Financial Markets » China

Satyajit Das : Back to the Future

mano — Mon, 23 Nov 2009 11:56:21 +0000

A global market perspective that I agree with . . .

November 23, 2009

The Future That Was

China’s economic model is reminiscent of 17^thcentury mercantilist policies. Thomas Mun, a Director of the East India Company, in England’s Treasure by Foreign Trade (1664), wrote that the purpose of trade was to export more than you imported. At the same time, a country should amass foreign ‘Treasure’ that would be the basis of acquiring foreign colonies to allow control of essential natural resources. The strategy required reducing domestic consumption and imports and export of goods manufactured with imported foreign raw materials. China’s strategy coincides almost entirely with Mun’s views.

China’s mercantilist strategies have important implications for other developing countries. Chinese investment in and trade with Latin America and Africa is concentrated on securing access to resources forcing these nations to specialise in commodities. This reversion to a 19^th century trend may not be compatible with Latin American and African long term development and stability.

The Chinese economic model may be unsustainable. It relies on global trade and investment (much of it export related), which together contribute a high proportion of China’s GDP. This trade entails importing foreign components that are then reassembled and then exported. Domestic consumption has been kept low. Treasure has been built up in the form of domestic savings and trade surpluses.

Recently, China announced that its $2 trillion treasure would be used to make foreign acquisitions to secure exclusive access to raw material. The problem is that China’s treasure is already invested in assets of dubious value and limited liquidity to finance global consumption.

Chinese Premier Wen Jiabao warned that the Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable“. That was two years ago! Currently, China may be aggravating the problems by massive liquidity-driven stimulus to perpetuate a failed strategy. Speaking at the meeting of the World Economic Forum in Dalian on 10 September 2009, the Chinese Premier Wen Jiabao repeated his message from two years ago without signalling any change in direction: “China’s economic rebound is unstable, unbalanced and not yet solid. We cannot and will not change the direction of our policies when the conditions aren’t appropriate.“

There is broad agreement that a key component of the GFC was the problem of global capital imbalances. A central feature was debt-funded consumption by the U.S. that allowed 5% of the global population to constitute 25% of its GDP, 15% of consumption and 48% of global current account deficit. Japan, China, Germany and the other savers funded the consumption.

Any lasting solution to the GFC requires this imbalance to be dealt with. The glib solution requires the U.S. to save more and consume less and the savers to save less and consume more. The problems in implementing the solution are considerable. Timothy Geithner’s recent discussion with Chinese officials, to assure his hosts of the safety of their investments in dollars and U.S. Treasury Bonds, reveals the dilemma.

On the one hand, America needs the Chinese to continue and increase their purchase of U.S. Government debt to finance its fiscal stimulus and bailouts. On the other hand, America needs China to cut the size of its current account surplus, boost government spending, encourage personal consumption and reduce savings. All this should also occur ideally without any major decline in the value of the dollar or U.S. Treasury bonds or the need for China to liberalise it currency and allow internationalisation of the Renminbi.

A cursory look at the respective economies also highlights the magnitude of the task. Consumption’s contribution to GDP in the U.S. is 71% while in China it is 37%. Given that the GDP of China is around $4-5 trillion versus $15 trillion for the U.S. and average income in China is around 10-15% of U.S. earnings, the difficulty of using Chinese consumption to drive the global economy becomes apparent.

During the last quarter of century, Chinese savings have risen and exports have been the engine for growth. Given that a significant portion of exports is driven ultimately by American and European buyers, lower global growth and declining consumption creates significant challenges for China.

Dealing with the global imbalance has not been a high priority in the various summits global leaders have shuttled to and from.

In March 2009 in advance of schedule G-20 meeting, the Chinese central bank proposed replacing the US dollar as the international reserve currency with a new global system controlled by the International Monetary Fund. In an essay posted on the Peoples’ Bank of China’s website, Zhou Xiaochuan, the central bank’s governor, argued that creating a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies“. Mr. Zhou wrote: “The outbreak of the [current] crisis and its slipover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”

The US predictably dismissed the proposal. The Wall Street Journal argued that: “For all its faults, the dollar is attractive as a reserve currency because it is the common language of global finance and trade. In other words, its appeal is proportionate to how many other market players use it. For decades, the dollar has been a convenient medium of exchange for everyone from a central bank seeking to buy US Treasury bonds to a business exporting commodities from Latin America to Asia.” The unstated reason was the loss of the ability to finance itself in its own currency would significantly disadvantage the US.

In July 2009, at the G8 Summit in the earthquake damaged town of L’Aquila in Italy, Dai Bingguo, Chinese state councillor, was again openly critical of the dominant role of the U.S. dollar as a global reserve currency: “We should have a better system for reserve currency issuance and regulation, so that we can maintain relative stability of major reserve currencies exchange rates and promote a diversified and rational international reserve currency system,”

Western leaders expressed concerns about even raising the issue fearing that discussion of long-term currency issues could undermine the nascent recovery in markets and economies. Gordon Brown, Britain’s prime minister, spoke on behalf of the West: “We don’t want to give the impression that big change is around the corner and the present arrangements will be destabilised.” The West it seems was heeding Deng Xiaoping’s advice to: “Keep a cool head and maintain a low profile. Never take the lead – but aim to do something big.“

In September 2009, the Americans and Europeans proposed an effort to tackle global economic imbalances at the G20 summit in Pittsburgh. Against a background of rising trade tensions, China’s ambassador to the U.S. Zhou Wenzhong expressed scepticism about the proposals, seeking focus instead on avoiding protectionism.

Still heavily reliant on exports, China was wary of a global push on imbalances that would focus of its large trade surplus (which reached nearly 10 per cent of GDP in 2008). Zhou pointedly blamed the crisis on “the lack of supervision and abuse of the openness of the market, very risky levels of leverage and too much speculation.” He proposed improving global financial supervision, strengthen bank capital and create global early warning systems to identify threats but resisted action to address the imbalance.

Ironically, recent modest improvements in the global economy potentially risked increasing the same imbalances that were one of the factors that caused the current financial crisis. China’s and the world’s economic future requires resolving fundamental global imbalances that lie at the heart of the GFC.

Turning Japanese

China’s problems, to a degree, mirror earlier problems of Japan, its neighbour and competitor for global influence.

Japan’s export driven model successfully generated strong growth of 10% average in the 1960s, 5% in the 1970s and 4% in the 1980s. This growth was driven by a number of factors, including an artificially low exchange Yen rate.

On 22 September 1985, Japan, the U.S., the U. K., Germany and France signed the Plaza Accord agreeing to depreciate the dollar in relation to the Japanese Yen and German Deutsche Mark by intervention in currency markets. The Accord had limited success in reducing the U.S. trade deficit or helping the American economy out of recession.

The Plaza Accord signalled Japan’s emergence as an important participant in the international monetary system and global economy. The effects on the Japanese economy were disastrous.

The stronger Yen triggered a recession in Japan’s export-dependent economy. In an effort to restart the economy, Japan pursued expansionary monetary policies that led to the Japanese asset price bubble that collapsed in 1989. Economic growth fell sharply and Japan entered an extended period of lower growth and recession, generally referred to as ‘The Lost Decade’.

In the 1990s, Japan ran massive budget deficits to finance large public works programs in a largely unsuccessful attempt to stimulate growth to end the economy’s stagnation. Only structural reforms in the late 1990’s and early 2000’s restored modest rates of growth. Japan’s public debt is now approaching 200% of Japan’s GDP.

Significant shifts in economic strategy are now necessary. Chinese President Hu Jintao recently noted: “From a long-term perspective, it is necessary to change those models of economic growth that are not sustainable and to address the underlying problems in member economies.”

China can try to continue its existing economic strategy, which looks increasingly difficult. Changing its economic model is also difficult if it means a slower rate of growth. China’s challenge will be to learn from and avoid the problems and fate of Japan.

History and cultural issues compound China’s dilemma. The 1842 Treaty of Nanking entered into at the end of the first Opium War awarded Britain war reparations, eliminated the Chinese Hong monopoly, set Chinese exports and imports at a low rate, provided British access to several Chinese ports and transferred Hong Kong to the English. The humiliation of the Treaty is deeply etched into China’s dealing with the West.

China should have heeded the warning of Kang His, emperor of China, on the British presence at Canton in 1717: “There is cause for apprehension lest in centuries or millennia to come China may be endangered by collision with the nations of the West.”

The trade-off between economic and political liberalisation may also be problematic. As Fang Li, a renowned astro-physicist often called China’s Andrei Sakharov, remarks in dissident author Ma Jian’s novel about China “Beijing Coma”: “Without a democratic political system in place, [China’s] economy will eventually flounder. The people’s wealth will be eaten up by the corrupt institutions of this one party state.”

There is an apocryphal story about a visiting world leader drawing back the current of his hotel room to be stunned by the futuristic skyline of Shanghai’s Pudong Financial District. “How long has this being going on?” He asked. Today, the question might be: “How long can this go on?”

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

USA-China flowchart : Neat !

mano — Tue, 26 May 2009 22:44:00 +0000

Double-click on chart to get a better picture.

China cements role as top creditor to US: Treasury

mano — Thu, 19 Mar 2009 17:56:56 +0000

The USA owes China $740B and the USA continues to beg China ad Japan buy more bonds in the next several years while we spend like a profligate drunkard.

Like Chavez (cash has run out), who is telling creditors that he will give them useless paper (like we do bonds) or turn on the printing presses and debase the US Dollar.

“We have lent huge amounts of money to the United States. Of course we are concerned about the safety of our assets.” - Chinese Premier Wen Jiabao

If you were a banker, would you lend more the USA ?

Why the Coke-Huiyuan Deal Failed

mano — Thu, 19 Mar 2009 12:33:34 +0000

Excellent review : economics, marketing, politics

Seven Reasons Why the Coke-Huiyuan Deal Failed

March 19, 2009

David Wolf

Just after the Ministry of Commerce announced that it had rejected Coca-Cola’s (KO) bid for Chinese juice-maker Huiyuan, I got a message from a very astute friend of mine who noted “that deal was dead the minute it made the headlines in the South China Morning Post.”

We are going to hear a lot of hindsight-laden “I knew it was going to be rejected” statements in the coming days. So let me start by stating for the record that this will at first sound like one of those posts, but what I really want to do is explore (with the full benefit of hindsight) why this deal may have been killed, in the fervent hope we can learn something at Coke’s expense.

It Sounded Like a Hard Sell at the Time

A momentary slide into the “I told you so” zone.

Not long after this deal was announced, I noted that this was going to be a rough sell for Coke in Beijing. Apart from the threat of the deal falling afoul of China’s shiny, new, and not-yet-tested anti-monopoly law, I said that Beijing has over the years actually made its current policy on FDI rather clear. Looking at that policy, it was fairly clear that the deal would have a difficult time passing muster with the government. and that Beijing might relish an opportunity to say “no.”

Rather than suggesting the deal was DOA, however, I noted that Coke had best kick a communications program into gear to start building support for the deal, because doing so would be their only hope in getting past the barriers they faced.

Whether this deal succeeds, then, has less to do with its considerable business merits or with the law itself. It has much more to do with how well Coke handles the government debates and public discussion on the deal’s merit.

Hopefully, Coke has learned from Carlyle’s experience, and has prepared a case that will convince the nation’s leaders to make an exception to policy and will gain the support of consumers and influential public voices in China.

Coke, in short, needed to manage the public debate, because regardless of the reason given by the Ministry of Commerce for rejecting the deal, there was actually a lot more stacked against Coke in its bid for Huiyuan. I count at least seven.

Reason One: One Man’s Market Leadership…

The first reason is the one the government gave, that the deal would violate the spirit of section 23 of the Anti-Monopoly Law, which is appears to be designed to ensure that a single player does not become so dominant as to be able to dictate market terms. As the Ministry of Commerce noted, their concern was that the deal would hurt small local players, drive up the consumer price of juice, and limited consumer choices.

Market share figures are painful to discern in most markets, and in China, where data flows like concrete doesn’t, the numbers are much harder to pin down. As best as we can tell, Huiyuan as market leader holds a bit over a third and possibly as much as 42% of China’s estimated $10 billion market in juices and nectars. That’s a pretty dominant position in a fragmented market.

Coke, for its part, is number two with about 10% of the market. If we use those figures, Coke would have owned somewhere around half of an otherwise fragmented $10 billion market. Does this count as a “monopoly” in the classic economic sense? Probably not.

But without other strong players to act as a counter (if Coke was #2 with 9.7%, the next biggest player would have held much less than 10%), you can see that the government was concerned about allowing the creation of a company that would have the brand, manufacturing, and distribution muscle to dictate market terms.

Would that concern have been enough by itself to derail the deal? Maybe. But there were other factors involved as well.

Reason Two: Not Our Kind of FDI

China’s foreign direct investment policy since the country began its “reform and opening” process three decades ago has been to create laws and administrative regulations to channel the investment into the sectors and vehicles where China needed it most. The policy has not changed, but the means of the channeling – and the government’s general attitude toward FDI – have.

As Steve Dickinson of Harris & Moure noted in an article unrelated to the deal a week before it was announced, the policy may be implicit, but it is clear:

Foreigners are free to invest in China through WFOEs [wholly-foreign-owned enterprises] or JVs [joint ventures] in the areas of investment classified as permitted or encouraged in the current Catalog for Guiding Foreign Investment.

Foreigners are permitted to purchase small established Chinese companies where the government is too busy to be concerned with management of the small company

Foreigners are permitted to purchase large established Chinese companies suffering from financial problems, provided the foreign purchaser will restructure the company and assume the company’s obligations to workers and creditors.

Foreigners are permitted to acquire a minority interest in large and successful Chinese companies, provided such investment will provide collateral benefits in the form of technology transfer or access to new markets.

Foreigners are not permitted under any circumstances to purchase a majority interest in a large and successful established Chinese company.

I can’t speak to the first issue, but it seems fairly clear that the Coke-Huiyuan deal failed to qualify under the other four.

This might have actually been the deal-killer, but since none of this is written down anyplace, it was easier to cite the Anti-Monopoly law.

But wait. There’s more.

Reason Three: Hands Off the Brands, Boys

An unwritten goal of China’s industrial policy is the creation of leading brands that will not only lead to a healthy, stable market at home, but also form the basis of a bevy of global Chinese brands. Even though candidates arise from time to time, China’s enterprises are still in the early stages of creating international markets.

Huiyuan, however, was a better-than-average candidate, with a leading position at home, smart marketing, and a brand that consumers associated with quality and purity. To have a potential champion gobbled up by a foreign company before it even had a chance to go abroad was probably too much for China’s leaders to stomach.

Which is probably the reasoning underlying China’s restriction on purchasing a majority interest in a “large and successful established” Chinese company.

Reason Four: What We Have Here is a Failure to Communicate

As my former colleague and frequent lunch companion Imagethief noted, public sentiment was probably not too terribly in favor of the deal to begin with, and things went from bad to worse as allegations came out that Coke’s people were trying to quash criticism of the deal.

A core rule of public relations is that you don’t try to stop journalists or others from trying to criticize your company because that effort then becomes a story, and you lose all credibility. Now, this rule is often ignored in China, in particular by Chinese companies, who use all kinds of creative and interesting tactics ranging from calling the government, to placing (or withholding) advertising dollars, to outright paying the reporter in order to try to keep negative stories about their company out of the press. Some foreign firms, sadly, have decided that the best thing to do in Rome is wear a toga, and so have picked up the practice.

Whether or not Coke actually did any of these things is not the point – the perception is that they did. That perception was built atop public sentiment that appeared to be skewing neutral to negative on an issue where what Coke needed was widespread support.

Coke failed to realize that it is now a truism that foreign companies cannot hope to successfully test the limits of government policy unless that effort appears to have widespread support – not just among China’s elites, but increasingly among the broader public as well.

Few companies will remember that, I’m sure, but the wiser heads among M&A advisors – investment banks, attorneys, and accountants – will realize they need to make room at the table for someone who understands how to win in the court of public opinion.

Reason Five: Morning After Syndrome

Speculation has been rampant of late that Coke may well have been looking for a way out of the Huiyuan deal long before it was dealt its regulatory death blow. Coke, for its part, denied the rumors, and we may never know the truth.

But less than two weeks after the announcement, the U.S. government decided not to rescue the beleaguered Lehman brothers, setting off a chain of events that immediately altered the priorities of companies around the world. Certainly if I were sitting at Coke headquarters in Atlanta, I’d be worried about whether I could afford to part with $2.4 billion in cash right as world credit markets were drying up and consumers were rethinking their spending habits.

Even if Coke lost a little of its ardor for the deal, that might have been enough for the company to give less than its full effort in trying to gain approval.

Or, indeed, it might have been enough for the company to become completely ambivalent about it. Given the challenges they faced, that might have been enough to weaken Coke’s chances.

Reason Six: Kindergarten Dynamics

There is a school of thought that Coke’s bid was sabotaged before it happened, not by either company or the Chinese government, but by the U.S. government when it blocked the acquisition of Unocal by CNOOC (CEO), or when it blocked the purchase of 3Com (COMS) by a group led by Huawei. The belief is that this rejection was a tit-for-tat, China treating a U.S. company in a manner to which Chinese companies have become accustomed in America.

This is not unlikely. China is a big fan of reciprocal behavior in its international relations, even raising visa charges for citizens of countries that have raised the cost of a visa for Chinese travelers.

Certainly there must have been a bit of that sentiment in the smoky room in Beijing where this matter was decided. How much of a role it played we will never know.

Reason Seven: The Global FDI Problem

Last June the Council on Foreign Relations published a special report, Global FDI Policy: Correcting a Protectionist Drift, in which the authors quantify a decided chill in the past several years by a number of countries toward foreign direct investment. While the authors (a Carlyle executive and a distinguished academic) might well have turned the report into a China-spank, the report is remarkably data-focused and even handed.

What they quantified – before the world lurched into its current state – was a decided tendency by nearly all of the world’s major polities to restrict foreign direct investment. The biggest culprit in the report was the United States, but the authors note that there is evidence of this trend worldwide.

The problem is that unlike trade, there is no global policy protocol around cross-border direct investment and acquisitions, kind of like the situation we had with international trade prior to World War II. And frankly, this is no time for countries to be turning off the tap, especially (as the authors note) local affiliates of foreign firms on average deliver greater economic benefit to host countries than local firms.

The Coke-Huiyuan deal was taking place in an global FDI policy environment that is starting to sour, and may come to be emblematic of the need to raise the matter of FDI to a global intergovernmental level – once the banks are sorted out, of course.

The lesson here is that the problem of FDI policy to an extent transcends Coke, Huiyuan, China, and the United States, and that those issues probably played some role here.

Making it Better

The above list is by no means balanced in terms of the relative importance of the factors, and it is by no means complete. Taken together, though, they underscore that Coke had to climb a cliff on this deal, and they will not be the last who face such a political escarpment.

But as China extends its policy fence around those companies and industries it wants to keep in Chinese hands, there are some lessons to be drawn from the above.

1. We need to begin with a clearer idea for how China defines a “monopoly,” so that we either avoid deals that test that definition, or we recognize the risk and seek to mitigate it intelligently yet aggressively. That definition will change on a case-by-case basis, based on the industry, the intended target, the buyer, and who is asking the questions.
2. The FDI policies that matter may not be written down, but they exist, they evolve, and they are ignored at one’s peril.
3. Healthy companies that may one day become global Chinese brands are not good targets. Sickly companies that could blossom under better management, with capital injections, and with a global owner are much safer. Of course, they bring their own problems, but China’s government wants value-add from foreign investors, not just a fat check.
4. Any acquisition of a local firm by a foreign company demands a communications effort directed at both the general public and the policy making elite that makes a logical, intelligent, and sensitive case for the purchase. The bigger the buy, the better you need to be at the communications.
5. Don’t ever let up or appear to hesitate.
6. International relations matter in business, and especially with M&A. Companies need to lobby their home governments to be as open with FDI as they are with trade, because the alternative is a deteriorating global FDI environment with companies caught in the middle.
A Final Note

As I said in my September post, I am no fan of mergers and acquisitions. I think they burn management attention and corporate capital, they are often used as a substitute for innovative strategy, and they rarely deliver the benefits promised. But I also recognize I am spitting in the wind – there is going to be a lot more of this activity in the coming years, particularly as Chinese companies step abroad.

The best we can do is work to reduce the friction of the process. As more about these events comes to light in the coming weeks, It is incumbent on those of us whose work touches M&A in China to learn whatever lessons we can. The next one will probably not be any easier.

China and US Treasury Bonds

mano — Sun, 23 Nov 2008 14:22:55 +0000

China and Japan continue to be the largest investors in US assets.

US treasury bonds ‘still the best option’

By Xin Zhiming (China Daily)
Updated: 2008-11-20 09:46

China is likely to continue increasing holdings of US treasury bonds even after becoming the No 1 holder because it is the best way to deploy its $1.9 trillion foreign exchange reserves, economists say.

On Monday, US Treasury data showed that China had replaced Japan to become the top holder of US treasury debt in September.

With a $43.6 billion increase in holdings of US treasury securities in September, China’s overall holdings amounted to $585 billion. Japan cut its holdings to $573 billion from $586 billion in August.

Net foreign purchases of long-term US securities totaled $66.2 billion in September, up from $21 billion in August and $18.4 billion in July.

Treasury data suggests that foreign investors still regard the US as a relatively better place to invest when markets worldwide are crumbling, analysts said.

“That’s why China has increased its holdings,” said Dong Yuping, senior economist at the Institute of Finance and Banking affiliated to the Chinese Academy of Social Sciences.

As the US financial crisis worsens, Washington is in dire need of capital to fund its massive market rescue plan; but some domestic economists argue that China should not use its foreign exchange reserves to purchase US bonds for fear that it may incur huge losses.

“But China may not have many options,” Dong said.

The US economy, though hemorrhaging from the crisis, remains the largest and strongest; and the EU and Japan are not yet a serious challenge to US pre-eminence. Investment in dollar assets, therefore, carries the least risk, he said.

If China reduces its holdings of US debt, others may follow suit, which will lead to a weakening of the dollar and depreciation of dollar-denominated assets, thus severely hurting China’s interests.

“China and the US are in the same boat,” he said.

“You may not like it, but China has to move along this path,” said Yan Qifa, senior economist with the Export-Import Bank of China.

And now that many countries are increasing holdings of US treasury bonds, China’s potential returns from the bonds will increase, said Chen Gong, chief economist and chairman of Anbound Group, a Beijing-based consulting firm.

“So China may continue to increase its holdings,” he said.

However, some experts argue that Beijing use its considerable financial leverage to set conditions such as the US opening its financial markets more to Chinese funds, and allowing exports of high-tech products to China.