiies”. I assume, from the customer base inside, they got the Arabic version correct on the sign. 

By the standards of other successful Chinese cities, Yiwu is more down-and-dirty. There are none of the showpiece infrastructure projects like new expressways and elaborate modern skyscrapers that proliferate in other Chinese cities. While clearly all this trade has made many in Yiwu very rich, the city looks like the China of twenty years ago. Its market stalls are not the kind of place where most Chinese care to shop these days. Chinese, especially urban-dwellers, like well-designed brand-name chain stores with higher-quality merchandise and slick packaging. 

Walking around Yiwu, you get the sense that at least 10% of the population is foreign. Nowhere else in China even comes close. The foreigners are mainly Arabs and Persians, but there are also many Africans and Russians crowding the streets, markets, restaurants and hotels. 

Yiwu has more “foreign food” restaurants than anywhere else in China. Most offer Arab and Turkish food. Indeed, much of downtown Yiwu has the feel of a Middle Eastern bazaar, with clutches of men sitting around smoking hookahs and fingering prayer beads.

You are as likely to hear “Salaam Alekum” as “ni hao” walking the streets of Yiwu. All kinds of services have sprung up in Yiwu to cater to the Middle Easterners. There are halal butchers, coffee shops selling Turkish coffee, manufacturers of the long Arab thawb worn by men. Less delightfully, a Chinese street portrait artist displays drawings of Barack Obama, Mahmoud Ahmadinejad and Osama Bin-Laden. 

I like Arab food, and have eaten a lot of it, both in the Middle East in London. Yiwu’s version was actually quite authentic and tasty. Inside the restaurant I went to, the loudspeakers were playing a recitation of the Koran. Arab and African men sat eating their lunch. There are few Arab women to be seen. 

African women, on the other hand, are thick on the ground, fulfilling their reputation as some of the most talented of all the world’s market traders. I spoke to one lady from Ghana, who comes to Yiwu three times a year, and buys enough each time to fill up a 40-foot container – kids and adult clothes, shoes, carpets, blankets. The profit margins are good. After deducting the $2,000 airfare, the $300 for a Chinese visa, food and lodging in China, plus the shipping costs back to Ghana (and the bribes needed to get the goods out of Ghanaian Customs) she still earns a tidy profit on each trip.

Her capitalist Odyssey, repeated thousands of times a week, with containers bound for the world’s most glamourless spots,  is what keeps Yiwu booming. There is nothing petty about the petty traders of Yiwu. 

It’s fair to say that Yiwu has built its wealth, to some extent, on the misfortune of others. The traders who make the long trip to Yiwu do so, mainly because their countries are criminally mismanaged. In these countries of the Middle East and Africa, there are no local manufacturers making goods at a price and quality that can match that of China, even when you factor in the high transport costs to get people and merchandise to and from Yiwu and the bribes and other levies that must be paid to make sure the items reach local store shelves. Prices in Yiwu are not particularly low, more “retail” than “wholesale”. The traders buy in relatively small quantities, meaning Yiwu merchants can charge higher prices and earn fatter margins for themselves.

 This sad and persistent reality of corruption, economic mismanagement and political tyranny in countries of the Middle East and Africa guarantees that Yiwu will continue to thrive for many years. Yiwu’s market economy was built by catering to places with no real market economy of their own.


 

Shanghai’s New Hongqiao Terminal: What’s Lost is As Important as What’s Gained

Tang horses from China First Capital blog post

Whenever possible on visits to Shanghai, I’ve always chosen to fly into Hongqiao Airport, rather than the larger, newer Pudong Airport. Shanghai is the only major city in China with two major commercial airports, and Hongqiao and Pudong couldn’t be more unalike. Or at least that was the case until a few weeks ago, when the new Hongqiao terminal and runway opened. I just flew in and out of this new building, and while it’s an impressively gleaming facility, I find myself mourning the loss of the old Hongqiao. 

Hongqiao was always a dowdy remnant of a bygone era in China, built over 20 years ago when the western part of Shanghai was still largely farmland. The first time I went to Hongqiao was 1982, to see my friend Fritz off. He was flying on PanAm Airlines to the US, back when there were very few international flights into and out of China. As I remember it, the PanAm 747 came gliding in like a metallic chimera, over the heads of peasants transplanting rice. 

Gradually, the city enveloped the airport and Hongqiao is now one of the few downtown airports in China, a short cab ride to the main business areas in Shanghai about 8 miles away. Its 1980s vintage terminal was also one of my favorite sites in China – a reflection, perhaps, of the fact I rarely get to travel to anywhere very scenic in China, but hop around from booming metropolis to booming metropolis.

The old terminal has a brute, utilitarian ugliness about it, fishhook-shaped, small, cramped and comfortingly ramshackle. It’s so past-its-prime, in fact, it would not be out of place at all in the US, with its outdated urban airports like LAX, Kennedy, LaGuardia, Midway. 

The comparison with Pudong, opened ten years ago 25 miles outside the center of Shanghai, was stark. At Pudong, you whizz along long corridors on motorized walkways, and travel downtown on the world’s only commercial Mag-Lev train. If Pudong is glass and steel, Hongqiao was cement and plastic. 

But, again, all this now belongs to the past tense. The new Hongqiao Terminal is, if anything, more loudly and verbosely modern than Pudong when it opened. I had no idea it was even being built, it’s so far away from the old facility, on what was the back fringe of old Hongqiao. It’s a 20-minute shuttle ride between the two. All domestic flights now operate from the new terminal, and my hunch is that the old terminal will not be standing for very much longer. Civic leaders clearly came to see it as an eyesore, an embarrassingly “Third World” entry-point for a city busily striving to become the world’s next great commercial and financial capital. 

There was a rush to open the new Hongqiao, since next month, the Shanghai Expo opens. The roads leading to the new terminal are still under construction, as is the subway line. Vast expanses of ground in the front and to the sides of the new building are now just barren plots, waiting for parking lots, airport hotels and rental car facilities to populate them. Our cab driver had not been yet to the new terminal and couldn’t find the departures area. 

On entering, the first impression is of a very un-Shanghai-like emptiness. The new terminal must be at least ten times larger and three times taller than the old one. The line of check-in counters stretches for half-a-mile. You get a sense of what Jonah must have felt like entering the whale. Everywhere else in Shanghai is so jam-packed that you are part of a perpetual mob scene, breathing in someone else’s exhaust. Not here. It hints at a Shanghai of the future, a city not defined mainly by its enormous and densely-packed population, but by its modernity, efficiency and polish. 

That’s just it. What’s most special, and worth preserving, about old Hongqiao is that it belongs to the Shanghai that “was”, rather than the China that “will be”.  Even the name itself is a delightful throwback. Hongqiao means “Red Flag”, a name straight out of the Maoist lexicon. 

The old axiom is very apt: “you don’t know where you’re going if you don’t know where you come from”. When Hongqiao’s old terminal goes, so too will the last conspicuous reminder of the Shanghai of thirty years ago, a city,  ever so tentatively, starting down the road of economic reform. 

A tangible part of my own history in China will also disappear. Flying into Shanghai will never be the same.  


Smart Commentary on China from Washington Post

John Pomfret article Washington Post in China First Capital blog post

From his perch at the Washington Post,  John Pomfret is one of the better-known American journalists writing about China. He is also, coincidentally, one of my oldest and closest friends. I quibble with him often about his take on China, particularly now that I’m living here and he isn’t. He moved back to the US five years ago, and wrote a well received book about China called “Chinese Lessons”.  Quite a lot of it was written in my dining room in LA. 

For a change, I actually agree with the main thrust of one of John’s articles on China. It’s an opinion piece, co-written with his colleague Steve Mufson, published recently in the Post. It’s title: “There’s a new Red Scare. But is China really so scary?” Read it here.

The key insight is that America, in the midst of a deep and long recession,  is undergoing one of its periodic bouts of self-laceration. The widespread anxiety that America is in decline is exacerbated by a sense that China is now better, smarter, faster in many important ways. A lot of this is plain silliness, as John’s article points out. 

America’s problems are home-grown. China’s rise over the last 30 years is overwhelmingly positive, for its own citizens first and foremost, but also for the rest of the world, US included. 

There’s a lot for an American to admire, even envy, about China. Two examples: even while remaking most aspects of its society, the family has retained its primacy in Chinese life, as a source of stability, happiness, and purpose. China also remains the most “kid friendly” country I know, measured by the care and affection lavished on the young Chinese, particularly infants and preschoolers. 

Americans, in the main,  have always had a special fondness for China, regardless of the state of the political relationship between the leaders of the two countries. But, that fondness doesn’t stop many of them from perpetuating simplistic notions about the place. Once, China was seem as hopelessly backward and poverty-stricken. Now, it’s seen as a novice superpower, outmuscling the US across the globe. 

John’s article cites a quote from Sun Tzu, “If ignorant both of your enemy and yourself, you are certain to be in peril.”


Life in the Fast Lane – Driving China’s Expressway Network

Bamboo painting

 

“Do Not Drive Tiredly”  That’s the message, in English, on large highway signs spanning the roadway in Jiangxi. I was charmed by the idiosyncratic English, and even more by the fact that almost all highway signs in China, including mundane ones announcing upcoming exits or defining the hard shoulder, are all bilingual, Chinese and English.

Based on my recent highway travels through part of Jiangxi Province, I was probably the only one who could get much value from the English. That’s because almost all the other traffic on the highway consisted of very large and heavily-loaded long-distance Chinese trucks. Passenger cars are few and far between. 

Highways are a recent phenomenon in China, of course. I’ve never seen anything quite like them, in my +30 years of driving around the US and lot of the rest of the developed world. The Chinese highways are mainly well-built and usually in pristine condition. Besides the English-language signs, another source of frequent delight are the life-size plastic policemen, pointing plastic radar guns at oncoming traffic. They’re planted in the highway’s central meridian as not-so-subtle reminders to avoid speeding– or as the sign calls it, again in English, “Overspeeding”.

It’s those large trucks, though, that really define for me the current experience of highway driving in China. Despite their huge size – the trailers often have 20-wheels, and seem to stretch the length of seven or eight passenger cars – the trucks are often buckling under the weight of their loads. Most of the time, the cargo hold is open at the top, and covered with a very large tarpaulin, in various colors, intricately tried to the bottom of the flatbed. The trucks have a tendency to wobble and weave as they move along the road – the result of either unbalanced loads or, more likely, less-skilled drivers.

Long-distance trucking may be among the fastest-growing new professions in China. It’s a safe bet few of today’s drivers have been behind the wheel for more than two or three years. Many have their own particular style of driving. Heavy, slow-moving trucks often canter along, 30mph below the speed limit,  in the left-hand passing lane. Their side-view mirrors – the only way the drivers can see traffic behind or alongside them – are often tilted at angles that seem to defeat the purpose.  

Few of the trucks have any kind of marking on them. The concept of a truck as a moving billboard is still an alien one in China. Not so the ordinary highway billboard, which is very common, as are advertisements posted on overpasses. 

China produces so much, including a huge percentage of the world’s manufactured goods, that it’s hard to imagine how all this stuff moved around before the expressway network was built. The traffic on many expressways, including the ones I was on in Jiangxi, must be over 90% trucks. That’s only going to increase, as more production in China is moved to cheaper, inland areas.

The expressways are already quite crowded. Often, they are only two lanes wide in each direction – which may have seemed more-than-adequate 10 years ago when first designed, but now seem to belong in the Pleistocene Age. Within ten years, these roads will almost certainly all need to be widened. That can cost almost as much, per kilometer, as building new expressways. 

China’s toll fees are among the highest ones I’ve seen. In Jiangxi, it’s 0.4 Renminbi ( or around five US cents) per kilometer for passenger cars, and more for trucks. So, financing all this construction won’t necessarily put a big dent in state revenues.  

Even with all the slow-moving truck traffic, the expressway network in China is a godsend. It makes distances much less foreboding than they used to be in China. It’s possible to average over 100 kilometers-an-hour. On the older, ordinary road network, you’d be lucky to average half that speed. Where the trucks thin out, you can “overspeed” at around 160kph, and rustle the plastic policemen in your backdraft.

Sino-American Relations – Some Overblown Analysis from the USA

Ge Vase from China First Capital blog post

Is China’s reaction to last week’s announced US arms sale to Taiwan really all that more strident than in the past? Should America be worried? To read some of the recent American news reporting, citing the usual ragbag of US-based “China experts”, you might conclude so.

http://www.washingtonpost.com/wp-dyn/content/article/2010/01/30/AR2010013002443.html
http://www.nytimes.com/2010/02/01/world/asia/01china.html?scp=1&sq=helene%20cooper&st=cse

I don’t buy it. China is not set, contrary to such reports, firmly on a course to antagonize America. It is, however, a great power with legitimate national interests to assert and protect. Sometimes those will clash with America’s national interests. But, the bilateral relationship also has a root system of common goals and shared admiration. 

I also don’t buy the line by American “China experts” about rising Chinese “triumphalism” , due to continued strength of Chinese economy. China’s economy has been outgrowing the US by eight to ten percentage points just about every year for the last 30 years. Same was true in 2009. The only difference: China grew by 8% while the US economy shrunk by over 5%. A similar net result as in the past, but one that highlighted a dramatic lessening of China’s economic dependence on the US. 

Do Chinese officials realize they now can maintain high economic growth without single-minded focus on exports to US, but look to domestic market instead? Yes. But, as you’ve also read, from Premier Wen Jiabao on down, there’s frequent public declarations on all the many problems and inefficiencies in China’s economy. 

Yes, China is getting stronger every year in every respect. But, is the tone now on arms sales to Taiwan really all that different? I don’t see it, and wonder how much others here see it, or whether it’s just the usual conventional US wisdom on China, a cousin of the “China expert” analysis that Chinese economic growth is a fraud, only resulting from cooked gdp numbers. 

China is mainly busy being China, just as America, most of the time is also mainly busy being America.  Both are continental powers with huge populations and vast domestic markets. Both also have a long history of being more inward- than outward-looking, quite patriotic, even occasionally xenophobic.

They often view the world with a similar sense of aloof distrust. There will always be points of friction between the US and China. But, time is gradually wearing down those points of friction, not sharpening them, as much of the US press would have us believe.

 

Navigating China’s Treacherous IPO Markets

Song plate from China First Capital blog post

How do you say “Scylla and Charybdis”  in Chinese? Thankfully, you don’t need to know the translation, or even reference from Homer’s The Odyssey, to understand the severe dilemma faced by China’s stock exchange regulator, the China Securities Regulatory Commission (CSRC). 

Scylla and Charybdis were a pair of sea monsters guarding opposite sides of a narrow straight. Together, they posed an inescapable threat to sailors’ lives. By avoiding one, you sailed directly into the lair of the other. 

The CSRC has been trying to navigate between twin perils over the last months, since the October launch of ChiNext , the new Shenzhen stock exchange for smaller-cap private companies. They have tried to stamp out the trading volatility and big first day gains that characterized earlier IPOs in China. But, in doing so, they’ve created circumstances where the valuations of companies going public on the ChiNext have reached dangerous and unsustainably high levels. 

Monsters to the left, monsters to the right. The regulators at CSRC deserve combat pay. 

Based on most key measures, ChiNext has been a phenomenal success. So far, through the end of 2009, 36 companies have IPO’d on ChiNext, raising a total of over $2 billion from investors. That’s more than double the amount these 36 companies were originally seeking to raise from their IPOs. Therein lies the Scylla-Charybdis problem. 

Before ChiNext  opened, the CSRC was determined to avoid one common problem with Chinese IPOs on the main Shanghai and Shenzhen markets – that the price on the first day of trading typically rose very sharply, with lots of volatility. A sharp jump in the price on the first day is great for investors who were able to buy shares ahead of the IPO. In China, those lucky few investors are usually friends and business contacts of the underwriters, who were typically rewarded with first-day gains of over 20%. These investors could hold their shares for a matter of minutes or hours on the day of the IPO, then sell at a nice profit. 

But, while a first-day surge may be great for these favored investors, it’s bad news for the companies staging the IPOs. It means, quite simply, their shares were underpriced (often significantly so) at IPO. As a result, they raised less money than they could have. The money, instead, is wrongly diverted into the hands of the investors who bought the shares at artificially low prices. An IPO that has a 25% first-day gain is an IPO that failed to maximize the amount the company could raise from investors. 

Underwriters are at fault. When they set the price at IPO, they can start trading at a level that all but guarantees an immediate increase. This locks in profits for the people they choose to allocate shares to ahead of the start of trading. 

The CSRC, rightly,  decided to do something about this. They mandated that the opening price for companies listing on the CSRC should be set more by market demand, not the decision of an underwriter. The result is that the opening day prices on ChiNext have far more accurately reflected the price investors are willing to pay for the new offering.

Gains that used to go to first-day IPO investors are now harvested by the companies. They can raise far more money for the fixed number of shares offered at IPO. So far so good. The problem is: Chinese investors are bidding up the prices of many of these new offerings to levels that are approaching madness. 

The best example so far: when Guangzhou Improve Medical Instruments Co had its IPO last month, its shares traded at an opening price 108 times its 2008 earnings.  The most recent  group of companies to IPO on ChiNext had first-day valuations of over 80 times 2008 earnings. Because of the high valuations, these ChiNext-listed companies have raised more than twice the amount of money they planned from their IPO. 

On one hand, that’s great for the companies. But, the risk is that the companies will not use the extra money wisely (for example by speculating in China’s overheated property market), and so the high valuations they enjoy now will eventually plummet. Indeed, valuations at over 80x  are no more sustainable on the ChiNext now than they were on the Tokyo Stock Exchange a generation ago. 

Having steered ChiNext away from the danger of underpriced IPOs, the CSRC is now trying to cope with this new menace. They have limited tools at their disposal. They clearly don’t want to return pricing power to underwriters. But, neither do they want ChiNext to become a market with insane valuations and companies that are bloated with too much cash and too many temptations to misuse it.   

CSRC’s response: they just introduced new rules to limit the ways ChiNext companies can use the extra cash raised at IPO.  CSRC is also reportedly studying ways to lower IPO valuations on ChiNext. 

The new rules restrict the uses of the extra cash. Shareholder approval is required for any investment over Rmb 50 million, or more than 20% of the extra IPO proceeds on a single project. The CSRC also reiterated that ChiNext companies should use the additional proceeds from their IPOs to fund their main businesses and not for high-risk investments, such as securities, derivatives or venture capital.

The new rules are fine, as far as they go. But, they don’t go very far towards resolving the underlying cause of all these problems, of both underpriced and overpriced IPOs in China.

The problem is that CSRC itself limits the number of new IPOs, to try to maintain overall market stability. Broadly speaking, this restricted supply creates excessive demand for all Chinese IPOs. Regulatory interventions and tinkering with the rules won’t do much. There remains the fundamental imbalance between the number of domestic IPOs and investor interest in new offerings.

Faced with two bad options, Odysseus chose to take his chances with the sea monster Scylla, and survived, while losing quite a few of his crew. The alternative was worse, he figured, since Charybdis could sink the whole ship.

The CSRC may well make a similar decision and return some pricing power to underwriters, to bring down ChiNext’s valuations.  But, without an increased supply of IPOs in China,  the two large hazards will persist. CSRC’s navigation of China’s IPO market will certainly remain treacherous.  


A Step in The Right Direction – But Capital Allocation Remains Highly Inefficient in China

Vrard Watch from China First Capital blog post

Capital is not a problem in China. Capital allocation is. 

Expansionary credit policies by the government has created a boom in bank lending. This rising tide of bank credit is also lifting Chinese SMEs. Through the first half of this year, loans to SME have increased by 24.1% , or 2.7 trillion yuan ($400bn).  All that new lending, though, has not substantially altered the fact that bank lending in China is still directed overwhelmingly  towards state-owned companies.  So, while lending to SME rose by nearly a quarter, that equates to only a tiny 1.5% increase in the share of all bank loans going to SME. 

State-owned banks and state-owned companies are locked in a mutual embrace. It’s not very good for either of them, or for the Chinese economy as a whole. Faster-growing, credit-worthy private companies find it much harder and more costly to borrow.  Over-collateralization is common. An SME owner must often put up all this company’s assets for collateral, then throw in his personal bank accounts and property, and finally make a cash deposit equal to 30% to 50% of the loan value. 

China isn’t the only country, of course, with inefficient credit policies. Japan’s banking system still puts too much cheap credit in the hands of favored borrowers.  But, the problem is more damaging in China that elsewhere, for two reasons: first, many of China’s best companies are small and private. They are starved of capital and so can’t grow to meet consumer demand. Second, the continuing deluge of credit for state-owned companies distorts the competitive landscape, keeping tired, often loss-making incumbents in business at the expense of better, nimbler and more efficient competitors. 

In other words, China’s credit allocation policies are actually stifling overall economic growth and inhibiting choice for Chinese consumers and businesses. 

State-owned banks everywhere, not just in China, have the same fatal flaw. They like an easy life, which means lending to companies favored by their controlling shareholder, not those that will earn the greatest return.  They can turn a deaf ear to profit signals because, ultimately, profit isn’t the only purpose of their labors. They allocate credit as part of some larger scheme, in China’s case, maintaining output and employment in the country’s less competitive,  clapped-out industries.  

There’s a regional dimension to this too. China’s richest, most developed areas are in South,  particularly the powerhouse provinces of Guangdong, Zhejiang and Fujian.  The economy here is driven by private, entrepreneurial companies, not the state-owned leviathans of the North. As a result, a credit policy that discriminate against private SME also ends up discriminating against the parts of China with the highest levels of private ownership and per capital wealth. 

That’s not sound banking, or sound policy. The good news is that the situation is changing. SME are gradually taking a larger share of all lending. The change is still too slow, too incremental, as the latest figures show. But, with each cautious step, the private sector, led by entrepreneurial SME, gains potency, gains scale and gains more of the resources it needs to provide the products and services Chinese most want to buy.  


No Preference: Disallowing Preferred Shares for Private Companies is Hobbling China’s Venture Capital and Private Equity Industry

 

Ming Dynasty mother-of-pearl from China First Capital blog post

Chinese securities regulations do not allow private domestic companies to issue preferred shares.  It does not sound particularly problematic, since preferred shares are not all that common anywhere. And yet, this regulatory quirk has serious unintended consequences. It is holding back the flow of private equity and venture capital investment into promising Chinese companies, particularly those with more than one shareholder. 

Preferred shares earn their name for a reason. These shares enjoy certain preferences over common shares, most often greater voting power and better protection in the event of bankruptcy. Preferred shares are the main mechanism through which venture capital and private equity firms invest in private companies. In general, when a PE or VC firm invests, the company receiving the investment creates a special class of preferred shares for the PE or VC. These preferred shares will have a raft of special privileges, above and beyond voting rights and liquidation preference. The theory is, the preferred shares level the playing field, giving the PE or VC firm more power to control the actions of the company, particularly how it uses the VC money,  and so protect its illiquid investment. 

Take away the ability to issue preferred, as is the case in China, and things begin to get much trickier for PE and VC investment. PE and VC firms are loathe to invest in ordinary common shares, since this gives them little of the protection they need to fulfill properly their fiduciary duty to their Limited Partners. There are, of course, all kinds of clever solutions that can be and often are employed to get around this problem in China. For example, the PE or VC firm can ask their very clever lawyers to craft a special shareholders agreement, to be signed by the company it’s investing in, that gives the PE or VC firm the same special treatment conferred by preferred shares. 

The problem here, though, is the legal enforceability of a shareholder agreement is not cut-and-dried.  A basis of most securities law, in China and elsewhere, is that all shareholders holding the same class of shares must be treated equally. In other words, if a PE or VC firm has ordinary common shares, it can’t get better treatment and more rights than any other common shareholder. 

What happens if a PE or VC firm’s shareholder agreement conflicts with this principle of equal treatment? China’s legal system is evolving, and precedent is not unequivocally clear. But, in general, the law takes precedence over any contract. In other words, if it comes down to a court fight, the PE or VC firm might find its shareholders agreement invalidated. 

This is not some remote likelihood, particularly if the company has more than just the founder and the PE or VC firm as shareholders. The “unpreferred” common shareholders have every right and many reasons to feel disadvantaged if they are deprived the same rights enjoyed by a VC firm also holding common shares.

There are many scenarios when this could lead to litigation, not just if the company runs into trouble, and shareholders end up fighting over how to divide whatever assets remain There’s also a big chance of legal mischief if the company does splendidly well. Let’s say the company is preparing for an IPO, and a shareholders agreement gives the VC firm special rights to have their shares registered and fully tradeable. This is a fairly common element in shareholders agreements. Other common shareholders would have ample reason to object, if their shares can’t be liquidated at the same time.  

Sometimes in business, legal uncertainty can be useful In this case, though, there are no clear winners. Anything that makes PE or VC firms less likely to invest disrupts the flow of capital to worthy businesses. That’s the situation now in China, with preferred shares disallowed and much uncertainty surrounding the legality of shareholders agreements. 

I have no special insight into why Chinese regulators have outlawed preferred shares for private domestic companies, or whether they are contemplating a change. But, a change would be beneficial. Most likely, the prohibition of preferred shares was designed to stop private companies from fleecing their unsuspecting equity-holders. In other words, the motive is sound. But, if the result is less growth capital available for successful young Chinese companies, the medicine ends up occasionally killing the patient. That doesn’t serve anyone’s interests: not entrepreneurs, nor investors, nor the country as a whole. 

 There are ways to give common shareholders some protection while still allowing private companies to create preferred shares. Ultimately, these common shareholders will likely benefit from the injection of PE or VC money into a company they’ve also invested in.  A shortage of capital is always a problem for growing companies, but it’s a particularly acute one in China. The PE or VC firm will also usually play a much more active role than other shareholders in building value, giving these other shareholders a free ride. 

Like most, I invest to make money, not exercise voting rights. So, my preference as a common shareholder will be to let the preferred have whatever rights they deem important – as long as they are doing the heavy lifting and pushing hard to build profits. They bring the capital, track record and expertise that often makes all the difference between a successful company and a has-been. I prefer to invest for success, and that often means preferring the presence of preferred investors.

Companies That Can IPO & Companies That Should: The Return to IPO Activity in China

Ming Dynasty lacquer in China First Capital blog post

After a hiatus of nearly a year, IPO activity is set to resume in China. The first IPO should close this week on the Shenzhen Stock Market. This is excellent news, not only because it signals China’s renewed confidence about its economic future. But, the resumption of IPO activity will also help improve capital allocation in China, by helping to direct more investment to private companies with strong growth prospects.

With little IPO activity elsewhere, China is likely to be the most active IPO market in the world this year. How many Chinese companies will IPO in 2009 is anyone’s guess. Exact numbers are impossible to come by. But, several hundred Chinese companies likely are in the process of receiving final approval from the China Securities Regulatory Commission. That number will certainly grow if the first IPOs out of the gate do well.

Don’t expect, however, a flood of IPOs in 2009. The pace of new IPOs is likely to be cautious. The overall goal of China’s securities regulators remains the same: to put market stability ahead of capital efficiency. In other words, China’s regulators will allow a limited supply of companies to IPO this year, and would most likely suspend again all IPO activity if the overall stock market has a serious correction.

China’s stock markets are up by 60% so far in 2009. While that mainly reflects well-founded confidence that China’s economy has weathered the worst of the global economic downturn, and will continue to prosper this year and beyond, a correction is by no means unthinkable. There are concerns that IPOs will drain liquidity from companies already listed in Shanghai and Shenzhen.

Efficient capital allocation is not a particular strongpoint of China’s stock markets. In China, the companies that IPO are often those that can, rather than those that should. The majority of China’s quoted companies, including the large caps,  are not fully-private companies. They are State-Owned Enterprises (SOEs), of one flavor or another. These companies have long enjoyed some significant advantages over purely private-sector companies, including most importantly preferential access to loans from state-owned banks, and an easier path to IPO.

SOEs are usually shielded from the full rigors of the market, by regulations that limit competition and an implicit guarantee by the state to provide additional capital or loans if the company runs into trouble. So, an IPO for a Chinese SOE is often more for pride and prestige, than for capital-raising. An IPO has a relatively high cost of capital for an SOE. The cheapest and easiest form of capital raising for an SOE is to get loans or subsidies direct from the government.

Now, compare the situation for private companies, particularly Chinese SMEs. These are the companies that should go public, because they have the most to gain, generally have a better record of using capital wisely, and have management whose interests are better aligned with those of outside shareholders. However, it’s still much harder for private companies to get approval for an IPO than SOEs. Partly it’s a problem of scale. Private companies in China are still genuine SMEs, which means their revenues rarely exceed $100 million. The IPO approval process is skewed in favor of larger enterprises.

Another problem: private companies in China often find it difficult, if not impossible, to obtain bank loans to finance expansion. Usually, banks will only lend against receivables, and only with very high collateral and personal guarantees.

The result is that most good Chinese SMEs are starved of growth capital, even as less deserving SOEs are awash in it. More than anything, it’s this inefficient capital allocation that sets China’s capital markets apart from those of Europe, the US and developed Asia.

Equity finance – either from private equity sources or IPO — is the obvious way to break the logjam, and direct capital to where it can earn the highest return. But, for many SMEs, equity is either unknown or unavailable. I’m more concerned, professionally, with the companies for whom equity finance is an unknown. Equity finance, both from public listings and from pre-IPO private equity rounds, is going to become the primary source of growth capital in the future. Explaining the merits of using equity, rather than debt and retained earnings, to finance growth is one of the parts of my work I most enjoy, like leading to the well someone weak with thirst. Raising capital for good SME bosses is a real honor and privilege.

Most strong SMEs share the goal of having an IPO. So, the resumption of IPOs in China is a positive development for these companies. Shenzhen’s new small-cap stock exchange, the Growth Enterprise Market, should further improve things, once it finally opens, most likely later this year. The purpose of this market is to allow smaller companies to list. The majority will likely be private SME.

I’ll be watching the pace, quality and performance of IPOs on Growth Enterprise Market even more carefully than the IPOs on the main Shanghai and Shenzhen stock markets. My hope is that it establishes itself as an efficient market for raising capital, and that the companies on it perform well. This is one part of a two-part strategy for improving capital allocation in China. The other is continued increase in private equity investment in China’s SME.

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China’s government — an example for the world on competent economic management

Yuan Dynasty blue-and-white porcelain vase

China’s government is managing very ably the global financial crisis, and continuing to deliver to its people a better standard of living. Yes, the economy in China is growing more slowly than it has over much of recent history, at around 7%-8%. But, overall, the country continues to bustle as nowhere else does. People still have spring in their step, and the same sense of boundless potential.

This is a measure of just how many things the Chinese government has done right economically. It’s a fact that’s too rarely remarked upon outside China, where the major talking points about China’s economy tend to be pollution, corruption and what’s seen to be the artificially-low level of the renminbi. This does a huge disservice to what’s been highly successful and competent management by China’s economic policy-makers. 

How good a job has the Chinese government done? Consider this: the country has managed, with relatively limited economic dislocation, the huge contractions in China’s export markets over the last year. Yes, factories have closed and workers have lost their jobs. This is a familiar enough boom-and-bust story in every country where manufacturing plays a big part in the overall economy. But, not long ago, most of China’s economic well-being was tied to its manufacturing exports. There was little other fuel for economic growth. 

China today is a very different place, economically, than it was even three years ago. The domestic market, not exports, is now the locomotive that’s pulling 1.4 billion people down the track. This shift was managed so deftly by the Chinese government that it’s hardly even been noticed outside China – and often inside as well. I run into a lot of Chinese who still believe that the fate of the nation is determined by the output of its assembly lines. Exports and manufacturing are still important, hugely so. But, they matter less than they did just a while back, and in the future, they will matter less. 

This shift away from manufacturing has caused huge ructions in other countries – just think of the endless labor strife in France, or Britain on the 1970s, and the persistent high unemployment in most other European countries. They have stumbled along, economically, as their competitive advantage in manufacturing was lost. 

In China, it’s a very different – and better – picture. There is so much economic opportunity here that people can, with far less disruption to their lives than in Europe, find new places to work and build a future. The Chinese government creates the circumstances that allow all this economic opportunity to occur. Again, the contrast with Europe is particularly marked. In Europe, economic activity is stifled by excessive regulations that set out who can do what, where, for how much. In China, the government, wisely, takes a much lighter approach to regulation, always with an eye focused on creating circumstance that will lead to new jobs, more activity, and more competition in most sectors of the economy. 

China’s government, rightly, does get credit internationally for the economic changes over the last 30 years that have lifted some 500 million people out of poverty. This is, unquestionably, the most important economic achievement of the last century, if not the last millennium. 

But, the policies that are generating China’s continued prosperity — the uplift that is carries as many Chinese into the middle class as were taken out of poverty — is much less well-followed and less-praised. That’s wrong. Arguably, it’s no less significant an achievement.