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My random thoughts on China


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I was planning to post this after I finished the writing. I definitely could be wrong, but this is definitely something different from what you read on the newspapers.

 

 

"My RANDOM thoughts about China

 

It was a remarkable vacation in China. I happily stayed with my parents for 51 days, visited my friends and had some memorable moments. When I arrived at home, I was wearing wintercoat made with feathers; when I left, I was wearing short sleeve T-shirt.  You must be wondering how much and how fast things can change in just 51 days.

 

And how things can change in China over merely three decades.

 

I have talked to many people from different countries. Not surprisingly, when asked about how they feel about their countries, there were tons of unpleasant things to say, especially those who come from developing ones. Why not? High inflation, uneven distribution of wealth, expensive health-care and education. Those are all things worth complaining about.

 

When I was in the 20s, I thought there were a lot of things wrong. People with relationship went up in the company without achieving anything. I still remember there was a girl in our bank sitting on the fourth floor doing nothing but taking a hefty income simply because she was able to attract 100m in RMB deposit because of the relationship.

 

However, when I returned to China, I heard quite a few of my former colleagues and classmates are doing really well, earning significant sum per year even by American standard. Make no mistake, those are people who went to vocational school(no formal degree in university) and barely had any strong relationship inside the system. So how did they succeed? Did I miss something here?

 

I lived in three continents so far, and stay in Canada is the shortest, which is 20 months. Maybe because of this experience, it occurred to me that I have certain bias against almost everything, especially towards my own country. If China has not changed a lot, I would not be sitting here, in one of the best universities in Finland, writing in fluent English.

 

It is no coincidence that the civilization of China survived for 5000 years. There were many times when the legacy was at the verge of extinction. But Han(the majority of Chinese people today) people survived and thrived. Ruled by many other ethnic groups, the Han still managed to keep its tradition and culture. Amazingly, it assimilated those ethnic groups into its own culture. How many civilizations have a similar record? Maybe there is something to consider.

 

Take one issue for example. My mother has strikingly different two sides. Inside the family, she is a model wife, daughter and mother. We lived with grandmother for 15 years and my mother took care of her until the very end. Grandma died 89 years old. She spent everything she has to nourish his two sons. Outside the family, she is suspicious, selfish and unmoved by others’ misery. It seems to her it is natural only to focus on her own family before thinking about others. And she can never give enough attention to her families.  I know, this sounds awful enough. But isn’s it a philosophy developed in the toughest times to ensure the continuation of the family? I simply understand better now.

 

Another example is the extreme tolerance of reality of Chinese people. Because of the censorship, many social unrests were covered up. China today is far from a harmonic society. Significant portion of students finds no job when graduated. In local words, graduation equals to unemployment. But the students do not go on the street and protest; instead, they chose to live with their parents and wait for things to turn around. In China, we call them “feed-on-the-old”. Early 2000s, in one of the big layoffs in the history by the GOEs, there were no protest or riots. People in the 40s’ and 50s’ accepted meager payment for almost a life time service in the company and waited until they hit 60 to get the pension payment. Remember, it is almost impossible for those people to find a job before they can receive the pension payment! If this were to happen in France or Greece, I doubt the government officials can ever save their lives.

 

Bearing that in mind, it is very easy to understand why Chinese can sustain almost a century long of civil war, social unrest, warlords, war with foreign countries, not including famine, mismanagement of economy, floods, cultural revolution and other difficulties. And it is therefore easier to understand when even a minimum level of incentive was given, the society took a forceful stride to prosperity and never looked back. For one thing, people like better lives. They enjoy abundant food, which was always a luxury for common people throughout the history. Good health care, traveling, education are simply unthinkable 30 years ago. For another, people just do not want to go back no matter how good they feel about the old times. China’s miracle happens because of its people and the culture comes with it. This includes close bond of families members, an extreme emphasis on education, a very good work-ethic and as it in other successes, the luck.

 

 

Every time when I was reading the history of ancient China, I could not help but felt really sorry for those people who suffered. And every time I think of that and look around, the feeling is stronger that Chinese people will not allow themselves to go back. In other words, they will not allow the “circle” to continue. For every few hundred years, the old dynasty will be overthrown by peasants. Civil war followed for many years. Chaos ensued and in books there is a saying: “nine houses are empty in every ten houses”. In the most famous book about 3 kindoms fighting for domination in China a few thousands years ago, the war was described as exciting as a hollywood movie. But in fact, the statistics showed after the war, 90% of the population was eliminated after 100 years of continuing clashes. Since the start of the 20st century, people died in millions and millions nonstop until the 1980s. In 1930s, a flood can cause 30 million people to become homeless, and that was more than 7.5% of the population.

 

Sorry for the history, but if you fully understand the past, you will truly appreciate what happened and what is happening in China. In China’s history, we never had such a degree of freedom to do everything we like, to pursue everything we desire and say everything without being put in prison. Of course, I meant not to say it VERY publicly.

 

In my opinion, the past 30 years is merely a turning point for Chinese people and not an end of the progress. People have changed a lot. That is the ultimate reason why I am still optimistic about China despite its short term problem. It is hard to argue that a money-oriented society has negative implications, but in China’s case, this concept has done very well. When money is the sole yardstick to valuate the success, no longer do people care about the ‘originality’ . Instead, how much money you have decides where you are on the social ladders. This is the absolutely the best thing happened in China’s history.

 

It has been 30 years since this concept was promoted across the country by Mr. Deng. We have tremendous respect for him even today. China’s real danger, as I was thinking a few years ago, is never a hard landing, but the consequences brought by a economic setback. The politics is still being dominated by the old folks, and in their mind, the past 30 years is probably a great experiment. So if things look really bad, they might want to go back to the status quo, or the communism concept. The probability is not zero, and I doubt people ever think this could be a reality.

 

I am reading a book written by Hallett Abend called “My life in China 1926-1941”. He was a correspondant of NYT and witnessed the history. There is one comment especially intriguing. This book was written in 1943. I will give the excerpt here:

 

“Years later, upon my return to the US to reside, when I was traveling widely on lecture tours, I found that this Chinese communist problem was most misunderstood of all Far East problems.

 

The Chinese Communists are not now, and have not for many years, been “communists” in the Soviet Russian meaning of that term - not in the Lenin-Trotsky meaning, or in what is now called communism under Joseph Stalin. The so called communist movement is China is an agrarian movement, a labor movement; it is a party organized against the tenant-farmer system of China, and against the exploitation of labor by what, before this war, was China’s growing industrialism and capitalism.”

 

If his opinion was accepted from day one, a lot of things would not happen and the world and China should be even better by now. The sad thing is, the western world is still thinking  about China this way. How can a country be a threat where everybody is concentrating on making money? With everyday passing, the probability that China will go back to status quo is getting smaller. So in my opinion, instead of promoting so-called democracy, it is better for westerners to leave China as it is and help when things get really bad.

 

 

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China today is more stable than before because the “moeny-is-everything” philosophy did wonders in the last few decades. Practically everyone in the society can climb the ladder regardless of education, gender or relationship. This is especially true before 2000, when people focused more on creating real wealth, instead of betting on apartments.

 

I still remember a guy who was a very bad student in middle school. He was the kind of bully well-known. But years later, when I met him again in 2000, he was working for the American company manufacturing Centrum, and a few years later became a manager of a domestic company. I have not seen him for ages, but I guess he must have done really well. Also in year 2000 in the middle school reunion, a guy who never figured out how to compete in the education system went to vocational school, which was considered loser’s choice, owned a car body shop. Many years later, when I was talking with my wife, we both wondered why those classmates in middle school, who never made it to college or university, achieved far more financially than those who actually considering to be elites in the school. Earning more money, and the ability to earn money is the absolute goal for majority of people. By that standard, we lost out handsomely in the last ten years, and we are happy about it.

 

Besides certain restrictions, Chinese enjoyed a degree of freedom never seen in history. Hukou? No problem. You can buy it with money. You can buy an apartment then the local government will give you Hukou. Or you if you are a successful business man, the local government will invite you to be a local resident. With enough money on hand, there is unlimited possibility for getting world-class education. Many business owners in China received little or no education but their children went to Cambrige, Harvard and so on. Many people in China today dislikes the wide gap between the rich and poor. However, I believe this is a very best thing we can have at the moment.

 

China is a big, experimental jungle where social Darwinism exerts its utmost power. It is true that without relation or heritage, you are unlikely to climb to the top of the social pyramid. However, there is almost nothing to prevent people with shrewd mind and good working ethics to become rich. There are thousands and thousands of ways to make money. There are always demand to be filled and there is always new markets. When the domestic milk is polluted with chemicals and the imported ones become too expensive, Chinese went to Russia to find the milk and turn them into milk powders to sell. There is no brand, no commercials, because they are selling it on TaoBao at only a fraction of brand name’s cost.

 

To demonstrate Chinese people’s abilities to compete in businesses, here is again an excerpt from the Abend’s book, a personal comment from a high rank Japanese official:

 

“All of this new construction seems to me to be a futile waste of time and labor and money. If we were to make peace with China tomorrow, and to take our armies home, we would undoubtedly have to come back again with our planes and guns and knock it all down again not later than the year 1950.

 

We knocked it down in 1932 and we knocked it down again in 1937, but even now, only a little less than two years later, reconstructed Chinese mills are already taking rice out of bowls of the Japanese workers. The Chinese are more shrewd than we are as businessmen. They work longer and harder and live on less than we do. By strikes, by tariffs, by chicanery, andy by sheer weight of wealth the Chinese can outdistance us within a decade unless we conquer and rule them.

 

By weight of wealth I mean China’s incomparably greater area, her natural resources and her 450 million people who constitute a potential labor reservoir of incomparable might. I feel the task is too big for us, both economically and militarily, and we are headed for ruin if we agree to any settlement that does not give us unquestioned rule.”

 

Those remarks were made when the Japanese used everything to suppress Chinese businesses and protect its own. Japan took advantage of its indisputable military power to try to build a market dominated by Japanese firms, but failed miserably. What they were good at was prostitution, gambling and drugs. Looking back from almost a hundred years later, I am still wondering how fast, and how dramatic things can change.

 

Part of the reason that the Chinese civilization can survive that long is its ability to adapt. There is a Chinese saying goes: “Better living with shame than dying with honor”. That concludes the philosophy of the Chinese people. The early migrants from China to American went there through illegal ways. Typically they pay a huge sum compared to their income and the money was raised from relatives. When they arrive at their destinations successfully, they work 16 hours a day, 7 days a week to pay their debt off. From what I know, those people are still doing this today because they want a better living for themselves and their children. Such sacrifices are just unthinkable in the western world. It is really not only hardworking. A lot of people in other nations are hard working too, but such a willingness to sacrifice is just unheard of.

 

I recently read an article on the Internet and it shows you how smart the Chinese people can be at exploiting the system and making money. Most of the electricity generation businesses are owned by the government. Every year, the fire-based plants have to book the coal prior to the start of the peak season, for a whole year. To ensure the availability of the coal, many companies simply choose to overbook. However, they do this for a different reason, which is price speculation of the coal. For example, when a plant needs 0.4 million ton of coal, they normally book 0.5 million ton. The price will be fixed for a year. If the price of coal falls during the year, the company will lose money and the cost will be on the government. However, when the coal price on the rise, insiders are going to make tons of money. Early this year, the coal price(market) is around 400 per ton. Now, it is around 750 per ton. I can’t recall exact number, but the difference of the price now exceeds 200 per ton, according to a market participant. 100K ton of coal multiplies by 200, that is 20 million RMB or 3 million US dollars. And this only a small plant. No wonder people are saying making money is easy in China. This is of course illegal, but we are playing the game everywhere.

 

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I mentioned Chinese have very good working ethics and I want to talk more about it here. In China, the bonds among families are considerably closer than those of westerners, especially between parents and their children. The fact is, Chinese parents are willing to sacrifice almost anything to make sure their children have the brightest future. Normally, this effort extends well beyond one’s adulthood. In many cases, the parents chose to work after they retired even though they’d never have to work if they are only to support themselves. One night a close friend of mine and me went to a grill shop. It is even not a shop because it is a location in the open. So every night, except for the new year’s day, the old man with his wife, obviously over 60 years old,  work from 6 in the evening to 4 in the morning. And they get up at 9 every day to prepare the food they are selling at night. Because it is an open location. In the summer it is unbearably hot. Nanjing is actually one of the hottest cities in China, and they work just by the fire. In the winter it is freezing cold because Nanjing is by the Yangze River, and therefore the humidity.

 

By my estimate, they can easily earn 20k per month, which is a considerable sum in China. They have done this for many years, so retirement is affordable for them. But they chose not to retire because they have two sons who are not married yet. In China, if you want to get married as a man, the prerequisite is to own an apartment. Because the mother-in-law is so insistent on the apartment, we Chinese joke that to own an apartment before getting married is “inelastic demand” or “steel demand”. A typical apartment in Nanjing for a couple costs around 1.6-2 million. If you count in the costs of furnishing(almost all new apartments in China are unfurnished) and marriage, it will add another 20% on the top of the housing costs. In Nanjing, earning 5K per month is considered to be a good job.

 

The one child policy has given every incentive for Chinese parents to invest heavily on their Children. In my opinion, that partly explained the China miracle for the last 30 years. In a month, Children who graduated from either kindgarden or primary school will know which school they are going to. However, this selection process is determined by two factors, money and relationship. It is very normal to pay a whole year’s salary to just let the child get admitted to this desired school or kindgarden. When China’s education input is one of lowest per head in the world, it is no wonder education system in China has advanced so fast and so decisively in the last few decades. As an investor, I truly believe the best ROIC will be achieved by putting money into education. With every parent in China competing on every possible chance to get into a better school, how can this investment not have a good return? Even though I am not an advocate of the current system, it seems to me every parent in China is an excellent allocator of capital on the education front.

 

 

Before we went abroad, we used to think that the first world has the best health care system. However, it is a consensus among Chinese overseas that if we ever we have a serious illness, we should go back to China immediately for BETTER treatment. Unlike the hospitals in CA or Finland, where people always needs an appointment, patients in China can walk into a hospital and get diagnosed the same day. Doctors were ranked from senior to junior and they charge different fees. It is a given that while a doctor is seeing a patient, there are always 2 or 3 patients in the same room without realizing they are intruders of other people’s privacy.

 

Chinese hospitals are extremely efficient. Doctors earning significantly less than its peers in US, seeing patients one after the other. If you do not look at the uniforms, you might wonder if you are nearby a supermarket where people are paying for groceries. Including diagnosis, writing prescription, it normally takes less than 15 mins to finish a patient assuming no further tests needed. Chinese doctors work 9 hours a day, so they see at least 30 patients a day! And because Chinese doctors have so many patients available, they have far more opportunities to improve their skills than their wester peers, especially in the surgery area. Even though it only takes 5 years for Chinese to finish medical school, I believe most doctors in China are better at dealing with patients after a few years’ work.

 

It is also common practice for Chinese to compete for better medical treatment using either money or relationship or both. When living abroad, I heard quite a few times even when people are dying, or feeling they are dying, the system still insists that they should make an appointment first. This never happens in China. When a patient is rushed into the ER, there will always be someone to attend the situation. Without taking into account the high costs and inequality, Chinese health care system is probably one of the most successful one in the world.

 

Many renowned investors including Mr. Buffett and Mr. Munger commented that the Chinese technocrats did a fantastic job in managing the economy in the last three decades. But in our opinion, they did the job that way because they had no other choice. And if aware of the probabilities, we should understand that luck played a very big part in China’s success. In the 80s, when funds were not available for road constructions, we borrowed the funds first and charge the users of road to pay back the loan. It turned out to be a brilliant decision. However, this has fired back in recent years. In the 90s, because the government no longer can afford the medical expense, it let the hospitals to become for-profit organization. In the next 20 years, the conditions of the hospitals improved dramatically. However, again, it has fired back because the poor can no longer afford health care.

 

I think those are very important things to understand because good outcomes do not mean they are the consequences of brilliant decisions. We cannot simply conclude that communist technocrats did a good job because the Chinese economy has advanced. In my opinion, except for a few leaders like Deng, nobody really knows why China has been so successful so far. But obviously the communists are not shy attributing every success to their flawless management. If my point is valid, we should no longer assume that China can manage so well in the next few decades, or at least we cannot take it for granted.

 

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Personally, I greatly appreciate the adaptability of Chinese people. As long as the drive to become rich remains intact for Chinese people, and no obstacles were set to hinder them, I believe we are going to do just fine in the next few decades. However, any fantasy that we can achieve as much as we did in the past 30 years, is just fantasy. There are huge problems in the society, and some of them are the consequences of many years’s mismanagement. There are great excesses in a lot of sectors, and once the economy slows down, it will take time to remove those. However, I do not believe that we will repeat Japanese’s tragic lost decades.

 

In China there is a saying goes like this, personality decides destiny. I think it makes a lot of sense. Let’s say a Chinese and a Japanese are travelling together. The journey was joyful and successful for many years. Both grew very rich doing businesses along the way. They have faced many obstacles but they managed to overcome them with resolution and luck. Over time, the Japanese believed that his method will work for every problem, while the Chinese guy was indifferent about everything but focusing on doing business. Then they hit a wall, a very solid one. They used all the tricks they have, bot to no avail. The Chinese realized that this is not a wall they have encountered before. It is higher, more solid. He then went around to see if there was an end to the wall. He tried to climb the wall and he even tried to dig a tunnel under it. On the other hand, the Japanese do not believe there is a wall he could not break. Not that he does not know the fact, but the sheer thoughts of a unbreakable wall sent chills down his neck. How could it be possible? He used every method he had trying to break it, but it did not work. Then he decided if he could not break the wall using the old method, it only meant he did not try hard enough. If he tried ten times and it did not work, it might work after a thousand tries. And this is exactly where the Japanese problem comes from.

 

Do not get me wrong. I am an admirer of Japanese people and culture although I do not like certain parts of them. The point I want to make here is, if there is a problem as big as Japan’s in the 1990s, Chinese people will try to solve them instead of kicking the can down the road. If we can’t using X technique, we would try Y until the situation gets better. The government cares about its power and survival; the Chinese people care about money. If both parties are practical, there will always be a way to work things out.

 

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Housing is an essential part of Chinese’s life. One of my mother’s dream is to live in a big apartment or house. Without having lived in China in the 70s and 80s, it is hard to understand why Chinese put so much value on its own real estate and why people keep buying even when renting is so much cheaper than owning a property. When I was a child, my family lived in a small apartment. We have four people and the apartment was around 30 square meters. Carpet or wooden floor were only things in the movies. People back then did not talk about furnishings, they talked about how big your apartment was. And believe it or not, our condition was better than a lot of other people. At least we had our private bathroom. Chinese also have a strange attachment to home. If they do not own the house they live in, they consider they are just a guest. That is why when people talk about settle down, it normally means they bought an apartment.

 

By any measure, there is real estate bubble going on in China. I joked to friends that almost everyone in China who owns an apartment is a millionaire, but it is only on the paper. When people sell their apartment for a million, they have to buy a new one for another million. Sounds familiar right? But unlike other bubbles, this one may not bust for another decade or two unless the interest goes up dramatically. I never have any doubt that the government will do anything to prevent the bubble from popping unless there is a threat to its very existence. That is why I care so much about the inflation in China. When the government is forced to raise interest rate, that is the ultimate signal that China is going to have major problems in the housing and local government sector.

 

When the housing bubble bursted in the US, the financial crisis was largely caused by financial innovation around housing. But when the bubble pops in China, there will be a chain reaction in the economic system. I have no idea about what will happen, but I do know it will have a huge impact on the society. There are so many things depending on the real estate development. The finance of the local government is counting on the income from selling the land; major corporations all around the country have RE subs, and they contribute a lot of profit; (I am not kidding. Even the company which makes rockets for the military has a huge RE sub. Other companies include those which make air conditioning, shoes, anything you can think of. ) Banks are on the hook too since they have so huge a book of RE business. The problem is, the money from building apartments is so easy to make. Without the contribution from RE, where is the GDP going to come from?

 

We are playing a dangerous game, but many observers failed to point out that the danger and sacrifice is mostly on the poor, who do not have money or relationship. This is also part of the reason the game can still last for a long time. I will give an example here. A friend’s parents live in an apartment built around 30 years ago. I went to see the building. It was maintained well and I guess it can last another 20 years or so. The building is on the ‘ChaiQian” list because there will be an exit for the subway which is being constructed. It really shocked me when my friend told me that a full 400 families have to move because of the subway exit. Can you imagine it? More than a thousand people have to move because the subway exit is being built.

 

Of course, this is only an excuse. The real reason is that the land around this area is so valuable that even after compensating the original residents at market price, big money will still be made when a bigger and taller building is built. However, this is a very bad deal for the original residents. Because the old apartment is generally small, when they were compensated based on the area, they do not get much. If they try to buy a similar apartment around this area, no one will sell because the supply in that area is very tiny. So they have to move outside the city where land is plenty and price is only a bit cheaper. It is really not hard to understand why people want to buy apartment. They really have no choice when they were forced out of their homes.

 

So the land supply is virtually unlimited. Whenever there is a need to sell land, the government can always find it at below-market costs. That being said, the biggest beneficiary of the real estate is actually the government itself. No wonder every time the government vowed to cool the RE market down, the price went up regardlessly. As we can see, the financial burden is largely on those people who have the least resources. If they had the ability, they would have moved to a bigger and newer apartment. When the price goes up, it only give the government more drive to seize more land from the poor. And when the poor has to use their life savings to buy a new apartment, it creates the demand for the land. This is a circle never ends. In my opinion, the RE development is actually a process in which the poor is being driven out of the city. When a new building is built, naturally the rich will invest and own it. It is more like a wealth transfer convened by the government.  

 

There is only one flaw in the model. When the land is seized, the developers will compensate the residents at market price. However, when the new building is built, the price has to be higher to compensate for the costs of compensation, land and development. In the last decade, the price has went straight up. Will this continue for the next 10 years? Trees are not going to grow to the sky and there will be a limit on the price. Until now, the limit is still no in sight even though the housing is unaffordable to majority people.

 

The reason that local governments are so keen on infrastructure spending is very obvious. Normally building big infrastructure projects involves huge spendings. Since the government decides who and which will get the contract, there are great opportunities for those guys to gain financially. Yes, those numbers come easily to millions or in some extreme cases, billions. It is a joke that Forbes magazine publishes a ranking for rich people in China. For premier’s son, the PingAn insurance IPO alone brought him 700 million US dollars, or almost 6 billion Yuan a few years ago. Of course, this was never proved.

 

Another reason is that China is forced to make infrastructure spending since this is an essential step in real estate development. For example, it is common sense that when a subway is built or extended, the value of land around the subway stations will rise substantially. Normally when the government is doing the planning, it wants to make sure that a project is viable socially and financially(not necessarily profitable). But in China, it is the other way around. The local government chooses to build first, then sell the land to developers. Developers build more apartments on the assumption that people will come and buy, and it worked like a charm. For the government, it earned more from land sale; for the banks, it means more businesses; for developers, what can be more dreamy than an ever-increasing revenue stream? By borrowing money to fund infrastructure spending and boosts land value, the urbanisation has progressed at lightening speed. But does it sound familiar? Yes, this miracle is built on mountains of debts.

 

Readers of world news might have been aware of the recent accident on the high-speed rail in Southern China. Rumor has it that 179 people actually died instead of 38 reported officially. (Do not be surprised though. I remember in a coal mine accident, the officials even let people to impersonate those who actually died in the accident and therefore made an accident appeared to be less severe. I do not make this up. People on the Internet actually analyzed the TV news screen by screen and showed those on the stretchers are not coal mine workers at all.) Why would China put so much money in high-speed rail system even though the early projection showed it is going to lose money from the start? It is because building a high-speed rail network will help the development along the rail. For example, there are now many commuters working in Beijing choose to live in another city. It takes them 4-5 hours a day on the road.

 

Until now, the model is obvious. Using debt to finance highways, subways, airports, high-speed rail network, you name it. Seize the land at low price for the sake of greater good for the nation. Sell the land when the value is up significantly to pay part of the loan and interest. Then do it over and over again. But there are two problems: diminishing returns and debt. When China starts to build infrastructure in the 1980s, every investment is wonderful. However, after the highway network has been built, airports largely ready, there are not much place to invest in. China’s economy, as we all know, is largely investment-oriented. And when promotion in the government is hooked with GDP, lower investment means less GDP and thus failure. Currently, the investment still looks good. For example, when Nanjing decided to build subway, I thought that was a joke with only a few million people in the city. Now the city practically cannot operate without it.

 

The second problem is more urgent and few economists covered it. The whole urban development, including those mega infrastructure project going in almost every city, is progressing on the assumption that housing price will never fall and there will always be people who are willing to buy an apartment at any price. But forever is a dangerous word. This process can go on 10 years, 50 years, but it has to stop somewhere. And there is a risk of de-leveraging. If there is a prolonged contraction in the housing market, let’s say 3 years. The revenue of the local government will fall. In fact, they rely so much on the land sale and we have term called ‘land fiscal policy’. Already debt-laden, how the hell are those local governments going to finance those projects, especially when the banks are vulnerable during a market downturn? In the end, Beijing will come to rescue. Yes, we will print over any unpleasant things. But what if this scenario happens when the government is not able to print? After all, people in China are losing faith on paper money and consensus of long-term, sustainable inflation is being formed.

 

It is truly remarkable to me that majority of economists failed to point out that a large part of China’s growth is built on debt. And it is debt which causes a financial crisis in almost every case. It is hard to imagine Chinese government will be unable to pay its obligations, but it can happen. Nobody really knows how much we owe, and how much asset we have. Is the foreign currency reserve really worth its face value? There is nothing wrong with building infrastructure. Those investment has changed life of Chinese people and the economy growth was made possible. If my memory served me well, it is the city Dalian firstly introduced this model and other cities followed very soon. However, it is dangerous to use debt to finance those spendings, especially when the low-hanging fruit is gone.

 

In the end, the probability of a financial crisis happening in China is still low, although massive debt is being accumulated in the financial system. Unlike other democratic countries, where political parties worry about election, the China government can always decide who will be left holding the bag. And we can be assured it will be Chinese people who are below the mid level of the society. Rich people are not stupid. They bought apartments, gold, arts and whatever you can think of to protect their assets. But people who are really poor has no choice but putting money into bank savings account. Essentially, people who put money in the bank will be taxed because of the dilution of the value of money. As long as people still trust the banking system, especially the poor, any financial crisis will be impossible.

 

But things are changing rapidly. As I noted in previous emails, even my mother is aware of the incoming inflation. When inflation happens in real estate sector, eduction sector or health care sector, people can always respond by not buying new apartments, not paying huge fees to attend a better school, or not choosing the best health care available. However, when inflation spreads to the food sector, people start to realize the money is worth less over time. That is exactly what’s happening in China today. Think about it. When financial assets appreciate, poor people will not feel much since they do not even have the means to participate. But when essential things like food become more expensive, poor people will respond very dramatically.

 

Of course, I think China has passed the stage that people will buy everything they can when the inflation hits. But looking around, they really do not have many options. My estimate is that in order to preserve the purchasing power of Yuan, the nominal return has to be at least 12-15% annually. I am not talking about food, but overall real inflation. Stocks are volatile and companies are focusing on getting more capital instead of shareholder return. We call it a casino. Real estate is better, but it requires a lot of capital. Besides, the rent is pathetic. Forget about CDs and bonds. Once I thought this through, I realized why Chinese now are putting money abroad and buying precious metals.

 

Inflation can be infective. In Toronto, housing prices went up and up, with no limit in sight. In Shanghai, 300K CAD can only buy 2 bedrooms apartment or probably a smaller one. However, you can buy a decent house in Toronto using the same amount of money. It is no coincidence that the countries with the largest immigrants inflow from China have the highest housing price. If you are still wondering how high the price can go, just look at Vancouver, where houses under half a million are rare. That being said, behind the surging price of housing in countries, there is a huge demand from the Chinese. It is not because the housing itself is not expensive. It is, but compared to housing price in China, those are still deep bargains. What can be safer than putting money into real estate when the rich immigrates to a new country? No one ever lost a dime betting on real estate in China in the last decade. Next time if somebody talks about real estate bubble in Canada and Australia, do not listen. Just watch closely how the real estate market in China is performing. That gives you a better idea."

 

 

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  Interesting. I lived in Taiwan from 1957 until 1960. The mainland people could look at the potential by looking right across the straits. Not like Hong Kong which was a colony at the time but at the real, from the bottom up, do it yourself way. The Taiwanese hated the Japanese because of the history of their brutal occupation. The Taiwanese were little more than native Indians in the US. Then came the Mandarins. At first there were wagons, each pulled by a water buffalo. The only cars were the ones left by the Americans that were there to defend the island from invasion. Quemoy and Matsu were being shelled daily. The factories were the most primitive you could imagine. All you had to do was let the people have hope. The freedom to better themselves without the strict restraints of their government controlling their every moment. Not everyone likes the fact that now the island has lots of skyscrapers. Lots of pollution. But you could not deny the obvious. They had an economic miracle. Deng could see that as long as the mainland kept their ways, they would be a big, strong, controlled 2nd rate nation. But to be a world power, a first rate power, you had to loosen up. They knew they could never catch up with the US the way they were going. They weren't so worried about Europe. Japan yes. But mostly they knew they had to open up to compete with the US who they also greatly admired for their wealth because of their economic system. And sitting just a few miles off their coast like looking at a test tube was the proof of how to do it. The Chinese love business. It's in their blood. My Chinese friends buy land because it's something you can value. They rarely sell. It will be interesting to see where things go when the going gets tough. But like history shows. They are very adaptable. I enjoyed reading your thoughts. Thanks

 

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Boax, thanks for the insights from an insider. Regarding investing in China, I would appreciate your opinion on how effective you think Western multinationals will be marketing in China long term. Is it likely that more nationalism could emerage and restrict market penetration, and could domestic chinese companies come to dominate the market long term with price or product or intangible advantages? There seem to be alot of success stories for some (YUM comes to mind). But Coke and Danone had some quite negative joint venture experience.

 

 

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Baoxiaodao,

 

Thanks for the post, really fascinating.  I guess I hadn't put 2 and 2 together that China had a lot of debt.  I guess I knew that they passed a massive stimulus but I forgot to ask where that came from!  I somehow always assumed that since China was the USA's biggest lender that they had a positive balance sheet, but I guess I was wrong!

 

A few interesting things I thought of as I read your post:

- Malcolm Gladwell talks about Chinese in his book "Outliers".  2 things he mentions: the culture of rice farming.  Farming is extremely precise, where you have to watch over it 360 days a year otherwise you can lose the crop.  He quoted some chinese expression like "He who works 10 hours a day and 360 days a year shall never go hungry"!  Pretty amazing.  The other thing was that in chinese you can remember more numbers on average.  I forget the details but in english you can remember up to 7-9 numbers, but Chinese people can remember about 10-11, this is because in Chinese the # of syllables are fewer!  This supposedly has some effect on how good chinese people are at math (and by extension perhaps money..)

- Another thing I noticed and was also pointed out to me.  In almost every country that the chinese immigrate to, they end up being the 'commerce class'.  Just not in China!  At least not until a few years ago! 

 

Thanks for your post, great to hear all this from someone in the know...

 

 

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One more thing..  Here's an interesting article about the geopolitics of China:

 

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/06/12/the-geopolitics-of-china.aspx

 

It touches on some of the history you mentioned, in particular the migration of the rural class to the cities and that struggle throughout China's history..

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Boax, thanks for the insights from an insider. Regarding investing in China, I would appreciate your opinion on how effective you think Western multinationals will be marketing in China long term. Is it likely that more nationalism could emerage and restrict market penetration, and could domestic chinese companies come to dominate the market long term with price or product or intangible advantages? There seem to be alot of success stories for some (YUM comes to mind). But Coke and Danone had some quite negative joint venture experience.

 

 

 

To make it simple, I do not have an answer for your questions. Sorry about that. One thing I am sure though. As Chinese firms finally started to climb up the manufacturing ladders, there will be a lot of blood in the western manufacturing sector.

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