16 May 1999 - The Roaring Dragon

SHANGHAI, China — Today I did something I’ve contemplated doing for decades: I walked into a Chinese brokerage house in Shanghai and opened a brokerage account so I could buy Chinese equities.

Paige and I entered China on the first of April across the Kazakhstan-Chinese border. We drove eastward across the Gobi Desert, along some excellent roads, stopping along the route—Yining, Urumqi, Hami, Lanzhou, and Xi’an—that I’ve taken twice before on journeys over the past eleven years. Despite the widespread reports in the western press about how poorly China is doing economically, our eyes told us a different story.

Hami, which in 1988 had a way in and out that was more a boulder-strewn path than a road, has turned into a boomtown, packed with trucks, cars, and motorcycles–as well as goats, geese, and cattle. In 1990 there were no dealers for motorcycles; today there are three. In Yining street markets were everywhere, and its streets, too, were filled with vehicular traffic.

Where before there were only a few state shops, now private shops proliferate. In 1990 there were no gas stations; once I was forced to go to a Red Army outpost and beg for gas. On this trip we’ve found an abundance of secular temples to gasoline, elaborate service stations with ten pumps and enough arches to rival McDonald’s. In Xi’an we even found several Mercedes.

In 1990 there was but a budding hotel industry; today there are three times as many hotels, many up to world standards. As for nightlife, in Hami and elsewhere there are many discos, karaoke bars, and nightclubs. Young men are dressed in suits and ties; only the older crowd wear Mao suits.

The western press wants to make much of the lack of human rights in China, but in 8,000 kilometers of travel we were stopped only a couple of times at checkpoints, whereas as we crossed the Stans—our fast allies—we were stopped scores and scores of times by heavy-handed police. Here in China everyone is too busy making money to poke his nose into anyone else’s business.

Today China is all construction, markets, and factories. Looking east from our hotel room in Nanjing, the old southern capital, we counted twelve separate cranes working at skyscraper sites, not that there was any shortage of skyscrapers. Everywhere the Chinese are feverishly building highways, houses, shops, and factories. Many of the roads are as good as the Autobahn – and much of all this has been built by hand, just as were the Grand Canal and the Great Wall a couple thousand years ago.

Along all the roads in every town and village we found constant activity, bustling markets, Chinese eagerly working, buying and selling at every turn, and an astonishing array of new consumer goods—bicycles, radios, trucks, cars, TVs, clothes—made by both foreign and domestic manufacturers. You name the consumer good, and the Chinese are buying and selling it. China is by far the most dynamic country we’ve encountered, making the boomtimes in Ireland and Turkey pale in comparison.

On my previous visits I stopped at a temple or two, but never had a sense they were too important to the Chinese. No longer: we are constantly running into packed Buddhist, Taoist, and Confucian temples, and the surprise is the extent of the crowds. An additional surprise is the sheer number of thriving mosques and Christian churches. We’ve stumbled onto several churches with vibrant congregations. I never know who is the more startled: Paige and I or the worshippers—some of whose families have been Christian for 200 years. We have yet to find anyone of any faith who is feeling repressed. Some of the oldest members can remember problems under Mao, but the younger ones are bewildered by the question.

All in all I am sure there are some rights’ violations; they exist in every country, especially in developing countries. Even Plato wrote about them as long ago as The Republic. My sense after six weeks close to the ground, however, is that the human rights’ tempest in the West is a cover for those with some other agenda, such as protecting their own interests from a dynamic new country.

How did China get here? Its recent history is fascinating. Starting in 1978 its leadership has moved the economy from Soviet-style central planning to more of a market-based economy, yet all within Communist Party political control. In place of collectivization in agriculture, national leadership has stressed “household responsibility,” allowing households to produce and sell, which has boosted farm production tremendously. In the same way, local officials and plant managers have been allowed far more control over their domains, and Beijing opened up the country to foreign investment. The result has been a quadrupling of gross domestic product over the past 20 years, with both agriculture and industry making enormous strides. The World Bank estimates that China’s GDP might have been as high as $4.25 trillion in 1997.

While successful overall, from this uniquely Chinese stew has sometimes come the worst of both systems. From the constraints of the Communist Party have come corruption and the petty hassles of bureaucracy, while capitalism has brought inflation and the corrupting influence of windfall gains. Between 1992 and 1997 growth reached levels as high as 10% annually, particularly along the prosperous coast.

The government, with some of the best national leadership in China’s history, has had its work cut out for it. Tens of millions of surplus rural workers have floated between the villages, towns, and cities, sustained only with low-paying part-time work. The Chinese leaders have struggled to keep afloat the large state-owned enterprises, few of which have grown with the rest of the country. In addition, it’s been hard for the national government to collect the revenues it felt it needed. On top of these problems, the leadership has not only struggled to reduce corruption and other economic crimes but also to contain the deterioration of the environment—air pollution, soil erosion, and the steady fall of the water table in the north.

Will there be continued tensions between the Communist Party and the decentralized economic system? Absolutely. How will they be resolved? I believe in favor of increasing prosperity, as under Mao the Chinese tried central economic planning for decades and they know it won’t work, just as after seven decades of socialism the peoples of South America came to lose their capacity to believe in economic poppycock.

So now that I’ve seen a country bursting with the capitalist spirit and opened my brokerage account, what stocks might I buy? In China there are two major exchanges, the first here in Shanghai and the other, south of us in Shenzhen, on both of which a total of some 500 Chinese stocks trade. Many of these are not stocks I want to buy; they are the leftovers from the Communist era, poorly-run government companies the authorities are eager to unload on unsuspecting investors.

And of course there are other impediments. The equity shares of Chinese public companies are divided into A and B shares. The A-shares can only be owned by native Chinese. If they are careful how they go about it, these shares can also be owned by the overseas Chinese, who number many tens of millions around the world. Foreign investors who play it straight—that is, who don’t use a Chinese nominee to trade or invest—are only allowed to purchase B-shares.

At this writing the foreigners’ B-shares are not convertible into A-shares. Whereas at one time western enthusiasm for China was so large that B-shares sold at a premium to A-shares, today Western pessimism toward China is so great that these B-shares have fallen 85% from their highs. Such a huge discrepancy has whetted my appetite—what a bargain!

Since the Asian economic turmoil began in mid-1997, I’ve been watching and asking when would be the right time to plunge back into Asian equities. I now believe that time is close at hand. My view of the rally over the past few months is that it’s a bear-market rally, that we will have another bottom, a second bottom, that will tell us that the Asian market is truly ready to march upwards. My long observations of major bear markets tells me there is often a second major leg down, one which tests the prior bottom, and shakes out those who have been suckered into the first rally. I’ve thought this second leg down might be marked by the devaluation of the Chinese currency or some other turmoil in China–say, labor unrest and strikes.

Some years ago the Chinese formed International Trust and Investment Corporations (ITICs), government-backed investment companies, usually one to a province. These raised billions of dollars to develop much-needed Chinese infrastructure: airports, toll roads, seaports, and especially power plants. Their bonds typically paid a high rate, 15% to 18%. However, these trusts made the age-old banker’s mistake, lending long and borrowing short. ITICs were usually owned by the local provincial governments, and sometimes appeared to be guaranteed by the government, just as in the U. S. agency bonds appear to be backed by the full faith and credit of the U. S. Treasury but are not. Investors’ arguments for trusting in such semi-guarantees are that the governments involved would be too embarrassed to let such bonds default.

One of these ITICs was the Guangdong International Trust and Investment Corporation, GITIC, located in one of the most prosperous Chinese provinces. At a creditors’ meeting in January GITIC announced it had $4.3 billion in liabilities and no assets with which to cover these debts, and that it was filing for bankruptcy. The next day the Guangdong authorities announced they weren’t going to meet any obligation they might have had to guarantee the losses. Over the past few months other ITICs have made similar announcements, and the national government has repudiated any responsibility to bail them out. Overseas investment houses, some of whom are insurance companies, have had to reserve massively, sometimes writing off the investment entirely, which will wipe out years of profits earned from China and put a sour taste in their mouths for more Chinese investment.

The way the collapse of GITIC was handled alarmed some of China’s big banks, which have alerted the government that this will damage Chinese credibility abroad and hamper Chinese prospects of raising funds in international markets. They were right enough. Since January international investing in China has backed up.

In fact, much of the early money into China has not been the wisest of money. Iveco, the Italian truck manufacturer, put its first agent in China in 1984. After investing $200 million along the way, it won’t see any profits until 2002, almost 20 years after its agent’s first arrival. Unilever arrived during the 80s, too, and it, too, had to waive its usual investment criteria to justify the millions it spent in China. General Motors and western banks later poured more money into the country, but the gold rush has now come to an end. January and February of this year show a 9.5% decline in foreign direct investment from last year, raising the possibility that in 1999, for the first time in this decade, investment in China from outside may fall. Indeed, Beijing officials are now saying that direct foreign investment may slump to $15 billion from last year’s high of $45 billion.

For a long time there’s been a myth that a global consumer company couldn’t afford not to be in China; but as the losses mount many Western companies’ boards are asking if they can afford to be in China at all. Those who rushed to be “first to the honeypot” have not found that establishing a brand has won them the riches that it earlier promised; in China as in other markets brand loyalty is fluid.

Indeed, several western businesses have pulled out of China recently: the Royal Bank of Canada, Southwestern Bell, Marks & Spencer, and Fosters of Australia. Many new projects have been put on hold. The hype about a market with hundreds of millions of eager consumers has encountered the reality that perhaps only millions want certain western products. Many companies have begun to regard China much as they regard any other country opportunity, as one with risks that might well not pay off. They’ve learnt that not all joint ventures work, and that all too many local partners may not be experienced in industries new to the country.

These pioneers didn’t reckon, either, with the intensity of the local competition, nor with the government’s “buy China” policies for many industries. While China has made repeated promises not to devalue its currency, it’s hard to see how the national government can fail to devalue with all the Asian regional pressures on its value, and that prospect, too, has made foreigners cautious.

Without foreign investment, not as many Chinese jobs will be created, which naturally will have an impact on the Gross National Product. In addition, without a positive attitude toward Chinese investment those in our investment and political circles will lean more toward the containment of China rather than engagement with it. It’s a shame Clinton didn’t make the WTO deal with China on Prime Minister Zhu Rongji’s visit to the U. S., as it would have done much to rebuilt the confidence of the foreign investment community toward China.

While many foreigners who have invested in China may have lost money through ill-conceived investments, you’d never believe it by the bustling economic activity we observed on our cross-China journey. For a long, long time I’ve been enthusiastic about China’s prospects. For many years I’ve urged my friends to teach their children Chinese, as I believe the 21st century will be as much China’s as the 19th century was Britain’s and the 20th century was America’s. For all these years I’ve been waiting patiently for the hibernating dragon to awaken.

Well, here at the end of the century and the beginning of a new millennium the huge dragon—slightly smaller in land mass than the United States but with more than four times our population—has awakened. To prepare for the right moment, which could be as early as this fall, I’m compiling a shopping list of those Chinese companies in which I will invest. I’m leaving off the inefficient holdovers from communist days, those giant labor-intensive companies that will never show a profit and whose going public was only a way of getting them off the government’s hands. As examples, I’m looking at a land company with huge holdings in raw land in the new part of Shanghai, a tire and rubber company, an appliance company, and a glass company. Nothing high-tech here, but well-established companies in basic industries that will meet the emerging Chinese middle-class desire for a better life. Tire and rubber may seem hum-drum to those whose portfolios are filled with Amazon.com and AOL, but when you’ve traveled across the breadth of China today and encountered thousands upon thousands of rubber-tired vehicles—cars, motorcycles, and trucks—the Chinese now employ, you come to believe that rubber mountains of tires will be sold.

My visits to the stock exchange and the brokerages taught me several interesting things. Everybody in the stock-market business here is young, including the president of the stock exchange. This is a new business, one that didn’t exist 10 to 15 years ago, and the people in it are like those in software and the internet in America—no one is over 35. They are full of the get-up and go of youth, too, eagerly accepting challenges and long hours.

I’m not actually buying any stocks yet, simply mapping out my strategy. I’m watching and waiting for the Chinese to work out their two major problems. Their currency is not yet convertible, which will keep foreign investors from plunging in again. Once the currency issue is resolved, the artificial division between the A- and the B-shares—which if it were dissolved today would give Chinese citizens a way of sending money out of the country—should also come to be resolved.

However, the most telling piece of information I’ve learned here is that the government is trying to make the ownership of stock shares more attractive to its citizens. Over the decades of my investing life, I’ve seen it over and over: When a government creates incentives—real incentives—for people to buy stocks, they always go up. It’s particularly exciting when, as here, there’s a high savings rate, and the banks are loaded with cash. The banks have grown cautious recently and won’t lend, so that these savings are trapped in the banks. If China’s citizens are genuinely encouraged to take their money out of the banks and buy equities, the market will soar. This could happen as early as this summer, but it might take until the end of the year for all this to occur. Remember, too, that these are only two small exchanges with no more than 500 stocks—and that the local population is 1.2-billion Chinese!

So, I’m waiting for the Chinese to allow its currency to float against other currencies and for stock-market incentives that are rumored to come to become real. One or both should happen this year.

And how might an American investor take advantage of these opportunities?

An approach I’m exploring is investing in companies domiciled in overseas Chinese communities such as Bangkok, Singapore, Vancouver, etc. that do business in China or with the Chinese. The Chinese consider the overseas Chinese almost the same as themselves, giving those outside the country a leg up on other nationalities. Find a few of these companies in which to invest and the alert investor will have found an entry point into the Chinese market.

How else to invest? In addition to various Asian mutual funds, I’m reminded of what John Templeton did in 1942. The stock market in New York was depressed because of the Great Depression and World War II. With a modest amount of money Templeton bought 100 shares of each of the stocks on the New York Stock Exchange that were selling for less than $1.00. He held on to them for a good long while, and although some of these companies didn’t survive, he had bought the vast bulk so cheaply that he made a fortune.

Today many Chinese B-shares sell on the New York Stock Exchange as ADRs for small sums. A similar strategy might be to buy all these stocks and hold them through thick and thin. In five, ten, fifteen years there’s an excellent chance that this will be one of the best investments an investor will ever make.