My Blog

December 4, 2007

Today’s Bloomberg article by Ying Lou quotes Ling Wen, president of China Shenhua Energy Co., the world's second-largest coal company, as saying “It's very important to use not only organic growth, but also mergers and acquisitions to make our enterprise larger, better and more profitable.  We have huge room to make some acquisitions.”  The article goes on to suggest that Shenhua could raise up to $80 billion by having its main owner, state-owned Shenhua Group sell enough of its shares to dilute ownership to 50%.  It would use this money to fund purchases of mines, power plants and ports abroad to supply its energy needs.

I think there is clearly a rising consensus in China, driven in part by political concerns, that local companies should be increasing their presence abroad, in particular through acquisitions, as evidenced by the huge amount of interest in BHP’s bid for Rio Tinto.  Many in China are concerned that a successful merger between Rio Tinto and BHP will give such pricing power to the new group that the cost of coal and iron may rise.  As a big importer of commodities, a lot of Chinese feel they need to spur their own expansion abroad, and there are rumors swirling around that Chinese companies, with the help of the government, may put in their own bid for Rio Tinto.

Assuming we do see an increase in Chinese purchases abroad, funded by selling shares in the domestic markets, what are the implications?  There are I think at least four points worth making.

1.        First, from a monetary policy point of view this must be an unambiguously good thing for China and for the PBoC.  Any increase in capital outflows due to foreign direct investment reduces the monetary growth problems facing the PBoC because these investments directly reduce the number of dollars the PBoC is forced to buy, and so directly reduces the amount of RMB the PBoC must put into circulation.

2.        One word of caution, however, is that the magnitude of necessary outflows is huge – probably too big for current levels of management experience to manage successfully.  How huge?  In 2004 and 2005 reserves grew by $207 billion and $209 billion respectively.  By then PBoC liabilities had already begun their surge and even then I was of the opinion that reserve growth was too high.  By the beginning of 2008, however, China’s GDP should be around 35% bigger than it was at the end of 2004, so what was big then might not necessarily be big now, although after so many years of excess money growth, there is a lot of reversing to do.  Still, let us use this very unscientific guesswork to suggest that it would be reasonable to get back to a number approximating $200-250 billion in annual reserve increases – still too high, but a lot better than now.

This year we will probably see reserve increases of over $500 billion if we include the reserves that were transferred to CIC.  Next year even if there is a slowdown in the global economy I expect net current inflows and gross capital inflows to exceed that number (especially as hot money inflows pick up).  Last year China had $21 billion of outward FDI, and as of September this year they had $15 billion – or roughly $20 billion outward FDI a year.  Even if we multiplied outward FDI by a factor of five (which would almost certainly strain the ability of management and regulators), that only brings us to around $100 billion of capital outflow for foreign acquisitions, assuming 100% of the purchases were financed domestically, with no foreign borrowings and no share swaps (as was the case, for example, with the CITIC-Bear Stearns deal). 

As an aside I should point out that if the Chinese were interested in countering the Rio Tinto acquisition, they would need to beat $134 billion, so it is possible that a few big deals could cause a lot more capital outflow than I am assuming, but until they have a few more deals under their belt I would guess that the Chinese would want to be cautious before making such large acquisitions.  So, sticking with the $100 billion as the high end of estimates, if we assume that there will be another transfer of $100 billion to CIC, reserve growth will still be excessively high, at over $300 billion (and the way the CIC funds those transfers does not fully eliminate the monetary impact, as I discuss in an earlier entry).

3.        These investments are a little more complex when seen from the PBoC’s point of view or the government’s point of view.  China is using a very undervalued currency, the RMB, to buy foreign assets, and it accumulates the dollars which it will use to pay for these assets by selling goods.  In effect this means that China is giving foreigners goods at low prices in order to acquire expensive foreign equity.

Of course by accumulating assets abroad, companies such as Shenhua will not be creating this bad trade for China.  The trade already exists in the form of PBoC holdings of US and other foreign treasuries and bonds.  What happens is that the PBoC will be able to shift a share of its overvalued holdings onto the shareholders of Shenhua (mainly the government, as of now).  As I see it this means a transfer of wealth from Shenhua to the PBoC, and we will see the effects of this transfer take place in the form of foreign exchange losses for Shenhua as the RMB appreciates (the PBoC will show correspondingly lower losses).

4.        From a long-term investment point of view one has to wonder about buying coal companies and other commodity related companies.  Prices for most commodities are at or near highs that they have rarely exceeded except under special circumstances (war, etc.).  Is this the best time to buy?  Ling Wen, the president of Shenhua, seems to think so.  According to Bloomberg:  “In the long term, I think the coal price will keep this high level and still have room to increase further,” Ling said. “In the next five to 10 years there is no doubt the Chinese economy will keep this trend, with GDP growth of about 10 percent.”  Since this seems to be a widely held opinion, I assume that the prices of coal and other commodity-related companies have already discounted these bullish expectations.

But of course we’ve seen these kinds of statements before.  The basic argument is: Prices have gone up because of factor X; I predict factor X will continue; therefore prices will continue to rise. 

Maybe.  But although it may happen I wouldn‘t be too certain that in the next 5-10 year China will grow by 10% on average.  There are many reasons why I think this is extremely implausible, and to mention only one obvious one, the demographic sweet spot in which China found itself since the mid-1970s, with the one-child policy forcing the country into a dramatically improving dependency ration, begins to turn in 2010 or 2011, and the country’s dependency ratio will begin to deteriorate sharply.  Add to that so many years of excess growth and a very wobbly financial system and I would want to bet that there will be at least one or two interruptions in those exuberant growth forecasts.

But even if China confounds my expectations and it (and the US, and India, and everyone else) continues to grow like crazy, we know that persistent high prices change consumer behavior and change technological developments.  Every prediction of permanently high commodity prices in the past (and there have been many, and they were asserted with every bit as much confidence) ultimately foundered because of technological changes, consumer adjustments, or failed forecasts, and I see no reason to assume that this time will be different.  China may be embarking on a buying spree at or near the top of the market.  Of course if this true it won’t be the first time a country suddenly flush with cash and self-confidence has done so.

5.        But if a non-coal expert like me is so smart about coal prices, and wouldn’t buy coal companies today, why aren’t the executives in Shenhua, who are real experts in coal, equally smart?  I am sure they are, but, ignoring the political dimensions of the decision to expand abroad, to explain why they might differ with me we might have to go back to one of the most discussed parts of finance and business theory, which we often refer to as the agency problem.  As is very widely understood, managers and owners have very different incentive structures and appetite for risk (mangers are a lot more like creditors in that regard than like equity owners).  I won’t go into details too much, except to say that the CEO of a state-owned company almost always benefits from increasing the size, importance and visibility of his company, and will often do so even when the reasons for doing so are economically unsound.

6.        Finally, what about if Shenhua (which I am perhaps unfairly treating simply as a proxy for any acquisition-hungry Chinese company) funds foreign acquisitions by selling shares in Shanghai?  As I see it, given the bubble-like conditions in the domestic market, domestic investors will be buying overvalued shares from a company which will use their money to buy overvalued foreign currency, which they will then use to buy commodity companies whose prices may be at or near a peak.  Probably not a good trade in the long run – perhaps it would be better for them to keep their money in a bank, earning negative real rates in RMB.

Comments (8) for "Foreign acquisitions?"

Pettis: I won’t go into details too much, except to say that the CEO of a state-owned company almost always benefits from increasing the size, importance and visibility of his company, and will often do so even when the reasons for doing so are economically unsound. One note is that this problem isn't confined to state owned companies. Private companies have huge incentives to increase size, importance, and visibility of companies, even when the reasons are economically unsound. You are better off being the CEO of a large unprofitable company than a small profitable one. In the United States, preventing managers from overexpansion is one of the justifications for things like leveraged buyouts and hostile takeovers, as well as corporate governance changes. One active area of interest in Chinese companies is how to create institutional structures that also prevent economic unviable transactions from happening. I should note, that I think that people are now playing the game of "hide the losses" which is a very important game in politics and economics. A 20% loss in value in treasury bonds is something everyone is going to notice and be extremely upset about. A 20% loss in stock price is something that people aren't going to notice as much because it gets lost in the noise of other stock moves, and people are going to be much less upset about that. By Twofish - 12/3/2007 10:44 PM

You are spot on. In the US the agency problem is still a problem even when there are enforcement mechanisms such as LBO funds, hostile takeovers, shareholder rights and stock options. In China where these enforcement mechanisms are all but non-existent, there is little to stop managers from turf building at the expense of enterprise value. By Michael Pettis - 12/4/2007 4:18 PM

Since China equities are traded at this ridiculous prices ( Shenhua 60X PE 07 and 8X PB), they will be formidible competitors in global acquisition as most deals will be EPS accretive and welcomed by A share market. They may pay big premium over prevailing idea of " Fair value", but it is probabaly better allocation of capital than pay dividend , buying otehr A shares, property or even domestic FAI investment . Foreign acquisition in energy/commodity is probably better allocation of China excess savings than current dollar dominant fixed income investment At 1988, A major Japanese co engaging global acquisition with inflated Jap equity wont be that bad idea. ( say now defunct IBJ buying HSBC or NTT buying ATT) By isaac - 12/4/2007 4:38 PM

"Shenhua could raise up to $80 billion by having its main owner, state-owned Shenhua Group sell enough of its shares to dilute ownership to 50%. It would use this money to fund purchases of mines, power plants and ports abroad to supply its energy needs." As described, this deal structure doesn't make any sense. If Shenhua Group sells its shares in Shenhua Energy, the money doesn't go to Shenhua Energy, it goes to Shenhua Group. If Shenhua Group just puts the $80 billion back into Shenhua Energy, how does it do so? A loan? A gift? (Seems unlikely.) If as equity injection, then there would have to be a new issue of shares to Shenhua Group to account for it. Possibly what is meant is that Shenhua Group will permit Shenhua Energy to issue enough new shares in Shenhua Energy to raise $80 billion and reduce Shenhua Group's share to 50%. By Don Clarke - 12/4/2007 10:11 PM

A few years ago, China state owned company bid $3 billion for Angola's oil, which is equal to $60 a barrel, while the international spot price is at $40-45. Everyone said that is a bad bid with an expensive premium. Today we looked at this bid, it probably one of smartest move by Chinese state own company so far. Given Fed will cut rates and inject liquidity in the future. Dollar may remain cheap comparing to other major currencies. Holding commodity might be a good bet now. By fatbrick - 12/5/2007 12:36 AM

Don, of course you are right. That was sloppiness on my part. Thanks. Fatbrick, holding commodities may turn out to be a good bet, but the higher prices go, the less likely that is. Angola may have been a good trade, and in retrospect many investors made good (and bad) trades, but the trick is to figure out what the trade is today, and although prices may climb higher over the next months, the value of an equity investment may play out over many years (especially if it is a strategic acquisition), and the historical data I have seen shows that over the past two hundred years while the price of oil has departed massively from its mean it has always regressed to $20 (1990 dollars) per barrell. I think there are good economic reasons for that and I don't think the rules have changed yet. By the Japan in the 1980s made many similar bets for many of the same reasons. By Michael Pettis - 12/5/2007 12:45 PM

One thing I am confident is that Japan's lesson is fully understood and studied, maybe the interpretation is different from Western view. I am worried less about oversea aquisition because generally the political risk of making mistake in foreign aquisition is too big for the managers of Chinese stateowned firms, i.e blackstone and even CNOOC. Thus, I doubt that you would see many similar high profile aquisitions. By fatbrick - 12/5/2007 10:30 PM

The general practice in Chinese companies would be for the parent company to loan the money raised from the stock offering back to the subsidiary at an extremely favorable interest rates and conditions. An alternative approach would be to use the cash raised by the stock offering to buy equity in a foreign corporation and then set up a joint venture with the subsidiary. The problem with reason money on Shanghai for foreign acquisitions is that you'd be getting RMB which has to get converted to foreign money, and one reason for the high valuations on Shanghai is the lack of companies trying to get capital there. One consequence of the industrial group structure of Chinese companies is that most industrial growth in China appears not to be driven by bank lending but rather by capitalization through internal investment. By Twofish - 12/6/2007 12:51 AM