WSJ: Beijing Duck

Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and other polished cabinetry are visiting China later this week. They'll see fields of skyscrapers, traffic jams of new cars and designer couture replacing the old Maoist uniform with five buttons and too-long sleeves. In other words, we've got the Chinese right where we want 'em.

Sure, the China Miracle is impressive -- double-digit economic growth, exports up 30%, a $150-billion trade surplus and a trillion dollars of foreign currency in their treasury as reserves. The prevailing opinion is that at any moment, China can stop funding U.S. budget deficits by not buying our bonds -- so Messrs. Paulson and Bernanke should come hat in hand and beg for indulgence. Don't believe it.

Your hotel will probably be on a street that didn't exist two years ago. The traffic jam getting you there? It's from the 1.4 million new family car drivers in Beijing, now just learning how to drive -- and not too well. Think of China as a bunch of high school kids (albeit with strict parents) with new driver's licenses and you won't be far off. Don't give them the keys to anything. Be a little coy. From the consumers to the government, they are simply adolescents.

China consumes one-eighth of the world's energy, one in four tons of steel and aluminum, and almost half of the world's cement. According to Stephen Roach at Morgan Stanley, half of China's GDP is fixed investment. They pay for this with loans from Chinese banks backed by our dollars. Like a teenager who stole Grandma's checkbook, the Miracle seems to be based on writing bad checks.

They can't handle our dollars. Every time the Fed increases money supply and you and I buy shirts and toys, dollars end up in China. As modern gold, these dollars are used as collateral for banks to write loans against. Each way you look in Shanghai, you see the equivalent of the Houston skyline, marble facades on tall postmodern glass and steel buildings. As far as I could tell, over half these buildings are still empty. In fact, I noticed families living in the rubble of the lobbies in many of these buildings. Yet even more skyscrapers are under construction at every point of the compass. China is looking more and more like bad Japanese flashback.

Call it Communist Cronyism. Nonperforming loans are an anchor on this system. More than once, China has dipped into its reserves to bail out its banks. A rising yuan has attracted investment funds; Mr. Paulson's old firm Goldman Sachs and the rest of Wall Street are busy recapitalizing Chinese banks, whose bad loans have been moved off to other entities. One bank yet to recap is AgBank, with a reputed $90 billion in bad loans. This is real money -- a giant black hole that needs to be dealt with very carefully.

At the same time, the U.S. National Association of Manufacturers -- wow, we still have manufacturers in the U.S.? -- has been lobbying this travel group hard for the Chinese yuan to float higher and the dollar to weaken. If it moves 20%, China's labor becomes uncompetitive and will be toast, as crispy as Peking Duck. Why the U.S. would want to give up cheap shoes and electronics is beyond me -- a dollar drop is a consumption tax on Wal-Mart and upscale shoppers alike. Chinese workers make $1.80 an hour, including all benefits. Unless the dollar drops by half, I doubt a single new manufacturing job in the U.S. will be created.

Their stock market could help. China is filled with entrepreneurs who build companies, not buildings. I spent 10 days in China this month meeting with investors. They are smart and hungry but crippled with Enron accounting. On Jan. 1, listed companies must start releasing two sets of numbers -- Chinese earnings and then calculated again using international standards. Many will start to show losses. Ouch. China is scared to open up because the first move might be to short the whole damn country. George Soros has been sniffing around, and they won't let him in. Outsiders need to be licensed as Qualified Foreign Institutional Investor with a quota -- currently less than 1% of total capitalization. Doesn't sound like a market economy to me. The total value of U.S. stocks is 20 times as large for a reason.

Adolescents eventually grow up. China is growing in spurts. They've got jobs and piles of debt. They need to keep working to pay it off. I actually think the U.S., with its immense wealth, is the main banker, not the Chinese floating our hopefully shrinking budget deficits. We are the ones with the leverage. Stick with the currency peg and make China open up their markets to competition and real outside financial scrutiny.

Mr. Kessler is author of "The End of Medicine" (HarperCollins, 2006).

Comments

[Andy Nardone]

Thanks for a variant perspective, and from street level no less.

[StarLin]

You are very famous in china now!
I admire you very much.

[Joe Buhler]

Excellent commentary. I noticed the same in Shanghai during a visit in September, my first after a quarter century! The facade has changed dramatically but behind the scenes and the further you go inland things are not as spiffy as most foreign media make us believe. Totally agree with your flashback to Japan. Except they never faced the same giant task of keeping a billion plus fed and clothed and not have a huge wealth gap open up with potentially catastrophic results.

By the way, send your comments to the paranoid Lou Dobbs who thinks bashing the Chinese would bring jobs back to the U.S.

[Alex Tijerina]

This article also need to be sent to New Congressional Speaker Nancy Polosi

[China Law Blog]

Your adolescent analogy reminds me of a post I did last month analogizing China to Yao Ming and concluding both are rising but neither are there yet. You can check out that post here: http://www.chinalawblog.com/chinalawblog/2006/12/man_i_am_pissed.html. BTW -- The Chinese really hate it when Westerners analogize them to adolescents.

[Ann Sherman]

What a great piece. I hadn't heard that Chinese companies would have to start reporting based on international accounting standards. That should be quite an eye-opener, if it really happens!

I'm still somewhat shocked that outsiders were so anxious to buy shares in China's non-performing loans. Bringing new capital into the banks won't solve things unless the banks stop making new bad loans, which would require some major shifts in thinking and in procedures.

[J. L. Pering]

Insightful article. Please do a story on India too.. Is it all hype? how much of the growth is real?

Let's assume the Adolescent thing is not inappropriate.

No one is born to be grandma, or experienced driver. It takes time to grow and mature.

As a established player and joking and poking at new-comer at the game (not to forget the fundamentals of modern economics and finance do not origin from China), is well, not the nicest thing one would expect. How about being more open and strategic?

Don't forget what else adolescents have -- energy to burn and future to bet, good or bad awaits to be disclosed, you all have been there and should understand what I mean.

China miracle, or whatever you call it, don't believe, see it.

However, personally I highly respect and appreciate Mr. Kessler's devotion of his time and effort putting this piece together.

He should definitely be treated with the mouthwatering Beijing Duck. Yummy...

[JXie]

How's that virtual short on "the whole damn country" doing? Should you add more to your short "position" or should you bail?

If those buildings were over half empty, why the heck the office rent kept going up? Oh wait, according to Collins International, the supply of available office space is actually very tight. Collins International, you know, actually surveys office space demand and supply for a living. They are rather like stock analysts, i.e. Andy Kessler in Wall Street Meat, than the know-it-all author of The End of Medicine.