Death of the China Cult

July 4th, 2012

Published on naked capitalism, by Yves Smith, July 3, 2012.

By Zarathustra, who is the founder of Hong Kong blog Also sprach Analyst. He was educated at the London School of Economics and the Chinese University of Hong Kong and was once a Hong Kong-based equity research analyst focusing on Hong Kong real estate (which he did not really like), with a secondary coverage on China real estate sector (which he actually hated). Cross posted from MacroBusiness … // 

… No one would ever dispute the achievement of the Chinese economy. What we see in China now, on the surface at least, is progress. And the progress was huge indeed. For 30 years or more, the Chinese economy has defied “gravity”, has never been in a recession, and has lifted enormous numbers of people out of poverty. Predictably, perception of the Chinese economy has changed very dramatically over the past decade, from a market that you wanted to stay away from to a market that no one wants to miss.

But this is not the whole truth. Before the story of “China as the forthcoming greatest economic power”, many held the impression that Chinese companies were either not well run, or were run by crooks, who cooked up their books and/or produce very inferior products simply to rip people off. On top of that, the Chinese government cooked up statistics, and doubters spun that in their own favour, suggesting that the economy could not have grown that fast. Meanwhile, corruptions was rampant. Businessmen bribed government officials in order to profit, while government officials got rich through taking massive amount of bribes.

If you insisted on that grim view on China in early 2000s (right after the Chinese government lied about SARS, as a reminder of who were the type of people who ran the government), although you would have missed the bull market in stocks, you would not have been inaccurate. Since the beginning of time (well, that’s an exaggeration of course), China has had the creativity and necessary skills to create fake and low quality products beyond anyone’s imagination. We also knew that corruption in China was horrible since the beginning of time (and this is not an exaggeration, as that has been a recurring theme of the rise and fall of different dynasties ever since Imperial China). Banks loaned to whoever had connections to government officials (i.e. those who have bribed government officials) so that it required extra faith for investors to believe in banks’ books. And as a businessman, as long as you had the great connections with government officials, banks would probably still be willing to lend to your company cheaply even though you were cooking your own books … //

… In the beginning of the recovery of the global economy, investing in China did pay off well relative to many markets in the rest of the world, reinforcing the idea, once more, that China is invincible. The same doubters who did not invest in Chinese stocks 10 years ago because they thought companies cook up their books started to buy in 2007, 2008, 2009, 2010, 2011, and 2012. The same doubters who did not invest in Chinese stocks because of worries about corruption are now accepting corruption as a reality and that it is something which determines whether a company can make money. The same doubters who thought Chinese banks have understated non-performing loans started to believe that buying Chinese banks is like buying HSBC in the 1980s, which will give you a return in the order of hundreds of times over the next 3 decades. Investors have also been much less careful about frauds as the cult reaches its climax. But instead of identifying the problems related to poor governance, frauds and corruption, some insist that these are isolated cases and have nothing to do with the culture of how businesses are done in China. Also, while Chinese statistics are not reliable, more and more people are trying to spin the unreliable data to fit their own bullish arguments. Instead of suggesting that growth is overstated, now they say consumption is understated, and the China consumption will be the biggest investment story of the era.

But Chinese equities outperformance did not last long: first in Shanghai, then in Hong Kong (and Australia), they have turned from two of the best markets to markets doing even worse than Europe. Bears (like me) started to be ever more vocal about the structural problems in the Chinese economy: namely, the real estate bubble, over-capacity across the economy, over-investment and the associated unsustainable increases in debt etc. And I am getting ever more concerned about issues that we did not mention much: corruption and its link of over-investment, and the consequence of lack of inflation. Bears have got it right for almost 2 years now as far as stock investments are concerned, and the economy is now slowing down rapidly while the real estate market cools, just as the bears predicted. Unfortunately, people increasingly blame short-sellers instead of admitting that they have been wrong.

Still, the cult has not yet died. The past few years have produced an impression of the Chinese government as invincible, and it has miraculous control over the economic machine, that the slowdown is “intentionally” engineered by the government and everything within the economy is still very much under control. Unfortunately, most who use this argument to justify that the slowdown is not a big problem have all invariably forgotten that most economic slowdowns in recent memories started with central banks tightening monetary policy to control inflation and slow down the economy, and most, if not all, of the cases ended with recession that they did not want to get into. Many have also not realised how difficult it is for China to boost its way out of a debt deflation.

As the economic slowdown becomes a reality and a hard landing looms, more of the problems we have identified will surface. The cult will surely die within the next few years. The only question is when and whether that death will be violent death or slow. (full text).

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