Chinese Society

China’s loan shark economy — Nikkei Asian Review

Leave a Comment / June 25, 2016

Nikkei2

China loan sharking

China’s loan shark economy

PF

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What’s ailing China? Explanations aren’t hard to come by: slowing growth, bloated and inefficient state-owned enterprises, and a ferocious anti-corruption campaign that seems to take precedence over needed economic reforms.

Yet for all that, there is probably no bigger, more detrimental, disruptive or overlooked problem in China’s economy than the high cost of borrowing money. Real interest rates on collateralized loans for most companies, especially in the private sector where most of the best Chinese companies can be found, are rarely below 10%. They are usually at least 15% and are not uncommonly over 20%. Nowhere else are so many good companies diced up for chum and fed to the loan sharks.

Logic would suggest that the high rates price in some of the world’s highest loan default rates. This is not the case. The official percentage of bad loans in the Chinese banking sector is 1%, less than half the rate in the U.S., Japan or Germany, all countries incidentally where companies can borrow money for 2-4% a year.

You could be forgiven for thinking that China is a place where lenders are drowning in a sea of bad credit. After all, major English-language business publications are replete with articles suggesting that the banking system in China is in the early days of a bad-loan crisis of earth-shattering proportions. A few Chinese companies borrowing money overseas, including Hong Kong-listed property developer Kaisa Group, have come near default or restructured their debts. But overall, Chinese borrowers pay back loans in full and on time.

Combine sky-high real interest rates with near-zero defaults and what you get in China is now probably the single most profitable place on a risk-adjusted basis to lend money in the world. Also one of the most exclusive: the lending and the sometimes obscene profits earned from it all pretty much stay on the mainland. Foreign investors are effectively shut out.

The big-time pools of investment capital — American university endowments, insurance companies, and pension and sovereign wealth funds — must salivate at the interest rates being paid in China by credit-worthy borrowers. They would consider it a triumph to put some of their billions to work lending to earn a 7% return. They are kept out of China’s lucrative lending market through a web of regulations, including controls on exchanging dollars for yuan, as well as licensing procedures.

This is starting to change. But it takes clever structuring to get around a thicket of regulations originally put in place to protect the interests of China’s state-owned banking system. As an investment banker in China with a niche in this area, I spend more of my time on debt deals than just about anything else. The aim is to give Chinese borrowers lower rates and better terms while giving lenders outside China access to the high yields best found there.

China’s high-yield debt market is enormous. The country’s big banks, trust companies and securities houses have packaged over $2.5 trillion in corporate and municipal debt, securitized it, and sold it to institutional and retail investors in China. These so-called shadow-banking loans have become the favorite low-risk and high fixed-return investment in China.

Overpriced loans waste capital in epic proportions. Total loans outstanding in China, both from banks and the so-called shadow-banking sector, are now in excess of 100 trillion yuan ($15.9 trillion) or about double total outstanding commercial loans in the U.S. The high price of much of that lending amounts to a colossal tax on Chinese business, reducing profitability and distorting investment and rational long-term planning.

A Chinese company with its assets in China but a parent company based in Hong Kong or the Cayman Islands can borrow for 5% or less, as Alibaba Group Holding recently has done. The same company with the same assets, but without that offshore shell at the top, may pay triple that rate. So why don’t all Chinese companies set up an offshore parent? Because this was made illegal by Chinese regulators in 2008.

Chinese loans are not only expensive, they are just about all short-term in duration — one year or less in the overwhelming majority of cases. Banks and the shadow-lending system won’t lend for longer.

The loans get called every year, meaning borrowers really only have the use of the money for eight to nine months. The remainder is spent hoarding money to pay back principal. The remarkable thing is that China still has such a dynamic, fast-growing economy, shackled as it is to one of the world’s most overpriced and rigid credit systems.

It is now taking longer and longer to renew the one-year loans. It used to take a few days to process the paperwork. Now, two months or more is not uncommon. As a result, many Chinese companies have nowhere else to turn except illegal money-lenders to tide them over after repaying last year’s loan while waiting for this year’s to be dispersed. The cost for this so-called “bridge lending” in China? Anywhere from 3% a month and up.

Again, we’re talking here not only about small, poorly capitalized and struggling borrowers, but also some of the titans of Chinese business, private-sector companies with revenues well in excess of 1 billion yuan, with solid cash flows and net income. Chinese policymakers are now beginning to wake up to the problem that you can’t build long-term prosperity where long-term lending is unavailable.

Same goes for a banking system that wants to lend only against fixed assets, not cash flow or receivables. China says it wants to build a sleek new economy based on services, but nobody seems to have told the banks. They won’t go near services companies, unless of course, they own and can pledge as collateral a large tract of land and a few thousand square feet of factory space.

Chinese companies used to find it easier to absorb the cost of their high-yield debt. No longer. Companies, along with the overall Chinese economy, are no longer growing at such a furious pace. Margins are squeezed. Interest costs are now swallowing up a dangerously high percentage of profits at many companies.

Not surprisingly, in China there is probably no better business to be in than banking. Chinese banks, almost all of which are state-owned, earned one-third of all profits of the entire global banking industry, amounting to $292 billion in 2013. The government is trying to force a little more competition into the market, and has licensed several new private banks. Tencent Holdings and Alibaba, China’s two Internet giants, both own pieces of new private banks.

Lending in China is a market rigged to transfer an ever-larger chunk of corporate profits to a domestic rentier class. High interest rates sap China’s economy of dynamism and make entrepreneurial risk-taking far less attractive. Those looking for signs China’s economy is moving more in the direction of the market should look to a single touchstone: is foreign capital being more warmly welcomed in China as a way to help lower the usurious cost of borrowing?

Peter Fuhrman is the founder, chairman and chief executive of China First Capital, an investment bank based in Shenzhen, China.

 

http://asia.nikkei.com/Viewpoints/Perspectives/Chinas-loan-shark-economy

Download PDF version.

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Watching NFL Football in China — Brought to You By the US Treasury

1 Comment / January 13, 2015

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Watching the NFL playoffs this weekend on Chinese internet TV channel PP Live, I saw something I never imagined. No, not a live broadcast in China of American football. The NFL has a great thing going here in China. While not a big-time success yet like the NBA in China, the NFL is quietly making fans out of a meaningful slice of the country’s most gold-plated demographic: males with advanced degrees and senior management positions.

No, what surprised me while watching the game was the frequent commercials paid for in part by money from the US Department of Treasury. Yes, Uncle Sam is now involved in buying advertising time during NFL games on Chinese tv. Never quite thought I’d live to see the day.

The ads are to promote tourism to the US. There are snapshots of American scenery, a catchy little song playing in the background, and then this splash screen comes up at the end:

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Follow that www.gousa.cn link and one eventually learns the group behind the ads is something called “Brand USA”, a body describing itself as a “public private partnership”. That’s generally code for some kind of organization where the US Treasury picks up some or all of the tab, but whose purpose is to help private companies make money. Sure enough. Last month, President Obama signed legislation that keeps the government money flowing to Brand USA at least through 2020, long after he’s out of office. The budget for fiscal year 2014 was $125 million.

The board of Brand USA includes top executives from hotel group Marriott International, Disney’s travel arm, the air reservation system Sabre Corporation as well as the top bureacrats in the tourist promotion office in the states of California and Minnesota. Brand USA’s chairman is president of a company I never heard of called Jackmont Hospitality, whose website says it is “a minority-owned, comprehensive foodservice management company and one of the fastest growing TGI FRIDAYS® franchisees.”

The intent of the commercial is, of course, to get more Chinese to travel to the US as tourists. A laudable goal, and one that became much easier at the end of last year when Obama and Chinese President Xi Jinping agreed a new bilateral visa regime which gives citizens of each country ten-year multi-entry visas. Chinese tourism in the US is growing, with 1.8 million visiting last year, fifth most among all countries sending tourists to the US, but still about half the number of British tourists each year.

What they lack in numbers Chinese tourists make up for in extravagance. They spend $7,200 per visit compared to $4,500 by the average foreign tourist, according to the US Travel Association.

Like a lot my government does, the commercials running during football timeouts don’t display a particularly keen knowledge of consumer marketing.  The jingle is sung in English, so not likely to be understood by a lot of Chinese viewers. The places featured don’t seem likely destinations for Chinese tourists. No Times Square or Fifth Avenue Apple Store in Manhattan. No Disneyland, no Harvard Yard and no Las Vegas.

So where is the US government pushing Chinese to visit?  Price Lake. I never heard of it either, but according to Wikipedia it’s in the Blue Ridge Mountains of North Carolina, about 200 miles from the nearest major airport, Raleigh-Durham. It’s said to host the largest annual gathering of lumberjacks each year. If China has a large contingent of passport-holding lumberjacks it’s news to me.

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While Brand USA hasn’t been around long, it’s already attracted a fair bit of criticism, led by Republican members of Congress, who launched a formal investigation into what is called a “history of questionable expenditures and lavish spending” at the organization. The report they issued says all Board members, though officially appointed by the US Secretary of Commerce, were in fact chosen by an Obama aide from among those who “have donated to Democrats and Democratic organizations almost exclusively.”

The private sector is supposed to donate funds which the US government matches by dipping into a pool of money raised through a $10 fee charged to all tourists arriving in the US under what’s called the Visa Waiver Program. Brand USA board members have claimed the amount they spend on travel should be considered by Uncle Sam as a “donation”, including first class air fares and hotel rooms paid for by their companies. Among the claims was one for $94.87 for a two mile taxi ride in Washington DC that the report points out should cost no more than about $15 including tip. The report’s conclusion is that the Brand USA documents and expense accounts “paint a picture of mismanagement, waste, and cronyism.”

No word on what Brand USA are paying for the ads during the NFL games on PP Live. Let’s hope they drive a tough bargain. Other than the Brand USA spot, repeated over and over, I saw no other ads during the second half of the game. During many of the commercial breaks, the Chinese broadcast stays with a live feed from the stadium of the players waiting around for the timeouts to end, something one rarely gets to see while watching football in the US.

The NFL games are broadcast in China with Chinese commentary only, once an annoyance but now a source of almost infinite delight for me. In case you’re wondering, the name for football in Chinese translates as “olive ball”.

Chinese who like the sport and are persuaded by the ads to visit the US would do well to read up first on Brand USA and its public/private affairs. It’s an excellent primer on how politics and spending sometimes operate in my nation’s capitol — and so why the US has this chronic reliance on China to finance our deficits by buying US Treasuries.

 

The ‘children’ of Deng Xiaoping — Toronto Globe and Mail

Leave a Comment / December 13, 2014

Globe and Mail

The ‘children’ of Deng Xiaoping

From left: Yang Hongchang, Hung Huang, Zhuo Wei, Grace Huang, Wu Hai, He Yongzhi.

The other Chinese revolution: Meet the people who took Deng’s economic great leap forward

By Nathan Vanderklippe

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Deng Xiaoping was no Winston Churchill. He possessed a thick southern accent most people found nearly impenetrable, and was anything but garrulous. In fact, little of what he said was memorable or even original. His most-cited aphorism – “To get rich is glorious” – did not actually spill from his mouth; historians suspect its provenance can be traced to the West.

But in deed more than word, Mr. Deng was the linchpin in redirecting China’s economy away from the backward, centrally planned beast it had become under Mao Zedong. He set it on a path that would see decades of unrelenting growth and the creation of credulity-defying prosperity.

What he wanted to do, he said in 1978, was to “light a spark” for change:

Deng Xiaoping

“If we can’t grow faster than the capitalist countries, then we can’t show the superiority of our system.”

– Deng, 1978

And on many indicators, grow they did – more than the U.S

 

Globemail

He succeeded in spurring growth, and wildly so, marshalling the power of the world’s most populous nation. Now, 110 years after his birth – an occasion that its leadership has sought to celebrate with lengthy TV biopics and other remembrances – China is filled with millionaires.

But has the sudden influx of wealth made it happy?

Where chasing profit was once grounds for harsh re-education, the country’s heroes and superstars – Jack Ma and an entire generation of tuhao, or nouveau riche – are now, in ways both spiritual and economic, the children of Deng.

President Xi Jinping has consciously sought to present himself as the current generation’s version of Deng. But for many of Deng’s figurative progeny, wealth and happiness haven’t always come together. In a recent survey published in the People’s Tribune magazine, worries about a moral vacuum, personal selfishness and anxiety over individual and professional status were high on the list of top concerns about the country today. The poll reflected a pervasive cultural disquiet that has reached even into the ranks of those most richly rewarded by the Deng-led opening up.

“On the social level, money became the only currency in terms of personal relationships, and that’s a really sad reality,” says Yang Lan, one of the country’s top television hosts.

She points to “the lack of a value system” that she sees when she hears young girls “discussing how they would love to be a mistress so they can live a wealthy life before they are too old. And you see girls discussing these things very openly.” China, she says, needs “a new social contract.”

There is little doubt that those who no longer need to worry about making money are more free to criticize others, raising the spectre of hypocrisy. But pained reflection has been among the less-anticipated products of the wealth China has amassed. The comforts of financial security have provided a new space to rethink the path the country has taken and ways it has fallen short.

And as China’s economy slows to a pace not seen in decades, it also faces a moment to consider the sweep of its modern history – decades marked by the vicious turbulence of the Mao years, followed by the full-throttle race away from it inspired by Mr. Deng.

From 1978, the first year of the Deng-led reforms, China has been so thoroughly reshaped that even numbers struggle to do it justice. Gross domestic product has expanded 156-fold, the value of imports and exports is 727 times higher, and savings are up by a factor of 2,131.

The growth has been driven by an extraordinary – and massive – cohort of people who have turned personal quests for profit into a national obsession. “China has, in absolute numbers as well as percentage of populace, the most successful entrepreneurs anywhere in the world,” says Peter Fuhrman, chairman and founder of China First Capital, a specialist investment bank based in Shenzhen.

But even those who most warmly embraced the Deng mandate are now pausing for a second look at a country whose vast financial progress has become marred by other problems.

 

Read complete article by clicking here.

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Nanjing: A Special Kind of Chinese Boomtown

Leave a Comment / November 25, 2014

Nanjing City Investment Promotion Consultant

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In 1981, when I first arrived in Nanjing as a student,  the ancient and rather sleepy city had a population of four million and a GDP of Rmb 4 billion. Today, the population has doubled to eight million and GDP is two hundred times larger. Yes, you read that right. This year’s GDP will exceed Rmb 850bn. Even by recent Chinese standards, that kind of growth rate for a major city is just about unheard of. Since 1981, Nanjing’s GDP has grown almost twice as fast as China as a whole. It is now richer in per capita terms than Beijing, and its economy continues to expand more quickly than the capital, Shanghai and just about every other major city in the country.

I was back in Nanjing in the last week to visit friends and clients, as well as receive from the Nanjing city government an official appointment as an “investment promotion consultant”. That’s me in the photo above celebrating with Mr. Kong Qiuyun, the cultured an charismatic director-general of Nanjing Municipal Investment Promotion Commission. It’s an especially welcome honor since I consider Nanjing, all these years later, my hometown in China, my  “laojia”. Every return is a homecoming.

With or without the official status, saying good things about Nanjing comes easily. It’s a special kind of boomtown. Despite the steep economic ascent over the last 33 years, today’s Nanjing is visibly woven from strands of its 2,500 year-old history as a city at the core of Chinese civilization. Old parks, streets and buildings stand. Though stained by tragedy – including the Nanjing Massacre in 1937 and bloody civil war at the end of the Taiping Rebellion civil war 73 years earlier — Nanjing is a city with a lightness of spirit and an intimate association with Chinese traditional culture of painting, calligraphy, poetry.

There is an ease, prosperity and comfort to life in Nanjing that is largely absent in Beijing. One is built upon the parched steppes below the Gobi Desert. Camel country. The other is set amid China’s most fertile, well-irrigated patch of bottomland –a kind of Chinese Eden, saturated by rivers, lakes, ponds and paddies, where just about everything can be grown or reared in abundance. The city is a symbiosis of man and duck. In a typical year, the people of Nanjing will consume over one hundred million of them. Every trip, including this most recent one, I return to Shenzhen with a suitcase padded out with three or four salt-preserved Osmanthus-scented ducks. Each trip back to the US I carry several with me and deliver them to my father in Florida. Somehow, age 82, he has developed a fine appreciation for them.

Nanjing took awhile to get its economic act together. During much of the 1980s, it was a backwater, trailing far behind the nearby cities of Shanghai and Suzhou as well as the coastal cities of Guangdong and Fujian. Earlier it had a reputation for being not very well-managed. Today the opposite is true.

Nanjing is the most ideally-situated large city in China. It is at the back door of China’s richest, most developed region, the Yangtze River Delta, stretching from Shanghai through Hangzhou, Suzhou, Wuxi and Changzhou. It is also now the front door for China’s huge market of the future, the inland regions where growth is now strongest, particularly the provinces of Hubei, Sichuan, Chongqing, Anhui farther up the Yangtze.

Nanjing’s is a large economy but without especially large and dominant companies. Few even in China can name its largest businesses or employers. This sets it apart from Beijing, Shanghai, Shenzhen, Hangzhou, Tianjin. Credit Nanjing government’s hands-on far-sighted economic management. It’s made up for the lack of large businesses by encouraging the growth of smaller mainly private-sector entrepreneurial businesses, as well as bringing in investment from abroad. Sharp, BASF, A.O. Smith, ThyssenKrupp are among the larger foreign companies with significant investment in Nanjing.

Major American investors are still comparatively few. This needs correcting. I hope to help in my new role as a consultant. Americans in the first half of the 20th century played a conspicuously positive role in Nanjing’s development. US academics and missionaries helped establish the city’s two oldest universities, Nanjing University (where I studied) and Nanjing Normal University. They remain the rock-solid backbones of Nanjing’s outstanding university system with over 25 institutions of higher learning.

An American team of architects and urban designers were responsible for creating the layout of much of the modern city of Nanjing, including the city’s main shopping district of Xinjiekou. The city was designed to combine elements of Paris and Washington D.C., with wide boulevards, stately traffic roundabouts like the Place de l’Etoile, and an elegant diplomatic quarter with large mansions spread along arching plane tree-shaded streets.

During the pre-1949 era, American companies were the most prominent and successful businesses in Nanjing. Two in particular – Socony (then the world’s leading petroleum company, a part of the Rockefeller Standard Oil group, and now ExxonMobil.) and British American Tobacco – managed large operations in China from their headquarters in Nanjing. They were then among the largest companies in China of any kind. They left in 1949 never to return to Nanjing and their previous prominence.

An individual American, a long-term resident of Nanjing, wrote while there the most popular and influential book about China in English. It was then made into a successful film which etched in the minds of many Westerners the enduring image of China’s Confucian values and pre-revolution rural poverty. Pearl Buck’s “The Good Earth” was for years a best-seller and played an influential role in winning her the Nobel Prize for Literature in 1938. *

To my thinking, America has an unfulfilled destiny in Nanjing. It’s a smart place for smart capital to locate. In modernizing, it has kept its soul intact.

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* For sharing his rich and consummate knowledge of America’s multi-facetted engagement with  Nanjing in the first half of the 20th century, I’m indebted to John Pomfret. John’s book “Chinese Lessons”, about his years as a student at Nanjing University and the lives thereafter of his Chinese classmates, is as good as anything published about China’s remarkable transformation these last thirty years. You can read more about the book, and about John, by visiting http://www.johnpomfret.org/

 

The Abacus. A Crowning Achievement of Chinese Innovation

Leave a Comment / November 14, 2014

 

abacus China First Capital

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While China’s recent performance may be a disappointment, averaged across the millennia no other nation has provided the world with such an abundant wellspring of innovation. Have a look at this long list of Chinese inventions. Not a day passes for most of us when we don’t rely on at least one product of Chinese ingenuity, be it paper money, the bristle toothbrush, toilet paper, oil wells. A slightly smaller group of us wouldn’t want to long tolerate life without noodles, steamed or stir-fried food, tofu, tea, alcoholic drinks.

Left off the Wikipedia list is one other Chinese gadget that played a central role in people’s lives, especially in East Asia, for centuries and then abruptly disappeared over the last two decades. It’s also my personal favorite among all Chinese inventions, the abacus. I grieve over its extinction.

When I first got to China in 1981, the abacus was ubiquitous — in every shop, bank, schoolroom and government office. If it had to be counted or calculated, an abacus was required. I still remember the loud and ceaseless clicking sound inside the main room of Nanjing’s cavernous People’s Bank as dozens of clerks tabulated and re-tabulated sums, louder and more rhythmic than the clatter of cicadas outside. Cheap electric calculators and PCs not only killed off the abacus they also have turned China’s banks and offices into quieter more monotonous spaces.

Among all Chinese inventions, nothing quite rivals an abacus, or “算盘 suanpan” in Chinese,  for pure “out of the box” ingenuity. There’s no clear predecessor machine, and no real evolution or improvement from the device that is first described almost eight hundred years ago in Chinese books and begins appearing in Chinese paintings five hundred years ago.

Though the name of the inventor (or inventors) is lost to history, none but a towering genius could invent a portable lightweight tool and the accompanying fingering technique to allow a few rows of beads separated on two stacked decks, five beads on the lower and two on the upper, to perform high-speed, accurate multiplication, division, addition, subtraction, square root and cube root operations. In geek-speak, hardware and software are proprietary and seamlessly integrated. The abacus, unlike the modern electronic calculator, is as easily used for calculations in base ten (decimal), base 16 (hexidecimal) or any other base you might choose.

Europe and America, so dominant in most spheres of invention these last 400 years, contributed in the 17th century the slide rule and adding machine to the technology of calculation. But, neither achieved the widespread use in teaching and daily life the abacus enjoyed for centuries. Most Chinese aged over 30 (as well as tens of millions in other parts of Asia) were taught in school to use an abacus. While most have since sadly forgotten how to use one, they once could manipulate the wooden beads as quickly and accurately as skilled touch typists.

I recently went off to see if I could buy an old wooden abacus. It’s harder than you’d think. My guess is there were at least 400 million abacuses in China thirty years ago. Today, they’ve completely disappeared from sight. I can’t recall a single time I’ve seen one in use during the last five years living full-time in China. Something of great functional beauty and utility has gone out of Chinese lives.

I did eventually succeed in finding one at an antique market in Shenzhen. It looked to me, based on the filigree bronze hinges, to be about 120 years old. The seller, in his early 60s, had forgotten how to use it, as did everyone else who gathered around to watch me bargain for it, with the exception of one handsome older woman trained in the early 1970s as an accountant. I asked the seller to give us some random four-digit numbers to add and subtract, with me using the calculator on my phone and her using the old abacus. In each case, she was quicker than me. I had to repeat each number in my head before tapping on the keyboard. Her fingers, on the other hand, were in motion from the first sound. It was a virtuoso performance.

An abacus is not a calculator, in the sense that you punch in numbers and it spits out an answer. “The person operating the abacus performs calculations in their head and uses the abacus as a physical aid to keep track of the sums, the carrys,” explain the experts at Canada’s Ryerson University.

After polishing away the dust, I put the abacus on the table in the CFC’s meeting room. I’m determined to learn better how to use it, but conscious of ebbing mental and physical dexterity.

It looks like nothing else on the planet, and yet it shares similarities with an iconic device invented 800 years later (in 2007) in Silicon Valley. A swipe-operated high-tech tool, with a simple rectangular design, its engineering elegant yet practical, and an intuitive interface that allows anyone with a little practice, from kids to old folks, to solve routinely and quickly a host of problems once thought too challenging for ordinary folk. The iPhone is the abacus of our age.

 

Why and how Beijing became one of the world’s more unmanageable major cities

Leave a Comment / August 21, 2014

Beijing Bactrian camel–

What if most of what we think about government spending was wrong? What if government money causes, rather than cures,  pollution, unaffordable and substandard housing, impossible traffic, more expensive and less available healthcare? Sounds impossible, right? Not if you live in or have traveled to Beijing lately. The city’s now infamous urban problems are at least in part the result of a deluge of government spending since the onset of the financial crisis in 2008. Direct central government funding doubled to over Rmb 14 trillion ($2.2 trillion) over this period while local governments borrowed an additional Rmb 13 trillion ($2.1 trillion) to finance their spending.

The government money, of course, wasn’t meant to turn Beijing into an urban sprawl with a population larger than every state in the US except California. In fact, most of the government stimulus was targeted for big projects outside the capital. But, in China, the nature of things is that much of government spending travels on a round-trip ticket. It is dispensed in Beijing and then a big part of it eventually returns home. And no, this isn’t all in kickbacks. A large part is from the build out of a huge new infrastructure in Beijing to support, steer and encourage the distribution of more government cash.

In the last five years, it seems like everyone rushed to open or expand offices in Beijing：  companies of all sizes from all part of China and the world; governments from the smallest local hamlet 3,000 kilometers away to provinces with populations larger than every country in Western Europe also staffed up. Result: commercial and residential real estate prices skyrocketed to the point now where they are among the highest anywhere in the world.

More people begets more cars, more cars begets more traffic, more traffic begets restrictions on the days-per-week any car can be on the road, which in turn begets Beijingers buying an extra car to get around the prohibition. End result: pollution that is now substantially caused by auto emissions, not as in the old days by nearby-factories burning coal. Many polluting factories have been shut down, which added to the available land for development into commercial and residential property in and around Beijing, particularly in areas you need a car to get to.

Here are the two charts, showing residential real estate prices and cars registered in Beijing from 2008 through last year. The numbers are likely underestimates. But, they show the trend.

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The torrent of government cash had all kinds of spillover effects that have altered Beijing permanently. More restaurants, higher prices, more wining and dining, leading to prohibitions last year, as part of the big anti-corruption crusade, on government officials accepting invitations to party outside the office. This then drives the behavior underground, so high-end restaurants empty out, while more expensive and exclusive “members only” clubs flourish.

Beijing has morphed into the financial capital of China. That’s attracted a large group of players to move from Shanghai and Hong Kong to get a piece. PE funds, private bankers, lawyers, consultants, so-called “guanxi merchants” who arrange access to government officials. Among my circle of friends in PE industry, I can count 15 who have moved to Beijing in recent years, to get closer to the action, and only one who left, who finally couldn’t take the crowds, pollution, high cost.

Beijing’s precise population is unknown. The official number is 21.1 million. Some in government say 25 million. Others claim the real number is closer to 30 million, when you count more recent migrants living rough, plus the huge throngs in Beijing for shorter periods, either for work or pleasure.

Since 2008, far more of China’s total economic activity is decided by government bureaucrats in Beijing. Overall government spending has more than doubled. Result, more people need to travel to Beijing more often.

Look at passenger numbers at Beijing’s Capital Airport. Between 2008 and 2013, this already crowded-facility saw passenger numbers increase by a remarkable 50%. It is, as of March this year, now the busiest airport in the world, eclipsing Atlanta’s Hartsfield. Capital Airport is now breaking under the load, and so Beijing is about to embark on building an even larger new airport in the southern part of the city. This mammoth $11 billion project by itself could support a lot of Beijing’s gdp growth in the coming few years. But, it will be just the cherry on top.

Beijing has the best hospitals in China, so people come from all over the country to try to get admitted for medical treatment. This has led to price increases and longer waiting times. Equally, those with a serious grievance about their local government, or who feel maltreated, will often gather up their documents go to Beijing to try to get redress. This trek to Beijing has been around since the days of the Emperors. As China’s government grows in power and economic clout and ordinary Chinese have the money to fight back, those seeking to petition central government’s help increase.

To serve all the new arrivals and visitors, Beijing continues to expand its Metro system. The average daily ridership is now 10 million, about triple London’s, and also triple the amount five years ago in Beijing.  Waits at rush hour to get into some stations can be horrific, so the government recently proposed to raise fares. Beijing currently has the cheapest public transportation of any big city in China.  While some may leave Beijing, the likely result of higher Metro fares will be more people trying to buy a car.

How bad is traffic in Beijing. Horror stories abound. A more reasonable evaluation: the manager of a big telecommunications company I know told me recently if he doesn’t leave his house by 7am, it will take 90 minutes to drive 10 km from his house to his office. That’s about speed of sedan chairs used to carry emperor and his cohorts within the Forbidden City.

To be sure, Beijing is not Dhaka. Since 2008, many aspects of the city’s infrastructure have been upgraded. It is a thoroughly modern city, with scarcely a trace of either poverty or blight. When I first visited the city in 1981, Bactrian camels were still occasionally seen on the streets hauling cargo.

For first time since 1949, the leader of the country, Xi Jinping,  is Beijing born and bred. Since he was a boy, Beijing’s population has about quadrupled, while China overall has almost exactly doubled.  Will he try to shift gears, slow or even reverse the growth in the city’s population? It won’t be easy. Government stimulus spending, once turned on is notoriously hard to scale back in any serious way. Do so and overall GDP growth will likely suffer.

In its 3,000 years as China’s major urban outpost on the country’s northern perimeter,  Beijing has experienced countless invasions, barbarian pillages, conquests, uprisings. But, nothing in history has altered Beijing as quickly, deeply, and perhaps permanently as five years of bounce-back and kickback from trillions in government pump-priming.

 

 

 

China’s rise enters a more challenging phase, where bold ambitions confront stubborn, often centuries-old obstacles

Leave a Comment / August 5, 2014

China First Capital 2014 Survey cover

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China’s economy and society have both reached levels of wealth and development that were unimaginable 30 years ago. What comes next? How can China continue to push forward, against some deep-seated problems, including how to generate globally-competitive innovation, how to sort out land ownership, how to attract and reward global investment flows? These issues are examined in detail in the new research study published by China First Capital.

The new report is titled ” China Survey 2014: The Rise Continues, New Directions & Challenges“. Copies may be downloaded by clicking here or from the research reports page of the company’s website.

China’s economy remains vibrant and fast-evolving. Many of the Fortune 500 successes stories of recent years – KFC, P&G, Coca-Cola – are finding it harder and harder to keep winning in the China market. As they lose share, other companies are gaining, both domestic and international. The report looks at this transformation through the vantage point of China First Capital’s rather long experience working in China,  alongside some talented CEOs in both domestic and global corporations, the incumbents and the disrupters both.

Investing successfully in China, either through the stock market or through M&A, also remains challenging. But, it’s worth the strain, the report asserts, since no other country can rival China today in terms of both the number and scale of money-making opportunities.

The new China First Capital report discusses these broad trends, and also examines the following in depth:

  •  is China’s investment community (PE and VC firms, stock market investors)  over-allocating now to mobile services and online shopping;
  •  an assessment of the serious challenge facing traditional shopping mall operators and retailers mainly because of competition from soon-to-IPO Alibaba’s online shopping giant;
  • a sober analysis of actual disappointing state of China’s high-tech industry;
  • how China triumphed over India, and won the battle as the world’s best and biggest Emerging Market,
  • why 3M may be the most successful American company in China, but flies so far beneath everyone’s radar

Some of the contents have already been published here on this blog and on Seeking Alpha.

The report’s core conclusion is that China has come a long way and in raw terms is certainly the most successful emerging economy of all time. But, it needs to become more innovative, generate more globally important technology breakthroughs, not just copycatting. There’s no absence of hype around about how China is poised to become a global technology powerhouse. The report, though,  cites China’s failure to serially produce an aircraft engine as a concrete, if not often talked-about, reminder of its technology frustrations and limitations.

 

 

Alibaba’s Taobao and Other Online Shopping Sites are Pushing Traditional Retailers in China Toward Extinction

2 Comments / April 10, 2014

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Welcome to the desolate future of mall retailing in China.

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China shopping mall–

This seven-story skylit shopping mall occupies a premier spot in a high-rent commercial district in booming Shenzhen’s main shopping street, with a huge underground parking lot and entrances that link it directly with a busy Metro stop. And yet,  everywhere you walk, floor after floor, retail shop fronts are boarded up, with most stores closed down. Only the ground floor supermarket, top floor Multiplex movie theater, basement chain restaurants and a large Starbucks are thriving. Thousands of square meters of retail space, fully rented as recently as twelve months ago at some of the highest commercial rents in the world, are silent and vacant. No customers, no tenants, no rent income.

Malls are starting to empty out in China, but Chinese are richer, and spending like never before. Overall, retail sales rose 13% in 2013. The paradox can be explained by a single word: Taobao.  It is China’s largest online shopping business, and the anchor asset of Alibaba Group, now preparing for one of the world’s richest-ever IPOs on the US stock market. Taobao, along with its sister site TMall, and a host of smaller online retailers including Jingdong, Amazon China and Wal-Mart-controlled Yihaodian, have landed like an asteroid, and are wiping out the ecosystem supporting traditional retail in China, especially brand-name clothing shops.

The impact of online shopping in China is already far more wide-ranging than anything seen in the US or elsewhere. The reason is price. Taobao and others sell the same brand-name products available in shopping malls, but at prices often 30%-50% cheaper.  More even than rising incomes, online shopping is the most powerful force in China for raising ordinary Chinese living standards and purchasing power.

Online shopping is everywhere in the world, at its heart, a price discovery tool. And Chinese are now discovering, in their hundreds of millions, they have been getting seriously ripped off by traditional stores, especially those selling foreign and domestic brand-name clothing and consumer electronics. They usually occupy 70% or more of a mall’s retail floor space.

Alibaba and other online merchants are joyously surfing a tidal wave of dissatisfaction with the high price of store shopping in China. Not only are brick-and-mortar stores’ prices much higher than buying online, they are also often more expensive, in dollar-terms, than the same or similar Made-in-China products sold at Wal-Mart or Target in the US.

Those two giant chains have fought back against online retailers in the US by using their buying power to offer brand name products at low prices. No retailer in China is really attempting this. Retailing in China is both fragmented and uncreative. As dynamic and innovative as China is in many industries, I’ve yet to see even one great home-grown retailing business here in China.

There’s also a big problem in the way Chinese shopping malls, especially high-end ones, are operated. Chinese mall owners are mainly a motley assortment of one-off developers who used government contacts to nab a valuable piece of commercially-zoned downtown land at a fraction of its market value. They then mortgaged the property, built a fancy shopping palace, and now take a cut of sales, along with a baseline rent. This revenue-sharing discourages retailers from cutting prices. If they do, they will fail to meet the landlord’s minimum monthly turnover figure.

Compounding the pressure on traditional retailers, mall owners often give the best ground-floor locations to global brands like Louis Vuitton or Prada, who pay little or no rent, but are meant to give the mall a high-class ambiance. The big luxury brands’ China outlets seem to have rather anemic sales, but use their China stores as a form of brand promotion richly subsidized by mall owners. Domestic brands are shunted to higher floors. Fewer shoppers venture up there, and so the stores will often end up failing.

The result, as in the photo above taken on a recent Sunday, floor after floor of vacant space. China is creating an entire new retail landscape – a glamorously-appointed mall in a nice part of town whose upper floors resemble downtown Detroit after a riot, with boarded-up shop fronts and scarcely a soul.

Anywhere else in the world, a mall with so much vacant space would either need to cut rents drastically or hand the property over to the banks that lent the money. Neither is happening. For now, the banks can often afford to be patient. Malls that have been around for a few years have probably already paid off the loan principal. Newer loans look far shakier. There are hundreds of bank-financed high-end malls now under construction or opening this year across China.

The stampede away from malls is only just beginning. Though China has already overtaken the US in dollar terms as largest online shopping market, there is every sign that the shift to buying online is accelerating and irreversible. Online sales in China should reach 10% of total retail sales this year, well above the US level of 6%. We project this percentage will rise to over 15% within the next decade. That’s because more Chinese will shop online, especially using their mobile phones, and because the range of items that are cheaper to buy online is so much larger in China than anywhere else.

For that, online merchants must also thank the country’s parcel delivery businesses, led by Shunfeng Express. They charge so little (about one-tenth the price of Fedex or UPS) and are so efficient in getting your parcel into your hands quickly that it makes economic sense not only to buy higher-priced apparel and consumer electronics, but also packaged food, soap, personal care items, even knickknacks that sell for less than $1.

The retail stores that remain in shopping malls are increasingly being used as free showrooms to facilitate sales by online competitors. Chinese shoppers go to stores to find what they like, try it on, check the price, then go home and buy direct from Taobao. That’s one reason malls are still drawing crowds.

Online shopping is not only cheaper, customer service is usually much better. Most merchants selling on Taobao manage and run their own online shops. Taobao is nothing more than an aggregation of millions of motivated individual entrepreneurs. They are available just about any time, day or night, by phone or online chat to answer questions, or even, when asked, offer an additional discount. They are, in my experience, smart, self-confident, friendly, competent.

Sales help in stores are often poorly-paid younger women who cling together behind the cash register. They clearly don’t much enjoy what they are doing, nor are they there to enhance the shopping experience. Often just the opposite.

So what’s going to happen to all the malls in China? There are over 2,500 across the country, already more than double the number of enclosed malls in the US. More are opening around China every week. Who will fill up all the space? There’s serious money to be made by investors or operators who can take advantage of the large disruptions now underway in traditional retailing.

Restaurants in malls are still doing well, and they don’t have anything to fear from Taobao. But, food outlets generally pay lower rent, per square foot, than retail stores and occupy either the top or basement floors. Premium office space is also still in demand in the downtown areas where many malls are located. Should malls be turned into food and entertainment centers? Or converted to commercial offices? Neither path looks easy.

The US went through a large wave of shopping mall bankruptcies in the 1990s, as large operators like DeBartolo and Campeau failed, and better ones like Simon Property Group and Westfield Group thrived. The good operators lowered costs, improved the economics and did well as newer retailers like Victoria’s Secret, Abercrombie & Fitch, Hollister, Juicy Couture, H&M, Apple, Papyruys, Teavana, Nordstrom honed retail formulas that could withstand online competition.

Retailers in China are in such peril because they charge too much, never innovate and do so little to win the loyalty of their customers. Alibaba and other online sellers are hastening them towards extinction.

 

 

 

How China buried India

5 Comments / May 25, 2014

Forbes India cover story 1994

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Twenty years ago, India, not China, was the object of my absolute and total focus.  Back then, I was living in London and working as a European bureau chief for Forbes Magazine. In May 1994, a story I co-wrote called “Now We Are Our Own Masters” appeared on the cover of Forbes (click here to read the article). It was the first time a big American magazine took the risk to suggest India, after so many years of pathetic growth, famine and unending poverty, was ready for an economic take-off. It turned out to be a smart call. Since then, India’s economy has surged, growing seven-fold while poverty has declined steeply.

India GDP growth 1950-2010

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I spent about a month in India researching the article, meeting with political and business leaders. It was my third trip to the country. The first had been in 1978, as a young backpacking college student, on my way back to the US from a summer in Taiwan studying Mandarin. The two most vivid memories of that first trip — nearly dying from untreated amoebic dysentery, and hiding out for days in a place called Aurangabad as masses of Indian men rioted on the streets against the forced sterilization policy of India Gandhi. (Life lesson learned at 19: political popularity will be short-lived wherever a leader orders men at gunpoint to undergo genital surgery.)

It took another three years before I first set foot in China. On a lot of levels, the two countries struck me as similar back then, both in the extent of the obvious poverty as well as the shared disappointment some thirty years after each had gained full independence as socialist states under charismatic intellectual leaders, Jawaharlal Nehru in India and Mao Zedong in China.

China began its reform process a decade earlier than India. I caught the first stirrings when I arrived in Nanjing as a student in 1981. When I went to India in 1994 for the Forbes article, it still seemed plausible India might one day emerge as the larger, more vibrant of the two economies. China had suffered a sharp setback in 1989, during the Tianmen Square Protests of 1989, an event I witnessed first-hand in Beijing. At the same time, India had begun at last to liberalize and energize its over-regulated and inefficient state-run economy.

While India’s growth has since surpassed my optimistic hopes in 1994, I firmly believe it will never rival China. This chart below shows how far the gap between the two has grown. Since 1994, China has all but left India behind in its tailpipe exhaust.

China vs. India GDP Growth 1960-2010

In per capita PPP terms, China is now almost 2.5 times wealthier than India. Year by year, the gap grows, as China’s gdp expands faster than India’s, while India’s birth rate is now almost triple China’s.

I haven’t been back to India since 1994. I have no doubt it’s changed out of all recognition. Changed for the better. Poverty is down. Exports are way up. Its biggest misfortune may be having to compete for capital, and for attention, with China.

Living full-time and working in China now for more than four years, I’m more impressed than ever how superbly China is engineered for rising prosperity. The comparisons I read between India and China generally give a lot of weight to the difference in political systems, between India’s raucous federal democracy with dozens of parties and China’s one-party centralized rule. The indisputable conclusion: sound economic policies are easier in China to design and execute.

The few times I’ve been asked to contrast the two countries, I prefer to focus on their most valuable long-term assets.  India has English. China has Confucius.

India doesn’t out-compete China in too many industries. But, in two of these — pharmaceuticals and computer software — English is probably the main reason. India’s educated population is basically native fluent in the language. China has tried to make more of a game of it, especially in computer software and services. But, China is now and will likely remain a bit player in these two large, global high-margin industries.

India also has, overall, a more innovative financial services industry. This isn’t really the result of widespread English, but the fact that India has a more open financial and currency system than China’s.

Both nations benefit from having large diasporas. In India’s case, it’s a huge source of cash, with remittances of over $65 billion a year, equal to 4% of gdp. In China, the benefits are as much in kind as in cash. Companies owned or managed by ethnic Chinese from Southeast Asia, Hong Kong, Taiwan and the US have been large corporate investors in China, with the capital matched by transfer of technologies and manufacturing know-how. This is an ever-renewing remittance, as money pours in each year to finance projects with solid long-term rates of return.

China’s trump card, though, is its Confucian value system. Its potency as an economic force is amply demonstrated by the affluence of China’s Confucian neighbors, not just Hong Kong, Singapore and Taiwan, but South Korea and Japan. Its impact is measurable as well in the outsized economic clout of Chinese immigrants in Thailand, Philippines, Indonesia. Free market capitalism and Confucianism. Anywhere in the world you find sustained economic success and rising prosperity, you will find at least one. In China, they are entwined in a kind of ideal synthesis.

India, too, has close-knit families and a tradition of thrift and obedience. Confucianism adds to these a reverence for education and practical problem-solving. It contains nothing transcendent, not much, if any,  spiritual guidance for a soul-searcher make sense of his place in the cosmos. Honor your ancestors with burnt offerings, sweep their graves at least once-a-year and they’ll grease the wheels of success in this life.

The Confucian system hasn’t changed much for two thousand years. One vital adaptation over the last century, though,  was to accept that women could, and should, play an active role outside the house, reaching the same educational level as men and joining the workforce in equal numbers. Here, India is woefully far behind. China’s growth has been on steroids these past twenty years because its 650 million women have contributed exponentially more to economic growth and prosperity than India’s.

Of the couple hundred stories I wrote while at Forbes, I’m probably proudest of this India cover story published twenty years ago. It may not seem like it now, but it was a gamble to suggest back then under my byline India was about to come out of its long economic coma. Imagine if instead I’d gone on the record 20 years ago to forecast the coming economic miracle in Russia, Mexico or South Africa – all countries back then seen by some to be “the next great emerging market”.  I heard afterward the article helped generate more interest in India’s economic reforms and ultimately more investment in India by US multinationals. This grew about 30-fold in the ten years after the article appeared.

On a personal level, I made a larger, and I think even safer bet with my own professional life, to move to China and start a business here. Yes, India has English. I work every day in an alien tongue and in a culture steeped in Confucian values that play little or no part in my own ethical code. But, China was, is and shall long remain the great economic success story of all-time. I don’t need someone else’s magazine cover story to tell me that. I live it every day.

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China SOEs — How They Think and Why

Leave a Comment / December 15, 2013

– China First Capital blog There are many flavors of State-Owned Enterprise (“SOE”)  in China, from polluting monster chemical factories to quaint dumpling houses that date from before the revolution.  Since coming to China, I’ve seen up-close quite a number SOEs, probably more than most other non-Chinese. No two are quite alike. But, equally, SOEs in China, from the largest centrally-administered “national champions” (known as 央企, or “yangqi”, in Chinese and include such familiar names like Sinopec, China Mobile, ICBC) that earn billions in profits every year to smaller local loss-making industrial companies with a few hundred employees, share a similar genetic code. Or more precisely, provide the same iron rice bowl.

That phrase (铁饭碗 ) was widely used during Mao’s time, and I still heard it frequently when I first came to China 1981.  It’s since faded from common use. But, the concept remains embodied within all SOEs. Simply put, an “iron rice bowl” means a job for life, and so a life without the worry of going unfed. In today’s China, with the threat and the memory of famine now extinguished, it’s more a way of expressing the unique way an SOE functions, how it views its role in society and the benevolent — some might say paternalistic — way it cares for its employees.

An SOE is, above all,  a very Chinese institution, and in many ways, one of the few holdovers from the Maoist era.  Chinese then didn’t so much work for a company as they belonged to a “work unit“, a 单位 (“danwei”). A paying job was in some senses the least important thing provided by one’s work unit, since cash salaries used to be very low, under $10 a month for mid-level managers. Instead, one’s work unit provided housing, schools, communal heating, medical care, ration tickets, permission to marry, to travel or have a child, subsidized meals and fresh food.

In theory, the work unit was the Great Provider, anticipating and meeting all of one’s needs in life. In practice, of course, it offered not a lot more than a very rudimentary existence and a job for life. For most Chinese, especially all working for private sector companies, the danwei system was dismantled ten years ago. A job is just a job, not a lifetime meal ticket.

But, for those working at SOEs, many of the more desirable features of the danwei system have been preserved, starting with the fact you are very unlikely ever to be fired. What’s more, the company itself is also highly unlikely to ever go bankrupt or face a serious crisis that would lead to mass layoffs.  Today’s SOEs hold, in effect, a permanent right to operate, regardless of market conditions.

China’s current group of SOEs are a privileged rump, those spared from a massive cull over ten years ago. That put the worst, least efficient SOEs out of business, and forced tens of millions to take early retirement or go off in search of new jobs, mainly in the private sector.

SOEs, along with the military and the Party, are the third of China’s key pillars of state power. While each is subject to the control of the country’s leadership, each also operates, to some extent,  by rules of its own. Chinese leaders are known to complain, at times, about the power, wealth and influence of the country’s larger SOEs.

SOEs are ultimately kept in business by other SOEs — loans from the state-owned banks, and orders or supplies from fellow SOEs. In most cases, they have a marked preference for doing business with one another.  Partly, this is because SOEs tend to understand better the way other SOEs think and act. Partly, it’s also because SOEs function together as mutual assistance society. If one gets in trouble, others will either voluntarily help out, or be ordered to do so by SASAC （“国资委”）, the government organization that manages Chinese SOEs.

SOE jobs usually pay less than private sector competitors. But, for many, that’s more than compensated by the perks that come with the job. While Google is famous for its free food and recreation areas,  an SOE has its own attractions, tailored to the tastes of its Chinese employees. Workloads tend to be modest, and a long lunchtime siesta is built into every working day. During winter, the company will often provide extra cash to pay for heating.

There is, in my experience, an obvious camaraderie among SOE workers,  a shared identity and pride working for what are usually very large, well-known companies that tower over their private sector competitors and neighbors. If not always in practice, at least in theory, an SOE is meant to be in business for the benefit of all of China, not to accumulate profits or generate wealth purely for its shareholders.

It’s a noble mission, but one that can lead to its own rather systematic form of inefficiency. Urged on by SASAC, they set ambitious growth targets every year to increase output. They achieve this, in most cases, by pouring more borrowed money into new capital equipment, often to produce products the government says China needs or wants. The amounts invested, and the returns on those investments, tend to move in opposite directions.

SOEs can borrow at half the cost of private sector companies. Their hurdle rate is also often half that, or less, than private companies’.  As a result, projects with limited financial rationale often get built.

Take LEDs, solar and wind power. All three were heavily over-invested by SOEs because the Chinese government had made such “green energy” projects a national priority. More energy was probably consumed forging the steel and building factories and equipment to produce LED assemblies, solar panels and wind turbines than has been saved by lowering overall energy use in China. A lot of these LED, solar and wind projects are now mothballed, due to losses and falling demand.

Part of what SOEs exist to do is to take government economic policy and turn it into hard, if sometimes not very productive, assets. That outlook, of course, also impacts the way SOE staff work. Their pay isn’t linked to profits any more than company-wide strategy is.

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Punishing the Righteous — How Lax Tax Compliance Distorts the Chinese Economy

1 Comment / July 23, 2013

The Chinese corporate tax system combines fairly high rates with low compliance. The result is that the companies that do pay all the tax legally owed will usually be at an enormous competitive advantage to the numerous competitors who pay little or nothing. Non-payers can either choose to earn fatter margins or undercut the price of their compliant competitors. Either way, the result is that profits flow to those least legally entitled to keep them.

This widespread tax avoidance is among the more serious distortions in the Chinese domestic economy. The government knows this, and so tries to level the field by giving special targeted tax breaks, subsidies, underpriced land (as well as awards of free land)  to the companies that do pay tax. But, this practice causes distortions of its own.

The corporate tax system in China is a cake of many layers. There is a VAT applied to most products along with a corporate profits tax of 25%, as well as a whole raft of other fees and levies, including taxes on real property and natural resources, and others to finance urban maintenance and construction.

In my experience, it’s exceeding rare to find a Chinese private company that obeys the rules and pays all that is asked of it. Doing so, in most cases, would render the company loss-making. The best payers are the private companies that have filed for an IPO, or have already been publicly-listed in China. It is the most critically important of all the prerequisites for IPO approval, that a company be fully compliant with all tax rules.

For companies we know, this process of becoming fully tax-compliant is the most painful and expensive thing they will ever undertake in business. In one case, a very successful retail jewelry company, has gone from paying almost nothing in tax to paying almost Rmb500mn (USD$80mn) during the three-year process of preparing to file the application for an IPO. An IPO in China is basically a way for a company to reclaim, from stock market investors, the cash it’s lost to the taxman over the preceding three to five years.

The government bestows favors on companies that do pay tax. Hanging prominently on the walls of many private companies I visit are plaques given to a locality’s largest tax-payers. The plaque is awarded for amounts paid, not amounts technically owed. So, it is possible to be both an award-winning local taxpayer and a world-class tax cheat at the same time.

Though there is no formal system of tax rebates, just about every business that pays some tax gets something back in return from the state. The more you pay the more you receive. The two most popular forms of rebate to companies are investment subsidies as well as the opportunity to buy land at concessionary price.

The investment subsidies can be very generous. Depending on industry and location in China, a companies will often get back one-third or more the cost of new factory machinery.  While this lowers breakeven cost and so improves a company’s profit margins, the investment subsidies help propel a system in China that often leads to rampant over-investment. This is especially noticeable in some favored high-tech areas like the manufacturing of LED chips or wind turbines. R&D spending is also often subsidized through a form of tax rebate.

Often, the best use of a company’s money would be to invest in marketing, or building its sales channels. The tax rebate system generally rewards none of this. So, arguably, companies can often end up worse off, with higher-than-needed outlay for fixed assets, because of the tax system.

The offer to purchase land at significant discount is a valuable perk, and one that’s available, in the main, only to Chinese companies that pay tax. It is probably the most frequent form of indirect tax rebate. I know of no specific formula, but the general principle is for every million in taxes you pay, you will be given a chance to buy land worth multiples above that, at a price at least 50% below market value.

Unlike factory equipment, which loses value every year, land is a scarce commodity in China. The government has lately tried to moderate price increases of land. But, overall, buying land in China, especially if done at a discounted price, is a winning one-way bet.

While a nice inducement to encourage tax compliance, the government’s offer of underpriced land to taxpaying companies also causes distortions. Chinese manufacturers, in general, are fixated on owning the land their factories sit on. Even if you can buy that land on the cheap, it is still a sink for capital that might be more efficiently invested elsewhere in your business. You also need to borrow the money, in most cases, to buy the land. Those interest payments can often lower your pre-tax profit margins.

There is also a problem of asyncrony.  You need to pay taxes for several years before you get a chance to buy land on the cheap. During that whole time, while you wait to make a profit on a land deal, your non-taxpaying competitors are enjoying much fatter margins than you. They can use this to steal lower prices, steal your customers and so lower your profits. This not only pushes you towards insolvency, it also reduces the ability to pay the taxes that generate the favors that offset the high tax rates.

From what I’ve been able to tell, nobody, including Chinese government officials, likes the current corporate tax system, with all its complexity and high headline rates. But, these same officials also argue that if they lowered taxes overall, there is no guarantee that the many tax-avoiding companies will then become taxpayers. They are probably right. From that simple standpoint, cutting corporate taxes may only lower the amount of money the government takes in each year. This, in turn, means less money to award to those who are paying.

China is likely stuck with its current corporate tax system. It punishes, then compensates, the righteous few who pay everything that’s owed.

 

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Private Equity in China 2013: the Opportunity & The Crisis — China First Capital Research Report

2 Comments / June 29, 2013

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Making money from private equity in China has become as challenging as “trying to catch a fish in a tree“*. The IPO exit channel is basically shut. Fundraising has never been harder. One hundred billion dollars in capital is locked up inside unexited deals. LPs are getting very anxious. Private companies are suffocating from a lack of new equity financing. PE firms are splintering as partners depart the many struggling firms.

Looking beyond today’s rather grim situation, there are some points of light still shining bright. China remains the world’s fastest-growing major economy with the world’s most enterprising private sector. Entrepreneurship remains China’s most powerful, as well as inexhaustible, natural resource. So long as these two factors remain present, as I’m sure they will for decades to come, China will remain an attractive place to put money to work. But, where? With whom?

China First Capital has published its latest survey covering China PE, M&A and capital markets. The report is titled, ” Private Equity in China 2013 — The Opportunity & The Crisis“. It can be downloaded by clicking here.

During the last year, as China PE first stumbled, then fell into a deep pit, a lot of people I talk to in the industry suggested this was a positive development, that the formation of funds and fundraising had both gotten out of hand. Usually, the PE firm partners saying this quickly added, “but this doesn’t apply to us, of course”.  In other words, as the American saying has it,  “Don’t blame you. Don’t blame me. Blame the guy behind the tree.” It’s all somebody else’s fault.

That’s an interesting take. But, not one that holds up to a lot of scrutiny. The reality is that everyone in the business of financing Chinese companies, myself included, got a little drunk and disorderly. China, in business terms, is the world’s largest punchbowl filled with the world’s most intoxicating liquor. Too many good companies. Too much money to be made. Too much money to be had.

It was ever thus. From the first time outside investors and dealmakers got a look at China, they all went a little berserk with excitement.  This was as true of Marco Polo in the 14th century as British opium houses in the 19th century and American endowments and pension funds in the last decade. The scale of the place,  of the market,  is just so stupefying.

The curse of all China investing is counting one’s fortune before it’s made.  In the latter half of the 19th century, for example, European steel mills dreamed of the profits to be made from getting Chinese to switch from chopsticks to forks and knives.

PE firms did a lot of similar fantasizing. Pour money in at eight times earnings, and pull it out a few years later after an IPO at eighty.   All the spreadsheets, all the models, all the market research and top-down analytics — in the end, it all came back to this intoxicating formula. Put a pile of chips on number 11 then spin the roulette wheel. There were a few winners in China PE, a few deals that hit the jackpot. But, the odds in roulette, at 36-to-one, turned out to be much more favorable.

For every PE deal that made a huge return, there are 150 that either went bust or now sit in this near-endless queue of unexited deals, with scant likelihood of an IPO before the PE fund’s life expires.

The China First Capital research report, rather than making any predictions on when, for example, IPOs will resume and at what sort of valuation,  delves more deeply into some more fundamental issues. These include ideas on how best to resolve the “principal-agent dilemma”, and the growing risks to China’s economic reform and rebalancing strategy caused by the drying up of IPO and PE financing of private sector companies.

We hope our judgments have merit. But, above all, they are independent. Unconflicted. That seems more and more like a rarity in our profession.

 

* A prize to the first person who successfully identifies the source of this quote. A hint: it was said by a former, often-maligned ruler of China.

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New capital drought threatens growth in China — China Daily

Leave a Comment / June 24, 2016

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Continued lack of IPO proceeds and private equity input will damage China’s economic reform

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By Peter Fuhrman

China’s private sector is experiencing an unprecedented shortage of new investment capital. The two predominant flows of growth capital for China’s private sector – initial public offering proceeds and new investments by more than 1,000 private equity firms active in China – have both dried up.

As recently as 2011, IPOs and PE firms pumped $20 billion (15 billion euros) to $30 billion a year of new capital into private companies in China. In the past nine months, that figure has dropped to almost zero.

Even when IPOs cautiously resume, the flow of capital to private companies will likely remain at levels far below recent years. If so, it will quite possibly damage the plans of the Chinese government, as well as the hopes of many of its citizens, to “rebalance” the Chinese economy away from reliance on state-owned enterprises and toward one oriented more toward meeting the needs and fulfilling the hopes of the country’s 1.3 billion people.

All companies need capital to grow. This is especially true among China’s private sector businesses. They operate in a particularly fast-growing market, where both opportunities and competitors are plentiful. Private sector companies are also the main source of new jobs in China, and an increasingly vital contributor to overall GDP growth.

Over the past decade, these Chinese companies became perhaps the world’s hottest investment targets. China’s PE industry, both dollar and yuan, grew from basically zero to become the second-largest in the world. PE firms raised more than $200 billion to invest in China and then put money in more than 10,000 Chinese companies. At the same time, Hong Kong, New York and China each year vied for the title of world’s largest IPO market, with most of the deals being new offerings by Chinese companies.

New capital drought threatens growth

China still has more of the world’s best, most talented private sector entrepreneurs than any country. Investing in their companies remains one of the best ways to make money anywhere. But, for the moment, only a few are willing to try.

This problem is at its core a market failure caused by the loss of investor confidence inside and outside China in the true financial situation of its private sector companies. Questions are raised about financial fraud inside Chinese private companies. Though the concerns are real, the problems are of limited scope, often technical, and the market’s reaction has been severely overblown.

The accounting issues first arose in the US, with the uncovering of several cases of phony accounts among Chinese private companies quoted there. The contagion of doubt spread first to other Chinese private sector companies already listed or seeking to IPO in the US, then to those waiting for an IPO in Hong Kong, until recently the largest market in the world for new IPOs.

Finally, from the summer of 2012, the stock markets on the Chinese mainland began shutting down new IPOs. When the IPOs stopped, most PE firms stopped investing.

The PE firms are sitting on more than $40 billion in capital that they say is for investing in China’s fast-growing private sector companies. But that money is now idle in bank accounts, not going to help good companies become better.

The longer China’s private sector goes without access to major new capital, the more unbalanced the Chinese economy may become.

I first came to China in 1981. During the past 32 years, China’s private sector has gone from non-existent to producing more than half of the country’s GDP. The private sector produces just about everything ordinary Chinese rely on to better the quality of their lives – not just more and better-paying jobs, but also new housing, shops, clothing, restaurants, tutoring for their children and a vibrant Internet and e-commerce industry.

As these private companies have gone from small mom-and-pops to some giant businesses, including virtually all China’s leading domestic consumer brands, the dependence on IPO proceeds and PE money has become almost absolute. So, the dramatic slowdown in the flow of capital to private companies will have an impact on these businesses, their customers and ultimately China’s GDP.

At this point, the only outside financing available for Chinese private companies are bank loans, which remain difficult and costly to arrange. The banking system is, however, fixated on lending to state-owned enterprises. That leaves only the so-called “shadow banking system”, where loan sharks provide short-term money at interest rates of at least 25 percent per year. But, recently, even many loan sharks have fled the marketplace.

The Chinese government has created a set of policies that allowed the private sector to flourish. It also encouraged the flow of capital from the PE industry and IPOs. The plan had been to rely on the private economy to shoulder much of the burden of restructuring the Chinese economy away from SOEs and exports, while creating new jobs and supplying the goods consumers most want.

But that planned rebalancing cannot happen without money, without new capital for the private sector. Instead of a rebalance, China’s economy is possibly headed toward a more lopsided reliance on the state sector and big-ticket government spending projects.

(The author is founder and chairman of China First Capital, a China-focused investment banking and advisory firm. The views do not necessarily reflect those of China Daily.)

 

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China’s Beauty Revolution — Deng Xiaoping Deserves Some of the Credit

4 Comments / May 2, 2013

Rather than discuss again the state of Chinese private equity and billions of dollars in capital flows, this blog will turn now to an even weightier topic. Pretty women. Specifically, the increasing abundance of them in China.

To my eye,  Chinese women have undergone a spectacular makeover over the last 30 years every bit as dramatic as China’s economic growth and modernization. I first came to China 32 years ago, as a graduate student. At the time, China was still partly under the leaden pall of the Cultural Revolution, which had officially ended five years earlier. College girls dressed like soldiers, wore no makeup and kept their hair short, often in stumpy pigtails. Army caps and threadbare canvas sneakers were considered fashion accessories.

Coming to China in 1981 after four years at university in the US, a fair amount of it spent chasing coeds, Chinese college girls seemed adorned mainly for calisthenics and bayonet practice. I duly kept them at a distance. Just as well, since had I fallen for a Chinese girl, it would likely have brought her nothing but ceaseless political browbeating and struggle sessions from her peers and professors. Chinese girls were not to be fraternized with. The thought barely even occurred to me. Instead, I fell under the powerful spell of my very glamorous Italian female classmates, including one who became, for a brief time, a famous Chinese movie star and perhaps the most lusted-after woman in China. She finished her studies, left China when I did in 1982, and ended up marrying one of America’s most famous movie actors. But that, as they say, is another story.

What a difference 30 years of hypertrophic economic growth can make.  Deng Xiaoping is not short of praise or recognition. But, to his list of titanic accomplishments must be added that he did more to beautify Chinese women than any man who’s ever lived. He liberalized not only the economy, but social attitudes and unwound the straightjacket that had bound women’s fashion for decades. For, that he deserves the eternal gratitude of every man living now in China, myself included.

The magnitude of this change in women’s appearance, over the last 30 years, cannot be overstated. If there is another aspect of China’s modernization that created so many benefits, so much net happiness, with few if any offsetting disadvantages, I don’t know of it.

Women in China today have opportunities to express themselves in ways that were unthinkable a generation ago. This runs not only from the clothes they wear and ways they style their hair, but also including the many elements of accessorized femininity, all of which were basically unavailable 30 years ago. There was no make-up, no proper skin creams, no sunblock, no perfumes, no nail polish, no hair dye, no properly-engineered underwear. Chinese girls looked a lot like toy soldiers because they were wearing clothes and underwear designed to neutralize rather than accentuate their curves.

This is absolutely no longer the case. To choose one example, on my short walk home from the subway, I pass through a 50-meter long underground mall with five different underwear shops, all selling domestic brands, and all very far down the “skimpy spectrum”  towards the sexiest things for sale in a Victoria’s Secret. The customers cross all age barriers. There is a popularity, as well as exuberance in China to the buying of sexy underwear that I never saw elsewhere, including Italy. It is also much more of an everywoman’s activity in China.

From the little I can tell from glancing at the age of the customers in these underwear shops, Chinese mothers are almost certainly the world’s largest market for sexy underwear. As for the fashions that are more visible to casual onlookers, Chinese women generally display a sense of style, of trying to look their best, across all ages and income levels.  The most popular clothing comes from domestic brands no one outside China has heard of, not the famous Italian or French fashion houses. Chinese brands know how to design clothes to flatter the way Chinese are shaped.

I have one friend, who started and runs one of these larger domestic female clothing brands called Ozzo. He has over 400 stores across China and caters to middle class women over 30. He sees virtually unlimited capacity for growth for his brand across China.

While beauty is in the beholder’s eye, it seems to me an objective reality that women in China are more attentive to how they look in public than at any time in recent, as well as probably ancient, history. This is true from the smallest farming village to the largest metropolis.

My sense is that colors here are brighter and more varied than you see commonly in US and Europe, where women tend to wear black. It’s apparently meant to be “slimming”. That isn’t a major concern for the majority of Chinese women, from what I can tell. Food is plentiful, and appetites are large. I’ve personally yet to run across a Chinese women who engages in the self-mortification ritual known as dieting.

One small downside. Chinese women are smoking more than they used to. But, the number of women smokers is still a miniscule fraction of what it is in Europe and the US. One reason more Chinese women don’t smoke is they know it damages the skin.

I travel within China more than just about anyone here, excepting airline pilots and government officials. Along with all the new buildings, roads and the new sense of national pride over the last three decades, this focus among Chinese women on looking and dressing well is the most emphatic statement of how far the country has come.

I can already hear the “feminist critique” of what I’m writing here, to wit, that to beautify is to tyrannize, and to “objectify” — a word I still can’t quite define. But, the best proof of how much Chinese women themselves appreciate the changes, appreciate the freedom now to spend more of what they have to look their best,  is how very few Chinese women have rejected all this and stay dressed as Mao once obliged them to.

 

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Five Minutes with Peter Fuhrman — Private Equity International Magazine

Leave a Comment / May 1, 2014

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The chairman of research firm China First Capital discusses China’s growing exit problem, and its possible impact on private equity in 2013.

A growing concern for private equity in China is the lack of IPO exits. How do you see that playing out in 2013?

“I don’t expect any substantial improvement or change in the problems that are blocking IPO exits domestically and internationally. And because the China private equity industry is significantly over-allocated to IPO exits, along with diminishing fund life, [this] will be a time of increasing difficulty for GPs. At the same time, the inability to exit will also continue to prevent [GPs] from doing new deals, and that is where the greatest economic harm will be done. Of course I don’t trivialise the importance of the $100 billion that’s locked away in unexited PE investments, but the real victims of this are going to be the private entrepreneurs of China. At this point, over half of all [China’s] GDP activity is generated from the private sector. The private equity money and the IPO money is what [businesses] need to grow, because private companies in China basically can’t borrow. They need private equity money and IPO proceeds to continue to thrive. “  More…

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