Guest Post: The Death Of China Cult
Submitted by Also Sprach Analyst,
People in Hong Kong have a long history of mistrust of China. This city, after all, was a colony of the British Empire for more than a century, and has only been under Chinese rule (under one country two system, to be precise) for a mere 15 years. In this city, you seldom hear anything bad about Britain (because most have no idea), but you hear a lot of bad things about China, particularly the Chinese Communist Party. We just never trust them.
While the mistrust of the political class of China continues in Hong Kong (and will certainly continue for much longer), the doubts on the strength of the Chinese economy and the doubts on the ability of the political class to manage the economy have more or less evaporated after 15 years of Chinese rule.
It used to be that Hongkongers go to China to purchase really cheap stuff. Now, it is the Mainland Chinese who come to Hong Kong to buy really expensive stuff. Places in China which were farmlands are now full of modern buildings. Infrastructures in large cities are getting better, sometimes even better than Hong Kong. Before the transfer of sovereignty, Hong Kong was already a rich city while China was a very poor country. China used to be poor, dirty, relatively uncivilised, you name it. Today, it almost as if this city would have died if the Chinese economy did not grow at the rate as it did in the past decade. China today, especially for big city like Shanghai, is just like Hong Kong: modern, international, classy. You can’t say many things bad about cities like Shanghai.
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”, and has never been in a recession, and has lifted enormous number of people out of poverty. Predictably, the perception on 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.
Chinese equities as something to be avoided is perhaps a bit of an exaggeration, but less than a decade ago, you could quite easily find people who had some serious doubts on investing in China. On the macro level, the story of “China as the forthcoming greatest economic power” was not yet the biggest story, even though everyone knew that China was growing very fast. On a micro level, 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 cooks up statistics, and doubters spin that in their own favour, suggesting that the economy could not have grown that fast. Meanwhile, corruptions were 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 (which ended in 2007 by the way), such grim view was not necessarily inaccurate. Since the beginning of time (well, that’s an exaggeration of course), China has the creativity and necessary skills in creating fake and low quality products beyond anyone’s imagination, which are sometimes dangerous for human consumption. 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): you couldn’t possibly not bribe officials if you want to do business and be successful in China, while for government officials, you can’t possibly be not corrupt if you want to have a successful career as a civil servant (and by successful, it really means climbing up the ranks while continuing to be bribed without being caught or something). Banks would lend to whoever with connections to government officials (i.e. those who have bribed government officials) so that it requires extra faith for investors to believe in banks’ books. And as a businessman, as long as you have great connections with government officials, banks would probably still be willing to lend to your company cheaply even though you are cooking up your books. Finally, no one has ever believed in Chinese statistics in full at face value, and with a political regime which is obsessed with promoting their own achievements, doubters are justified in believing the statistics are purposefully massaged to make them look great.
These are the problems for China in the past. But if all these problems with China sound familiar to you, it should, because they are more or less what increasing number of people are talking about. These are not just history, but current reality. China is still full of businessmen who make crap products that are dangerous for human consumption. Corruption is as serious as it was, if not more so. You still have to bribe officials to achieve your goals successfully (and the costs of bribing officials to achieve your goal, as I understand, are getting ever higher), and government officials cannot have a successful career without being corrupt. Banks have not changed their practices in determining who to lend money to, so as long as you have good relationship with government officials, you can get cheap loans even you did not actually own the collateral you are posting to banks, and as long as you can get loans, you can’t possibly go bust even if you are already insolvent and are cooking up books (as long as the officials that you have connection with are still around and well). Finally, there is still no one who is willing to believe in Chinese statistics in full at face value.
The only difference between the recent years and ten years or so ago is that people just ignore it now, because the extraordinary bull market and the seemingly unstoppable economic growth has created a China cult, a cult among investing community that China is the best place to be investing in. Just as hedge fund manager Hugh Hendry said “10 years are enough to create a cult in capital market”. In fact, China has not seen any year with negative growth for more than 30 years.
Despite the fact that the Chinese stock market bubble has gone bust in 2007, the whole China cult continues to get new followers. After the bubble went bust and the Lehman crisis hit, quite a number of people were confident that the stock market will surpass the 2007 peak very soon because the Chinese economy has been strong. The view that China became the best place to invest has become ever more popular as the Western economies looked mortally wounded after the crisis (while they are not). The ever more popular idea that the economic weight has shifted from the East to the West, or the idea that we are back in a bipolar world for the first time since the end of the Cold War, and among many other ideas, have reinforced many people’s belief that China is the place to go. Even to this date, we understand that there are a lot of European companies which are still looking to invest in China apparently because China looks “safer” relative to Europe.
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 really invincible, that China is the best place to invest. 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 the worries on 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, even though things have not changed. 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, they have turned from two of the best markets to markets doing even worse than Europe. While a lot of investors were still very hopeful that stocks could get to the 2007 peak very soon, that is just not happening. Bears like ourselves started to be ever more vocal about the structural problems in the Chinese economy since late 2010 and 2011, namely, real estate bubble, over-capacity across the economy, over-investment and the associated unsustainable increase debt etc., and we are 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 have predicted. Unfortunately, people increasingly blame short-sellers instead of admitting that they have been wrong.
Still, the cult has not died yet. The past few years have produced an impression of the Chinese government that it is 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 would be for China to relate its way out of a debt deflation. So how different China is in this regard is totally beyond our comprehension, and we are forced to suggest that the believers of China cult have gone delusional.
As the economic slowdown becomes a reality and a hard landing unavoidable, more of the problems we have identified will surface. The cult will surely die within the next few years at most. The only questions are when it will finally die, and whether it will suffer a violent death or slow death.