According to a China Business News article today, the new sovereign investment fund, which is rumored to be set up in October but which has already made a $3 billion investment in Blackstone, may invest in 16 state-owned companies, including PetroChina, China Mobile, Sinopec and China Life. The rationale for the investment is "to help them compete abroad".
In my opinion this does not make sense except from the point of view of domestic political maneuvering, in which different groups are trying to get as much influence as possible on local levers of power. It does little to help China.
First of all, I assume that if they are going to "help" these companies compete abroad, that means that they will be buying newly issued strategic states in the companies, rather than purchase their shares in secondary markets. If they do, they are defeating one of the purposes of the exercise, which is to help minimize the monetary expansion associated with bringing dollars into the country. Their domestic purchases will simply increase net capital inflows into China and so force the PBoC to buy the inflows and expand the domestic money base.
But there is a bigger objection. One of the most useful roles a sovereign wealth fund can perform is to act as a stabilizer for government revenues. This increases government creditworthiness and reduces financial distress costs, which never seems like an important thing when conditions are optimal, but becomes extremely useful when the good times reverse themselves.
In that sense, the fund should be invested in a way that its assets do well when the economy is doing badly, and vice versa. If it purchased oil, for example, that would be stabilizing. The Chinese economy is hurt by high oil prices and helped by low oil prices (i.e. it is naturally "short" oil), so by taking the opposite position it can stabilize government revenues, which are presumable correlated with the health of the economy.
Buying the largest Chinese companies may seem like a great idea when the economy is racing forward and profits are rising, but in fact that is the time when the government least needs the help of a profitable investment strategy. It needs profits most when things are going badly on the revenue side, and only someone who is extrmemly certain that things will never go badly should recommend that the government effectively "double up" on the bet that it is already implicitly making on the economy.
There is a more general point here. Developing countries are cursed by excess volatility. There are many reasons for this excess volatility, but in every case it has a significant effect on the cost of financing, especially debt financing. Lenders hate volatility, and charge a premium for it. Anything that can systematically reduce volatility automatically increases value by lowering the cost of capital. If China uses the new sovereign investment fund in part as a hedge, i.e. it reduces expected volatility, this will have an almost immediate impact on investors' risk perceptions, and the benefit will feed through the economy in the form of a lower cost of capital. No big thing now, perhaps, but a great little remedy to help relieve hangovers when the party is over.
The booming Chinese stock market was responsible for up to half the earnings growth of companies listed in Shanghai and Shenzhen duirng the first six months of 2007 - a worrying trend that analysts say will exacerbate any market downturn.
Profits increased on average 71 per cent in the first half for the more than two thirds of listed Chinese companies that have published results. But profits from core operations increased at about 35 per cent, reckons Jerry Lou, equity strategist at Morgan Stanley: “I don’t think the market fully appreciates that half of the current earnings growth is a one-off thing . . . ”
Non-operational income at listed Chinese companies accounted for only 13 per cent of total profits in 2006. That rose to 31 per cent in the first half for the 900 or so companies that have reported earnings so far, according to Morgan Stanley. The proportion is much higher than most developed markets where non-core income usually accounts for less than 10 per cent of total profits.
From the more-reminders-of-Japan drawer, during the middle and late 1980s, if I remember well, earnings from zaitechu, the catchy name for the speculative profits earned by corporate Treasury Diivisions, accounted for a growing share of corporate earnings until in some cases they represented over 100% of net earnings. Needless to say if stock prices are affected by earnings (as they are through PE valuations), in China stock prices and corporate earnings are likely to be self-reinfoicing -- on the way up as well as, of course, on the way down.
An interesting quote from today's Financial Times discusses the time it took for Japanese capital outflows to become significant.
Chinese investors, excluding the central bank, currently hold foreign securities worth 5 per cent of annual economic output. [Capital Economics' China analyst] Mark Williams said China would generate $1,300bn of additional overseas investment if the country raised its level of foreign portfolio investment to the average for member countries of the Organisation for Economic Co-operation and Development.
"Of course, this will not happen immediately,” Williams says. “It took Japan 20 years from the opening of its capital account in the 1980s for its foreign portfolio holdings to rise from five per cent to 40 per cent of gross domestic product.”
More interesting information in today's Financial Times lists the amount of incoming remittances for a variety of countries, according to the World Bank.
The biggest receiver of remittances are, not surprisingly, India and Mexico, with approximately $25 billion in 2006 (equal to 2.9% and 3.0% of GDP, respectively), China, with $22 billion (0.9% of GDP), and the Philippines, with $15 billion (14.6% of GDP).
One of my favorite former students (from Tsinghua University) quit his job at a major SOE not too long ago and joined a large Chinese investment fund that purchases distressed assets. He recently wrote me an email discussing what he does.
Among other things he says: "The distressed asset sector is really a dark side of financial market where there are full of thieves and robbers who spent much efforts to make public or state-owned assets into distressed ones."
Two years ago I met a partner at another Chinese distressed asset fund who told me that his firm never participates in NPL auctions. They preferred to go directly to provincial and municipal authorities to buy NPLs (not all NPLs are held by banks -- municipalities and provinces, whose borrowings are guaranteed by the central government, have also made lots of non-collectible loans) because, in his words, there was more "discretion" about pricing. I interpret "discretion" to mean something a little shadier -- perhaps fraud or bribery.
I haven't seen any serious study (and I doubt any exists) but there is a lot of evidence that looting and pillaging are taking place on a massive scale under the guise of resolving non-performing loans. Aside from the social implications, there are also of course banking implications because I suspect a lot of the accumulated wealth inevitable represents transfers from the banks.
After all, as Willy Sutton said, "That's where the money is."
Yes I know this happens everywhere, but rarely on this scale, and when I see stories like this they only increase my skepticism about whether or not we should be confident that the financial system is in good shape and most of the skeletons taken out of the closet. These stories involve a lot of people at the center of the corporate and financial worlds. This is from today's South China Morning Post.
Finance chief replaced amid sex scandal
Finance Minister Jin Renqing has been replaced abruptly after a sex scandal snowballed to implicate several senior mainland officials, sources said.Mr Jin had been shifted to a government think-tank and would be replaced by Xie Xuren , director of the State Administration of Taxation, Reuters reported, citing an announcement by the Communist Party's Organisation Department.
Its report did not give any specific reasons why Mr Jin, 63, had been transferred to the Development Research Centre. But sources said there had been intense speculation about the minister's career after the mainland leadership said it was stepping up investigation of a corruption case involving Du Shicheng, the former party secretary of Qingdao , a booming coastal city which will host the sailing events of the 2008 Olympic Games.
In December, Mr Du was fired from his government and party posts for "serious breaches of discipline", the party's euphemism to describe corruption and moral lapses including keeping mistresses. As the party's anti-corruption watchdog, the Central Commission for Discipline Inspection, continued its investigation, it also detained a young woman believed to have had an intimate relationship with Mr Du. To the shock of anti-graft officials, the woman, known as a social butterfly, later confessed she had also had intimate relationships with several senior government officials and some of them had abused their power to advance her business dealings.
In June, Chen Tonghai, chairman of oil giant China Petroleum & Chemical Corp (Sinopec), was detained for corruption. Sources said the woman's confession had prompted anti-graft officials to launch an investigation of Mr Chen but that they focused their investigation on economic irregularities involving Mr Chen but unrelated to the woman's case. The woman was also believed to have implicated Mr Jin and several other senior government officials who have important roles advising on foreign and domestic policy.
The keeping of mistresses and dalliances with young women have been among the main reasons for the recent sackings of senior officials. State media has reported that the majority of government officials arrested for corruption were accused of keeping young women as mistresses.
Aug. 29 (Bloomberg) -- China sold 600 billion yuan ($79 billion) of bonds, the most ever, to fund a company that will help invest the world's biggest foreign-exchange reserves. The Ministry of Finance sold the 10-year bonds to the central bank at a coupon of 4.3 percent, according to the Web site of the government's biggest debt-clearing house...
...Lawmakers approved a special issue of 1.55 trillion yuan in debt for the new fund in June, which is more than half the size of the 3 trillion yuan government debt market. The People's Bank of China will gradually sell the debt into the market to drain cash from the banking system. Inflation reached a 10-year high of 5.6 percent in July, while the economy grew at an 11.9 percent pace in the second quarter.
The yield on China's three-year government bond fell 3 basis points to 3.39 percent as of 5:30 p.m. in Shanghai, according to China Interbank Bond Market. The price of the 3.53 percent security due July 2010 advanced 0.092 yuan per 100 yuan face amount to 100.36 yuan. The yield on 10-year bonds, which haven't traded today, was 4.20 percent yesterday.
I am puzzled that the MoF sold the bonds directly to the PBoC because I understood that, in order to protect PBoC independence, the PBoC's charter did not permit it to buy primary government issues. Guess I was wrong.
However I am glad that these bonds are now part of the PBoC tool box. The PBoC is supposedly planning to sell the bonds into the market as part of its open market operations. I have never believed that anything as liquid and as short-term as the central bank bills they usually use to manage the money supply had much impact. Central banks bills are too close a substitute for money to be of much use in reducing the money supply.
These new, long-dated MoF bonds are likely to be a much weaker subsitute for money, so that the gradual sale of the new MoF bonds by the PBoC should have a bigger impact on reducing underlying liquidity. The trick is whether the PBoC will be allowed to sell them at whatever is the market clearing price. The government is generally seen as determined to control interest rates directly, so it is unclear whether they will allow long-term interst rates to rise to whatever level the market demands.
Alternatively, they may sell them simply by instructing commercial banks (or insurance companies) to buy them at whatever the PBoC determines to be the "right" price.
I received an investment advisor email today that muttered darkly about how the current world structure, in which the US acts as a design and assembly platform while other countries, like China, do all the manufacturing, was unsustainable and would lead inevitably to the collapse of the US. I have heard this idea repeated in many different forums and ways. Apparently, the fact that the US manufacturers nothing but financial assets, as the email complained, while China produces real goods, will lead to the end of the world as we know it.
But all the thousands of stories about China's manufacturing buttons and toy trains doesn't mean that US manufacturing has crumbled. In fact US industry continues to produce a greater share of industrial value added than any country in the world, and it has been growing every year.
The confusion probably comes from two sources. Total value of US manufacturing has grown consistently over the decades, but other sectors -- research, design, services -- have grown faster, so that manufacturing's share of the US economy has declined. Also manufacturing productivity has grown quickly, resulting in a decline in the number of workers involved in manufacturing. But producing more and more with fewer and fewer workers is actually a sign of economic success, not failure.
On that note here is an article that was published in yesterday's Chicago Tribune:
Trade Fears are All Smoke
by Daniel J. Ikenson
Daniel Ikenson is associate director of the Center for Trade Policy Studies at the Cato Institute.
On the campaign trail and on Capitol Hill, politicians are promising to save U.S. manufacturing from the sweeping tides of international trade. "If we don't have a strong manufacturing base in our economy, it won't be long until we don't have a strong economy," proclaims presidential candidate and Sen. Hillary Rodham Clinton (D-N.Y.). Congressional Democrats have been pitching a new trade policy agenda that will "stand up for American workers, farmers and businesses, especially in the hard-hit U.S. manufacturing sector [emphasis added]."
When Congress reconvenes, committee leaders are expected to begin marking up some of the nearly two dozen pieces of pending trade-related legislation. Most of those bills are antagonistic toward our trade partners or outright protectionist, inspired in large measure by the myth of American manufacturing decline. But U.S. manufacturing is not in decline; it is thriving. By historic standards and relative to other countries' manufacturing sectors, U.S. manufacturing is firing on all cylinders.
In 2006, the sector achieved record output, record sales, record profits, record profit rates and record return on investment. American manufacturing performance has never been stronger. Nor was 2006 an aberration. Since the nadir of the manufacturing recession in 2002, all of those indicators have been trending upward. Earlier this month, the Federal Reserve released its monthly report on industrial production, which found that U.S. manufacturing output has continued to rise throughout 2007.
Contrary to the inferences one would be expected to draw from the dishonest political discourse, U.S. factories remain the world's most prolific, accounting for more than 20 percent of the world's added manufacturing value. By comparison, Chinese plants account for about 8 percent. Thus, for every dollar of product made in China, U.S. factories produce $2.50 of output. And not only is manufacturing thriving. It is thriving in large measure because of international trade. Manufacturing exports and imports hit records in 2006.
Over the past few years, the world economy has been growing at a faster clip than the U.S. economy. Domestic producers have availed themselves of the benefits of that growth through higher foreign sales revenues and declining unit costs of production — the result of the longer production runs afforded by growing foreign demand. Meanwhile, better access to imported raw materials, components, other production inputs, and capital raised though stock and bond issues has helped restrain overall costs of production, as growing world demand has bid up the prices of industrial commodities.
While misguided (or disingenuous) politicians rail against the rising trade deficit, they fail to comprehend (or acknowledge) that U.S. producers are America's largest importers. In 2006, 55 percent of all U.S. goods imports were industrial products and components, the kinds of purchases made not by consumers, but by producers.
That statistic supports the strong correlation between manufactured imports and U.S. manufacturing output, which has been observed for decades. Imports and output rise and fall in tandem. Thus, policymakers who seek to restrain imports are effectively advocating a manufacturing recession. If their mercantilist worldview prevails, and imports decline, reports of idled factory equipment will not be far behind.
Those who speak of American deindustrialization often cite the decline in manufacturing employment. Recently, Sen. Carl Levin (D-Mich.) complained that "the Bush administration has not lifted a finger to support manufacturing in America while we have lost 3 million manufacturing jobs on its watch."
While it is true that the number of workers employed in the U.S. manufacturing sector declined by about 2.8 million between 2000 and 2003, the fact is that job attrition in the sector reverted to its much more modest, decades-long rate of decline after 2003. Since 2003, the sector has shed about 300,000 jobs.
But declining employment in a sector that is producing record output is hardly credible evidence of doom. In fact, the two indicators taken together are evidence of soaring labor productivity, which is the source of long-term increases in living standards. With the national unemployment rate at 4.5 percent, 1.8 million net new jobs created on average every year since 1980, U.S. plants producing record output, and manufacturing companies earning record profits, what is so troubling about the loss of manufacturing jobs?
The much larger threat to manufacturing is the proclivity of meddling policymakers to fix what ain't broke. Spreading myths about the precariousness of U.S. manufacturing and laying the blame on trade policy may score political points with the unions. But if Congress passes legislation that compromises the access of U.S. producers to international markets, there will be real problems to solve.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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December, 2007
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