Rising Chinese steel production - is the end in sight at long last?

The following as reported in China Daily:

30 firms banned from bank loans for pollution violations

(AP)
Updated: 2007-07-30 14:45

China's environmental regulator said Monday it has put 30 companies on the first blacklist of pollution violators that are to be barred from receiving bank loans under a policy aimed at enforcing often-ignored regulations.

The government announced this month that the State Environmental Protection Agency, the central bank and bank regulators would cooperate to bar access to credit to companies that violated pollution standards.

The list posted Monday on SEPA's Web agency includes food processors, producers of paper and alcoholic beverages and steel makers. The agency did not say whether the companies would be allowed to appeal.

The central government has been tightening enforcement of environmental and energy efficiency regulations. China's economic boom has left major rivers and lakes badly polluted and its cities are among the world's smoggiest.

This has been in the cards for some time but is the first evidence I am aware of that the new policy is being enforced. It is significant for the following reasons. A key cause, if not the primary cause, of the recent surge in China's trade surplus with the US is continued rapid growth in steel output. There are various explanations for this (small producers attempting to ramp up production ahead of the reductions in export tax credits, or attempting to bulk up because otherwise they know they will be consolidated with larger firms) but the important point is that China wants to slow the growth of or even reduce capacity in heavy industry like steel and whether or not they could accomplish this will determine whether the trade surplus stabilizes, how quickly China can shift away from industry to consumption, how much progress China can make in reducing the growth in energy consumption, and - of course - what kind of progress can we expect to see in terms of improved environmental protection. Cutting heavy polluters off from state funds is a key step in the right direction on all these fronts. As usual, Beijing keeps pushing buttons until they get what they want.

Beijing Olympic Debacle?

Excellent piece from Wired on the likelihood that the Beijing games are symbolic not of the rise of a great new power - but of environmental catastrophe. Visualize the media impact of athletes wearing face masks... Grim stuff.

The US slowdown – and what does it mean for Asia?

I have been in the bear camp for some time regarding US growth and stock prices so last week was a little bit of vindication for me. My view was basically that housing is a big nasty broadbased shock to the economy which will take more than a year at least to play out AND that the tremendous amount of leverage in global asset markets – both explicit (LBOs) and embedded (CDOs, CDSs, etc.) mean the upside is limited but the downside – should the real economy slow – is significant. Before looking at the implications of whatever is going on in the US, first let me give you my views of what IS going on in the US.

I think the risk of an outright recession is high and growing (let’s call it 60% over the next 12 months). Looking at Q2 GDP released on Friday, the character of a slowdown is pretty easy to see. Consumer spending does seem to finally be slowing and with housing in (cliché alert) freefall, is likely to get worse. That’s my bet regardless of whether gas prices rise or fall. Remember that the average American household isn’t saving enough and so the secular trend (given babyboomer retirements) has to be for increased savings and lower spending. Business investment won’t bail us out because they aren’t spending much now (in the US anyway) and will slam on the breaks at the first sign of slower growth. Trade may help a bit but is way too small to offset slower consumer spending. Government spending is above trend due to the ‘bonus’ of higher property taxes but now this will go the other direction and so the trend here, over time, will be somewhat slower. By the way, I don’t buy the argument that a low US unemployment rate is indicative of a “solid” employment situation. The last few months of significant growth in construction jobs is fishy as hell. I’m betting that both construction and finance see job losses in the months ahead. The other reason not to be comforted by a low unemployment rate is that the denominator isn’t growing. The participation rate has gone down a bit and this leads one to consider a rather scary secular trend: slower labor force growth. If the unemployment rate is low because of increased retirement and fewer available workers, and not because of significant increased job growth – this ain’t good for consumer demand, instead it’s bad for the long term inflation outlook. Cue the Fed to keep rates higher than they might otherwise. Growth may be slowing but the Fed will still have to remain wary on the inflation front due to secular trend of labor shortage and higher wages (a global problem btw).

Looking at the global picture, I’m not much more optimistic. Yes, Europe and Japan are no longer completely and utterly stagnent but neither seem likely to take over as the engine of global growth. How about all those emerging markets which the folks at Goldman keep telling us have no where to go but up? Won’t Brazil, Russia, and Chindia take over as global growth engines? Hah. Not a chance. Brazil and Russia are growing above their long term trend BECAUSE OF global demand (for energy and other commodities) and have made little progress in diversifying their economies such that domestic demand will accelerate independently of a global slowdown. Chindia is a slightly different story but I’ll come to that in a moment.

Lastly, one has to factor in the effect of a slowing in the real global economy on risk appetite, leverage, and liquidity. This is an unknown factor. Will pockets of ugliness in one sector (US housing) have little effect elsewhere because of the miracle drug of securitization? Will a handful of hedge fund blowups cause anything other than fewer new BMWs and Fifth avenue penthouse renovations? Maybe, maybe not but the risk is all downside in my opinion.

So… what does this mean for India, China? In very big picture terms, I think you have to consider the effect of lower real demand and lower global risk appetite and liquidity. Regarding the former, I think India and China can weather a US induced global slowdown reasonably well. Dispite the popular notion that both are highly reliant on exports, the truth is that neither are as remotely exposed as the other Asian tigers were in the past. Why? Because they both have pretty large and fast growing domestic economies. So unless there is a severe recession in the US, and Europe and/or Japan slows as well, I don’t see slower export demand as a big enough hit to Chindia to cause growth rates to fall by more than a percent or two. Actually one could argue that slower external demand is just what they need given concerns about overheating and supply constaints in both countries. It’s the other factor, capital flows, that seem a bigger worry to me and here the two countries diverge in terms of consequences.

Assuming a significant US slowdown or outright recession combined with lower US stock prices, obviously Asian stock markets decline – probably by more. Global investors will look to take some money out and local punters will be willing to pay less for the same amount of earnings. In terms of capital inflows from private equity investors, it is important to note that the aggregate amounts actually have not been large to date. Total investment by PE investors (domestic and foreign) is running at a pace of around $10 billion per year for both China and India – a huge increase but insignificant for the whole economy. China has seen $60 billion or so of FDI per year, what will happen to this? Well, for one thing not a lot of it (or less than you may think) is from US MNCs. I don’t have the numbers at hand but my recollection is that less than a ¼ of Chinese FDI is from the US (I will post a correction if I’ve got that wrong). I wouldn’t be surprised to see FDI slowing somewhat but I think this may be more of a secular trend as Chinese costs rise and outward FDI increases – though some US companies may use the fact of a slower global economy to reduce planned investment in China (it’s been my bet for sometime that off-shoring by US companies to China was likely to slow anyway due to zooming costs and increased concerns about product quality). Finally, to complete the case for China’s insulation from a global capital risk reduction pullback, is the fact that Beijing is rolling in it. They didn’t actually need our dosh in the first place (just wanted the know-how that came with it). Conclusion: the Chinese economy will be fine and stock market, after the initial knee-jerk selloff, will also be okay.

India is a different story in terms of capital flows. India runs a mamoth trade deficit (5%ish of GDP) which is only balanced by inflows by NRIs and foreign investors. It seems likely that at the margin, foreigners will take some money off the table in India and this could – worse case – cause a balance of payments crisis in India. I know, sounds farfetched now but anyone who’s watched India for more than 10 years won’t laugh. If global asset markets are bad enough to cause foreign investors to take meaningful amounts of money out of India (public equity or private equity) than it will be nail-biting time in Mumbai. Unlike China, India desperately needs foreign capital in order to create a modern infrastructure. Their ability to do this was by no means a certainly under the best of circumstances. Doing so with significantly less foreign capital at their disposal becomes… questionable. And then one starts looking to lower one’s longer term potential growth rate for India (in addition to staying up nights worrying about the possibility of a currency crisis. The odds may be low but they won’t be 1%, they’ll be 10-20%). Stay tuned.

Give that man a gold star!

Who says all the savviest institutional investors are at endowments and foundations? I'm beginning the think the reverse is possible given how much risk the large "sophisticated" E&Fs are taking (fully hedged, uncorrelated, alpha, whatever...). And a voice of wisdom has emanated from a public pension plan of all places. As reported in Fund Fire last week:

Alternative assets may not be the portfolio diversifiers they’re thought to be, Rhode Island’s deputy general treasurer for finance told an audience last week. Speaking at the annual Fire and Police Pension Fund Summit in his home state, Kenneth Goodreau warned that allocating to alternative classes might not end up reducing a portfolio’s overall volatility, as common opinion holds.

Bravo Kenneth! Couldn't have said it better myself.

“If you look at alternatives right now, the asset classes are moving in tandem. We’re basically dealing with a global liquidity pool where everybody’s looking for the same thing,” Goodreau said. “The more people you get on the same side of an asset, the riskier it gets.”

“The real asset class I’m looking for is non-correlated,” Goodreau said, “and it’s very difficult to find.”

Who needs David Swenson? For investment wisdom you could do a lot worse than go to the Rhode Island Fire and Police Pension Fund Summit!

Cheap and deadly

According to World Bank estimates, there are 600 deaths in auto accidents per day and another 45,000 injured. That works out to 219 thousand traffic fatalities per year and a whopping 16.4 million injuries! Although those numbers sound so high as to be slightly questionable, I've spent enough hours in Beijing traffic to believe that they can't be too far off. According to China Economic Review, the cause is due to the fact that few drivers follow traffic rules (what rules?) but also due to the poor safety standards of Chinese made cars. Chery and Geely were cited as getting about the lowest scores possible for several models based on US and European standards. The cost of improving safety standards is estimated to be about $2,000 per car - pretty steep compared to the average car price in China of $6,500. But maybe this is one consumer good where the Chinese will pay up for quality. Or natural selection may change consumer buying preferences.

Matsushita makes it go away

Matsushita's partial sale of JVC is a perfect example of how Japan Inc. is still unable to execute genuine restructuring, instead taking tiny muddled steps which don't accomplish anything. CEOs look at these annoying problems (total lack of scale and competitiveness) and want to just make them go away. To make the contrast between what IS being done and what NEEDs to be done, in this case Matsushita rejected an offer by TPG to buy JVC and execute a full restructuring. Instead Matsushita reduced their ownership stake from 52.4% to 36.8% (to get the pig off the income statement) while Kenwood and Japanese hedge fund Sparx (developing a role as the white knight for besieged takeover targets) take 17% and 13% respectively. Who will be responsible for JVC now? Will Kenwood and JVC consolidate? Er... well... consensus not yet reached on those minor points...

The head line in the Nikkei Financial says it all:

JVC-Kenwood Tie-Up Leaves Some Scratching Their Heads

Recommended allocation to US private equity: 0%

If, that is, the poor misunderstood undercompensated babies make good on the following threat if carried interest is taxed as income, reported in PE Week Wire:

Private equity investors – both VC and LBO pros – keep warning that they will pass on additional tax costs to their limited partners, via increases in management fees and carried interest percentages

HA! I say. Make my day. Given the number of mindless secondary fund buyers out there, and given that the expected rate of return for US LBO and VC funds in the next five years is about equal to your average low vol hedge fund of funds... I say, SELL.

Okay, just a bit of venting there... but really, if any US buyout or VC comes to my little corner of the world and says anything remotely along these lines, we will wish them well and say thanks for the memories.

Run for your lives!!

China is a global menace and will take over the world! No it won't it's going to collapse - and destroy the world! Panic! Over-react! Ahhhh!

Okay, just kidding. These days, the world press seems intent on casting China in the role as either looming menace or teetering on the edge of collapse. Regular readers know what I think of all this ill-informed hogwash.

Nonetheless... sometimes one just has to jump on the bandwagon so here goes. Presenting RIIP's very own "China Menace" story:

As reported in today's WSJ, China is destroying the GLOBAL air supply:

An outpouring of dust layered with man-made sulfates, smog, industrial fumes, carbon grit and nitrates is crossing the Pacific Ocean on prevailing winds from booming Asian economies in plumes so vast they alter the climate. These rivers of polluted air can be wider than the Amazon and deeper than the Grand Canyon.

Holy smoke, Batman!

Once aloft, the plumes can circle the world in three weeks. "In a very real and immediate sense, you can look at a dust event you are breathing in China and look at this same dust as it tracks across the Pacific and reaches the United States," said climate analyst Jeff Stith at the National Center for Atmospheric Research in Colorado. "It is a remarkable mix of natural and man-made particles."

Think of it as a sort of new kind of foreign exchange program.

The team detected a new high-altitude plume every three or four days. Each one was up to 300 miles wide and six miles deep, a vaporous layer cake of pollutants. The higher the plumes, the longer they lasted, the faster they traveled and the more pronounced their effect, the researchers said.

I like Chinese food as much as the next guy but a 300 mile wide vaporous layer cake?!

All right, all right, I know, this is disturbing and serious. Someone better alert Al Gore. Speaking of vaporous outpourings of polluted air...

Chinese government to back VCs

It's a tiny amount of money but still interesting as an indication of how the government is thinking about investing and funding innovation. As reported in Xinhua:

The Chinese government has set up a special fund of 100 million yuan (about 12.8 million U.S. dollars) to encourage venture capital companies to invest in technology-based small and medium-sized enterprises (SMEs).

By "venture capital companies", they mean VC funds. What is different about this initiative is that instead of government entities giving direct grants to companies, the government has figured out that this approach is largely a waste of money and is encouraging investment into VCs, with the idea that they will allocate capital more effectively. In the past, government money has been given out by various research institutes either to companies that were well-connected politically, or to companies founded by researchers who worked at the government institutes themselves. As usual, the Chinese government eventually catches on and experiments with an another approach. If shows promise, the funding will rapidly increase (they don't lack for money as you may have noticed).

Unlike past investment which has been directly injected into technology-based SMEs, the fund, jointly offered by the Ministries of Finance and Technology, will, for the first time, target venture capital companies, venture capital management enterprises and service agencies capable of investing in a burgeoning number of technology-based SMEs.

It is worth noting that "technology-based" is to be interpreted broadly and does not necessarily mean "IT" as westerners may think of it:

Technology-based SMEs refer to those whose business development mainly hinges upon new technical innovations which are relatively uncertain in terms of application and market prospects. As a result, banks and venture capitals tend to be cautious when it comes to invest in them.

One final point is that the success or failure of this approach may come down to which type of VCs are funded. There are a large number of government sponsored VCs who are pretty much hopeless. If this money goes to the Inner Mongolia Venture Capital Fund then all bets are off. If it goes to IDG or Kleiner Perkins China then Beijing may be on to something.

Chinese cost advantage: going, going...

This just in (from China Daily):

Excluding inflationary factors, the wages of employees in China have seen an averaged annual growth of 12 percent in the past four years, the fastest growth since the country's reform and opening up in the late 1970s, according to figures from the China Association for Labor Studies.

Well, at least its not poisonous...

Beijing baker caught filling his buns with cardboard...

Indian private sector urged to adopt affirmative action

Leave it to the Indians to find a way to snatch defeat from the jaws of victory. Although their government is among the most dysfunctional, corrupt, and poorly performing on the planet, the Prime Minister (instead of doing something about this) is browbeating corporate India to adopt the same affirmative action programs for "scheduled castes" and "scheduled tribes" that have failed so spectacularly and consistently in Indian education and government. Imagine how fast India could grow if the lead weight of government was removed?

A bit late...?

Headline in WSJ today:

Antifreeze Agent Banned
From Chinese Toothpaste

Take That! Japan Inc

This one is going to be interesting. In the last year or so, it's looked liked the old guard Japanese management forces are winning the war against activist hedgies and others who believe that companies are owned and should be managed for the benefit of shareholders. But in a shot across the bow of NEC, Perry Capital shows that this war is far from over. As reported in NikkeiNet:

Perry Capital Offers To Buy 25% Stake In NEC Electronics From Parent

NEW YORK (Nikkei)--U.S. investment fund Perry Capital LLC told NEC Corp. (6701) that it was willing to buy an additional 25% stake in NEC Electronics Corp. (6723) as part of its drive to make the semiconductor manufacturer more independent from the parent, The Nikkei learned Tuesday.

Perry Capital, which is already NEC Electronics' third-largest shareholder with a 4.5% stake, has argued that NEC's ownership of more than 50% of NEC Electronics, a publicly traded company, is causing the subsidiary's stock price to slump. Perry Capital is demanding that NEC reduce its stake from the current 70% to less than 50%.

The U.S. shareholder offered to buy 30.87 million shares of NEC Electronics for 154 billion yen, or 5,000 yen apiece, a 65% premium over NEC Electronics' average share price over the past three months. But it is unlikely that NEC will accept the offer, with President Kaoru Yano saying Tuesday that the company did not plan to change its stake in the subsidiary.

NEC Electronics posted a second straight loss in fiscal 2006 as it expanded system chip operations in line with NEC's management policy. Perry Capital believes that NEC Electronics' corporate value will increase if its business independence is established.

With Perry Capital offering a hefty premium, NEC will have to come up with a countermeasure to raise NEC Electronics' corporate value to justify its decision to shareholders.

Rejecting a 65% premium bid for NEC Electronics shares will take some serious explaining to NEC shareholders. It would be foolish to underestimate the power of the old guard and their overwhelming desire not to change - but this one will be interesting nonetheless.

Good but not good

A very important consideration when investing in almost any SOE is the ownership structure whereby the listed entity is controlled by an unlisted parent. The parent is 100% owned by the state and has significant operating assets in addition to those held by the listed entity. One of the peculiar aspects of the current popularity of Chinese stocks is the recent phenomenon of "asset injections". This is where the parent company "sells" some or all of it's operating assets to the listed entity. This is viewed by investors as a positive development and of course, in one sense (assuming the price is fair), it is. It is a move towards less ownership complexity - generally a good thing. But, on the other hand, who determines the price? The parent company does, and it's a take it or leave it proposition for shareholders of the listed company. For Hong Kong listed entities, there are some minority shareholder protections but one ought be a bit skeptical about these given the power of the parent and the fact that all the assets are in China. A slight variation on the asset injection is the recent announced deal between Chalco, the largest Aluminum producer in China, and another listed entity which is controlled by Chalco's parent. Think of it as an arranged marriage. Reuter's gives the details. The point is that 1. it is impossible to evaluate or analyze or forecast any of this and 2. the price of the asset purchases is not determined in an arm's-length fashion. This is a generic example of the type of risks that investors in China need to be aware of.

Bye bye Abe?

I'm still catching up after two weeks in China then one week on vacation in lovely Sea Isle New Jersey with family. Prime Minister Abe of Japan - who was doing relatively poorly when I last checked - now seems to be imploding. Elections for the upper house of the Diet are to be held the end of the month and the LDP will get it's butt kicked. What's going wrong for Abe? In addition to the most recent controversy when the Defense Minister made comments that appeared, possibly, maybe, sort of - to justify the atomic bombs dropped on Japan in WWII (he's now resigned), the more significant issue was plummeting confidence in the competence of Abe's cabinet caused by a screw-up in the national pension agency. The following from the Economist gives the details:

Three ministers have now gone during Mr Abe's nine months in office, including a suicide. A fourth, Hakuo Yanigisawa, the health and welfare minister, is certain to go. Not only has he outraged Japanese women by referring to them as “birth-giving machines”, but he oversees a pensions agency which has admitted to losing 50m pensions records. This pensions fiasco, more than anything, is what has undermined Mr Abe's fortunes. On July 2nd a poll in the Asahi Shimbun showed approval ratings for his government fall below 30% for the first time, down by more than half since he took office.

It seems that just as damaging to Abe has been his focus, since assuming office, on issues like changing the constitution and revamping the educational curriculum - instead of on what seems to most people to be the obvious critical issue of figuring out how Japan can remain a properous nation with a shrinking, rapidly aging population and a massive government debt.

So what happens next? None of the pundits I've read seem to have a clue. All that seems to be clear is that Abe might be forced to step down if the LDP does worse than expected in the election - and no one knows what would happen after that. As J.P. Morgan once said when asked his view on direction of stocks, "markets will continue to fluxuate."

China infrastructure: too much of a good thing?

China announces plans to build a 67 miles highway on Mt. Everest. Uh, guys, you might want to chill out a little bit with the mindless road construction...