Back Soon!

Hello, everyone!

The last month has been a busy one for both myself and my company. My firm China Monitor is releasing a batch of quarterly industrial analysis reports in about 5 weeks, and I will have to temporarily pause the production of China Pulse in order to help my team meet our deadlines.

Thank all of you for your continued support, and all of your terrific emails! I appreciate all of your suggestions for article ideas, and will resume research as soon as my schedule permits. Please send me an email if you have any questions or ideas, and I will write back ASAP.

My email: christopher.d.lowder@gmail.com

Best,
Chris

Ministry of Rail Apologizes to 235 Million (1-13-2012)

 What an absolute mess. The Ministry of Rail has issued its “first apology of 2012” after a failed attempt at online train ticket sales that discriminated against China’s lower classes. Transition to new ticketing systems will be pushed to 2013

March of the Penguins

3.158 billion passengers will trek across China in the forty days between January 11 and February 21. Not different people, obviously, as the transit systems double and triple count individuals making return trips and layovers. Even so, the end result is still the same; over the next five weeks, China’s infrastructure will have to absorb a little less than half the world’s population in commuters as students and workers go home for the holidays. Spring Festival is unquestionably the largest mass migration of human beings on the planet, and the government has to handle this phenomenon every single year in the dead of winter when travel conditions are at their worst.

According to announcements from the NDRC, Ministry of Transport, Ministry of Rail, and other relevant ministries (see full article in Chinese here), China’s 3.158 billion commuters will be distributed in the following ways:

• 2.845 billion will drive (71.13 million per day)
• 235 million will take the train (5.88 million per day)
• 45.5 million will travel by boat (1.14 million per day)
• 24 million will fly home (0.6 million per day)

Rail is the obvious option for those headed inland who can’t afford a plane ticket. Even if all of China’s lower classes had access to automobiles, who would ever want to drive 1,130 miles of traffic from Beijing back to Sichuan when they can just sleep on the train? The 2.845 billion car trips this winter won’t be made by motor enthusiasts. They will be made by people who simply couldn’t get one of China’s precious few train tickets.  

Thousand of workers queue in vain for a train ticket home

Angry and Empty-Handed

Spring Festival train tickets are a precious commodity in China, and so like iPads or access to the Shanghai World Expo, Chinese people will spend days lining up for them. The catch is that train tickets are only available from certain designated kiosks located throughout the city, and can only be purchased up to five days before your trip. Supply is extremely limited, and so tickets generally sell out within the first hour of being on sale. You don’t have to be a master of game theory to predict that every year China will see a longer line of angry, cold, and tired citizens lining up at these ticket windows with hopes of getting a seat on the country's increasingly bottlenecked train system.

China plans to dramatically boost consumption by increasing urbanization to 51.5% by 2015. This means that over the next four years, an additional 53.6 million Chinese citizens will move from rural to urban areas. Many of those relocating will be migrant workers, looking to build infrastructure in China’s burgeoning cities in exchange for some money to send back home. Without roots in the city, though, Chinese culture dictates that these people all return home each winter to spend a few weeks with their families. Unless they have access to a car and a driver's license, the majority of these workers will lining up for a train ticket.

Don’t expect the supply-demand gap to improve. As of Q3 2011, the Ministry of Rail (MoR) was RMB 2.1 trillion in debt, making their debt ratio about 60%, up 7 percentage points from 2009.  In early November, the government granted the MoR an additional RMB 250 billion in credit, of which RMB 140 billion was needed to make “emergency” late payments to rail workers. The workers were mostly billing for work done on China’s high-speed rail projects, over 70% of which have been suspended this year following a series of crashes and scandals that shook the nation and embarrassed the Ministry.

Fumbled Reform

The Chinese government realizes that with no hopes of closing the passenger rail supply gap, each year will see a larger mob of cold, frustrated workers disappointed at the news that they again won’t be able to go home to their families for the culture’s most significant holiday. In their frustration, the mob will turn their anger towards the Chinese government, or more specifically the MoR – the government body that monopolizes all of China’s railways.

If you can’t prevent the frustration, then at least prevent the mob. The government’s solution to the train ticket problem in 2012 was to pull most of the tickets from China’s traditional kiosks and sell them instead through a new online platform www.12306.cn. Tickets were linked to passengers’ personal identification number, which prevented people from buying bulk tickets and scalping them at stations for inflated prices. Guards were put in place at stations to ensure that ticket numbers matched the numbers on passengers ID cards. The new rules were broadcasted both online and over television news channels to make sure everyone got the message.

In their planning, the government seems to have overlooked the fact that the proportion of migrant workers to residents in the first-tier cities of Beijing, Shanghai and Guangzhou is more than 3:10. In Shenzhen, it is more than 7:10. Migrant workers live on bunk beds in dormitories. They don’t watch the news every day and they certainly don’t have internet access. They miss their homes, they miss their wives, and they have been looking forward to this train ride for the last 11 months.

Server Error

Predictably, migrant workers missed the memo. Many queued overnight in the freezing cold only to be turned away for not bringing their personal ID cards to the ticket window. Even the few who knew to bring proper documentation found themselves frustrated that most tickets were only available online, not at physical kiosks. Others found their way to public computers, but were unable to complete transactions without credit cards or online bank accounts.

To make matters worse, the government low-balled their servers after drastically underestimating consumer traffic. Users continually refreshed merchant pages hoping to be the first in line to buy tickets, netting a jaw-dropping 1.4 billion hits for the site in a 24-hour period on January 9. Broadband internet in China is already 1/10 the speed of that in the U.S., and so the equivalent of 20% of the world population logging onto the same site in just 24 hours caused more than a few problems.

Image of 12306.cn, down for repairs

What users didn’t know when angrily logging on and off of the frozen ticket website was that the system is built to lock users out after three unsuccessful attempts at purchasing tickets in a 24-hour period. As the day wore on and servers stabilized, the remaining patient few found themselves barred from finishing their transactions.

An Unsatisfying Punt

The MoR has acknowledged defeat for 2012, pushing major reforms to 2013. 12306.cn is still in use, but train tickets have been largely reallocated back to traditional sales kiosks. Train tickets will remain linked to passenger ID numbers, making this the one point of reform that will stick this season. Laborers caught in ticket lines without their ID cards will just have to come back next week and line up with the proper documentation and an extra blanket.

The announced plan for 2013 is to have a series of regional online ticket vendors, to replace its plan of funneling the entire nation onto a single website. This will take pressure off of the government servers and hopefully give citizens a 12-month window to set up online bank accounts and master the e-commerce learning curve. The problem still stands that if the government doesn’t find an effective way to alert migrant workers to new changes, the net effect will be trading one large national problem for a series of regional ones.

Chinese citizens are calling the Ministry’s statements their “first apology of 2012,” reflecting a growing bitter sentiment among the masses. Both on the street and online, Chinese are openly wondering why an unprofitable, corrupt, and inefficient government ministry continues to enjoy a monopoly over the nation’s railways. Over the last 12 months, the MoR has been faced with disastrous PR and a skyrocketing debt ratio. If the MoR isn't careful, their current minister may not last any longer than his predecessor.

 "If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

稳中求进 - The Phrase to Know in 2012 (1-6-2012)

2011 has concluded with China’s annual Central Economic Work Conference, which has set the rhetoric that will shape the decisions of 2012. Not surprisingly, the emphasis for next year will be to shore up and seek stability in a treacherous world economy. Expect conservative-leaning policies from a China looking to shield itself from overseas shocks while still squeezing out just enough growth to keep people employed and happy at home. Political terms are ending later this year, and so we may have to wait until at least November to see long-awaited financial reforms.

The Phrase to Know in 2012

In his interview earlier this week with Caixin Media, People’s Bank director general Zhou Xiaochuan made reference to the Chinese government’s new goal to “seek progress through stability.” What does this phrase mean? I agree that this phrase sounds vague and meaningless by itself. The trick with this and any other party rhetoric is to read between the lines. In the right context, these government phrases take on a potent meaning and reveal much about the communist party’s confidence in the domestic and world economies.  

The phrase “稳中求进” (wen zhong qiu jin) “seek progress through stability” was coined during December’s Central Economic Work Conference (CEWC). The work conference is one of China’s most influential economic summits in which the country’s leaders meet to decide the direction of economic policies for the following year. This piece of rhetoric is meant to become a recurring theme in 2012 government policy, and will be reflected in every decision made over the next 12 months. “Seek progress through stability” will be the phrase to know in 2012, and so it’s important that we stop to take a look at what it means.

f′(政策)

With all Chinese phrases, the devil is in the subtle details. I like to joke that the trick to understanding Chinese government rhetoric is to not read it at face value, but to analyze its first derivative. In other words, it’s really not about what the government is saying this week, but more about what they’re no longer saying, or what they’re just now saying for the first time.

In 2010, the CEWC concluded that the government’s 2011 goal would be to “pursue active, healthy, stable growth while remaining cautious and flexible” (积极稳健、审慎灵活). This sounds vague, but the phrase is a lot more than what meets the eye. Specifically, the order of the Chinese characters here tells a lot about government goals in 2011.

积极 - “Active” here means “we have room to overshoot the magic 8% minimum GDP growth needed for social stability.” “Stable” is a reference to controlling inflation. By putting these characters next to each other, the government is saying that they will shoot for more growth than the minimum, but will hit the brakes if inflation gets out of control.

稳 - Growth is further qualified as being “healthy.” The word “healthy” here isn’t directly talking about sustainability, but is rather referring to the structure of China’s economy. In years past, provinces would invest in fixed assets to create jobs and boost output regardless of whether or not these projects created redundancies in regional industrial economies. This “unhealthy” growth resulted in massive yet powerless sectors of the Chinese economy that are now overcapacity, unprofitable and internationally uncompetitive. Steel is a great example of this.

审慎灵活 - “Cautious and flexible” is making reference to the instability and unpredictability of the world economy. 2011 was the first year China enacted its 12^th 5-year plan (FYP). There is a risk with new major policies that government officials on a county level might follow them too literally to fulfill quotas and seek promotion. Political gain here comes at the expense of critical thinking and decision-making, and so in the event of an economic downturn officials might be stuck reading cookbooks while the oven is on fire.

Reassembled, the 2010-2011 government rhetoric can be understood as: “We would like to see GDP growth in 2011 to be higher than 9% while still taking measures to prevent inflation and overheating. Fiscal policy will be loose enough to spur growth, but investments will be purposeful and forward thinking. Having said that, we expect quick and drastic decisions if we start to see signs of a hard landing from our RMB 4 trillion stimulus package.” The beauty of Chinese government rhetoric is that you can condense all of that nuance into just eight characters.

2012 Rhetoric in Context

Now that we have established the 2011 rhetoric set by the 2010 CEWC, it is possible to do a YoY analysis on China’s new slogan for 2012. Reading the rhetoric, we immediately see that “积极” “active growth exceeding the minimum requirement of 8%” has been eliminated outright. Chinese officials are trenching for a hard year and no longer expect 2012 GDP growth to exceed 9%. In fact, the rhetoric has shifted from describing what kind of growth the government expects to no longer talking about growth at all.

稳中 - The emphasis in this year’s economic rhetoric is the character “稳” - “stability.” China is looking to avoid a hard landing at any cost, because economic instability means social instability, and social instability means political instability. In 2012, China will have to create enough jobs in urban areas to satisfy the joint demand of migrant laborers and new entries into the workforce. At the same time, too much gas can lead to a spike in CPI or a fresh investment bubble. In fact, they have taken the idea of stability a step further by making the primary goal “稳中” – “surround ourselves in stability.”

Political stability will be a major issue for China in 2012. The US election is sure to bring an unprecedented storm of anti-Chinese sentiment as politicians frame capital outflows to China as the reason for US. The reality that China is now losing manufacturing orders to India, Vietnam and Mexico will make little difference once campaign ads start to air. A flailing Eurozone will only add fuel to this fire as countries stop importing Chinese goods in favor of stimulating their own economies or in search of a cheaper deal from less developed countries. All the while, China will be making its own political transition in October from Hu Jintao’s administration to that of Xi Jinping. China doesn’t want an incident while everyone up top is shuffling offices.

The hunt for stability will also mean scaling back some of the more ambitious directives launched in the 12^th FYP. Goals to restructure and upgrade certain industries or launch major infrastructural projects may have to wait until the storm has passed and policymakers are comfortable enough to loose the necessary funds. 2012 will be a year of managing expectations.

求进 – Once the first goal of establishing firm and lasting stability has been accomplished, China will transition into its second 2012 goal of “seeking progress” “求进.” Some issues have to be tackled in 2012. Economic reform will be a major point of contention between political groups in China. Recently, neo-leftist circles in China have been attacking the privatization of industry and capitalistic trends initiated by Deng Xiaoping in the late 80’s. These groups have cited class separation, the corruption of officials, and the privatization of health care and education as the evils of capitalism. This debate will not result in a major reversal of economic policy, but it will determine whether state-owned enterprises or small-to-medium private enterprises will be granted more power as China’s economy continues to develop.

Financial reform will be on the table this week at China’s National Financial Work Conference. This conference is held once every five years, and will be taking place today and tomorrow, January 6-7. Issues up for discussion will be the creation of regulatory bodies for China’s bond markets and SOE asset management, as well as reforms aimed at weaning China away from knee-jerk financial controls and towards mid-term policies established scientifically through the careful and measured use of forecasting models.

Considering China’s upcoming political shifts, though, some issues may ultimately be punted into 2012. China will likely reach its goal of maintaining stability, but we may have to wait until next year’s CEWC for real talk of major reform.

 "If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

Policy Peep Show with Zhou Xiaochuan (1-3-12)

2012 will be a year of political transition for China. Hu Jintao's administration is coming to a close, and will be replaced by that of Xi Jinping in October. Likewise, local governments will also see a reshuffling of offices as new bureaucrats take charge of the Chinese economy. At the same time, 2012 promises to be a hard year for the global economy, and so the current set of leaders will have to battle domestic and international problems with one foot out the door. 

Chinese leaders face the joint pressures of slowing growth in emerging markets and instability in the US and Europe. At the same time, policymakers have to stimulate the economy just fast enough to create new urban jobs for migrant workers, but just slow enough to protect its citizens' wealth from inflation. The government has shifted its goals from aggressive economic restructuring to maintaining domestic stability. As a result, certain infrastructural projects may be delayed until 2013 when the global economy is (hopefully) more stable and China's new leaders have had a chance to settle behind their new desks.

Nowhere is this shift in tone more clear than in China’s most recent Central Economic Work Conference. The work conference is one of China’s most influential economic summits in which the country’s leaders meet to decide which direction economic policies will take in the following year. Taking a central role in the conference was Zhou Xiaochuan - Director of the People's Bank of China. 

Today, January 3, 2012, the Chinese business and economic magazine "Century Weekly" published an interview with Zhou (original Chinese text here). The interview touched on topics such as inflation; adjustments to monetary policy; a free-moving interest rate; how much room the exchange rate has to drift; the opening of capital accounts and the question of making the RMB an international currency - all of which are challenges that the new administration will have to tackle in the new year. I have translated the interview below:

12-31-11 Interview with Zhou Xiaochuan

Caixin Media "Century Weekly”: Looking back on 2011, there were a few changes to macro policy made to suit changes in the economy. The year started with tight macro controls that were later fine tuned, and then the Central Economic Work Conference (CEWC) announced in December the government's new platform of "seeking progress through stability." How do you see the economy changing in 2012, and what policies will be chosen to match these changes?

Zhou Xiaochuan: The CEWC has set explicit macro policies and has considered the issues of preventing downward economic trends and controlling inflation.   China faces a number of international issues including the European debt crisis, the uncertain state of the US economy, and slowing growth in emerging markets. If all of these issues intensify simultaneously, it will form a very negative environment outside of China. More importantly, the international economy is changing rapidly, and so China has to take some precautionary measures to guard against unstable growth abroad.

As for our domestic situation, China's local governments will be changing leaders as political terms end in 2012. China is still showing strong growth and has a lot of potential for further economic expansion. Commodity prices have taken a turn for the better, meaning that the issue of controlling inflation is not as pressing as it was in 2011. Of course, China also has its own points of instability. We haven't accumulated enough experience or data, for example, to know how recent real estate trends will impact the national economy.

In general, China needs to prepare for poor international economic conditions.  It must also continue to put pressure on overheated commodity prices while reasonably managing inflationary expectations. China also still has the formidable task of restructuring its own economy.  All of these issues still need to be addressed in our macro policies.

Caixin Media "Century Weekly": November data shows that CPI was only up 4.2% YoY for the month, which is a 1.3 percentage point decrease from October data and is also lower than the market's expectations. How do you view these changes in inflation?

Zhou Xiaochuan: The CEIC has reiterated that it wants to "maintain a steady level for commodity prices." This shows that our leaders are still worried about inflation.

China's goal for inflation for FY 2011 was around 4%, but they will be hard pressed to meet this goal. The final figure for the year will come in at around 5%. The second issue is more technical and has to do with monthly YoY data. This kind of data can give people false impressions, and so they need to do more work with the numbers before reaching conclusions. Since the financial crisis, data has been unstable, and this instability has caused a substantial base effect on YoY data. You need to account for the base effect on all monthly YoY data. On one hand, you can say that a shift from 5.5% to 4.2% means that efforts to control inflation have been successful so far. On the other hand, the CPI grew 1.1 percentage points between October and November 2010, creating a strong base effect. In order to push against inflation with the appropriate strength, you first need to have an accurate quantitative understanding of the situation. You cannot presume that numbers will fall again by 1.3 percentage points next month. I have always advocated the use of seasonally adjusted monthly data, as that kind of data is able to quickly reflect changes in the CPI. Anyway, we can see that we have had some success in controlling inflation and that things are moving in a positive direction, but we can't afford to suddenly drop our guard as a result.

Looking at the general trends of China's economic growth, we can see that China still has huge potential for urbanization. More people will move into cities, seeking to improve their livelihoods. This trend means that China still has a lot of room for major infrastructural projects nationwide, and it is up to the government to assume a role of leadership here. Government officials have a uniform desire to take care of their duties, take care of the economy, and build beautiful and comfortable cities. But this all takes money. It has been over 30 years since China opened its economy. During this time, there have been periods of deflation. During the Asian financial crisis, for example, we saw some negative growth in the CPI. Generally speaking, though, inflation has been a constant issue during these years. For this reason, it is easy for China's economy to exhibit hotter trends. Generally speaking, emerging markets tend to have a higher CPI than developed countries. This doesn't mean that China is currently facing risks of overheating, but it does mean that we can't let our guard down when it comes to inflation.

Caixin Media "Century Weekly": It's been two years and the CEWC is again taking precautions against economic downturn. Which macro policies will be readjusted?

Zhou Xiaochuan: Currency policies and financial stability policies need to be used to make adjustments in opposing ends of the economic cycle. For the most part, they have been incorporated into the framework of China's prudent macro policies.  The conventional wisdom is to make knee-jerk adjustments at alternating ends of the economic cycle. When the economy slows, hit the gas. When inflation rises, hit the brakes. The CEWC specifically made mention of the fact that macro controls need to be more forward thinking. We need to start with a reasonable forecast and make measured adjustments and fine-tune our policies ahead of time.

Sliding Iron (12-16-11)

A slump in China’s real estate, auto, rail and household appliance markets, coupled with a flailing Eurozone has led to very soft global demand for steel. All the while, global miners Rio Tinto, Vale and BHP have continued to ramp up production, which may mean a short-term glut in ore supply until demand catches back up. Traders will likely respond to the news by shorting global miners in the short term, but going long in 2020 when developing economies and the Eurozone recover. Expect more industry consolidation as smaller ore providers fail to weather the storm.

Mayan Predictions for Iron Ore

BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. Investors are nervous for good reason; China – the world’s leading producer of steel – is loosing steam. 2012 is going to be a very bad year for iron ore.

China is able to supply 40% of its iron ore needs with domestic reserves, but the rest needs to be imported. In importing the other 60%, China consumes about half of the traded world supply of iron ore each year. This colossal demand for red earth allows the country to generate about 46% of the world supply of crude steel - approx. 700 million tons for 2011. About half of this output is pumped directly into the construction of domestic infrastructure.

With the Eurozone in a tailspin and the US a sneeze away from sickness, the world is importing less Chinese steel. As a result, China will have to swallow unprecedented volumes of its own products with fixed asset investment in order to maintain growth necessary for China to stay above 8% GDP growth. China needs to see strong growth in the major downstream industries of construction, autos, rail, durable goods and machine tools if it stands a chance of offsetting losses from exports to plunging western peers.

Q4 data has revealed a downturn in China’s real estate market. Sales and prices have taken a plunge, resulting in halted construction projects and a significant drop in land auctions to real estate developers. A drop in land sales has meant a natural decrease in new construction projects and a subsequent decrease in steel demand from this sector.

The government’s goal is to have 10 million units of government assisted housing under construction by the end of 2011. Some analysts say that the investment coming from this project will offset the slump in demand from floundering commercialized properties. However, a significant portion of the steel used in these projects will come from China’s 14 million ton stockpile of excess steel. Indeed, soaking up this excess was one of the factors that motivated the creation of this policy in the first place. If we assume that each unit of government assisted housing is 50 square meters, and each square meter consumes 50 kilograms of reinforcing steel bars, then the 10 million units set to begin construction this year will generate a demand for 25 million tons of raw steel materials. If 14 million tons come from China’s excess stock, then there will only be new demand of 11 million tons, or less than 1.6% of the country’s annual production capacity.

When you run the numbers, you find that for every 1% decrease in the construction of China’s infrastructure, the global demand for internationally traded iron ore drops by about 0.7%. Of course, apartments that aren’t built don’t need to be furnished with ovens and refrigerators, and so softened investment in fixed assets today will translate to weakened demand for steel to build household appliances tomorrow. Less apartment buildings also means a weakened appetite for Japanese and South Korea specialty steel. China imports roughly 6% and 7% of these countries total crude steel output, respectively. The immediate impact of a 1% slowdown may only be -0.7%, but the long-term impacts are far more severe.

If less steel is going into housing, and less steel will be required for durable consumer goods, then that leaves autos and rail pick up the slack. According to the CISA, between 50 and 60% of the weight of a typical car is made up of steel and a further 12 to 15% comprises cast iron. In the years following the financial crisis, the Chinese government spurred industrial growth with a series of policies stimulating the purchase of autos. Sales reached a climax in January 2010, seeing numbers as extreme as 124% growth month-over-month. Consumers, knowing that the tax breaks were set to expire, made their 2011-2012 purchases in 2010. Once the party ended, the hangover set in; October is historically a strong month for the industry, but sales YoY sales were negative this year for the first time, ever. China’s auto industry is in a slump, and will not need new steel production capacities any time soon.

Rail isn’t doing any better. A high-speed rail crash on July 23 followed by a number of accidents and industry scandals have caused the government to halt the construction of a number of new rail lines pending thorough investigations. Not only does this mean a greatly diminished demand for steel from the rail industry, but it also means that China is no closer to solving the problem of massive coal shortages caused by transportation bottlenecks. Already, 60% of all freight movements in China are solely for the transportation of coal. Many of China’s steel mills have had to relocate to the eastern seaboard to circumvent the rail issue and import its anthracitic coal directly from Australia. Wage rates are significantly higher in these areas, though, and coal prices are destined to see a seasonal spike over the winter, as China is still 68% dependent on coal for energy. These factors will spell a very hard year for a steel sector already struggling with profit margins of less than 3%.

Rock and a Hard Place

Government policies will finish what waning downstream demand has started. According to the most recent rounds of government policies, the goals for the steel industry is to destock, consolidate and upgrade. The Ministry of Environmental Protection and the Ministry of Industry and Information Technology have launched new stringent requirements for the reduction of pollutant emissions and energy consumption. China’s steel industry will have to eliminate many outdated production capacities, and invest a large sum of capital to renovate and upgrade.

At the same time that demand is declining, the industry will be ousting outmoded production capacities to meet China’s New Environmental Production Standards. This process will eventually restructure the industry to create a small number of massive players capable of churning out large volumes of a high-tech product mix. In the short term, though, industry output will be stagnant for at least the next year, meaning that there will definitely be no increase in China’s demand for iron ore any time soon.

Bullish Plans for a Bearish Decade

The CISA has forecasted that the growth of China’s demand for steel will slow to just 2.6% YoY by 2015, down from this year’s 4.6% YoY growth. November data showed a crude steel output of just 49.88 million tons – the lowest production in 14 months. Aussie giants Rio Tinto and BHP have responded to this news with the counterintuitive approach of ballooning their mining operations. Rio’s board has just approved a USD 14 billion budget for 2012 mining projects, up from this year’s budget of USD 12 billion. BHP is looking at similar expansion plans, and has earmarked more than USD 80 billion to invest in major projects and exploration by 2015. Sam Walsh, director of Rio Tinto’s iron ore division has stated that the mining industry goal is to increase iron ore supply by 100 million tons per year until 2020.

With supply ballooning and demand waning, prices have naturally taken a massive tumble. Iron ore spot prices fell 24% from early September to mid-December. A recent report from Reuters has stated that the plunge of spot market prices for iron ore and lukewarm tenders have indicated that the spot market is likely to drop further throughout the month. Steel mills, expecting additional price drops, are hesitating to purchase ore. As a result, stock of imported iron ore at Chinese ports have been hovering around 100 million tons, up from the usual volume of 70 million tons. Of course, this hesitation has become a self-fulfilling prophecy, and prices have continued to drop throughout December.

China Spot Index (CSI) for Iron Ore

Blue: Spot Prices for Imported Iron Ore with 62% Iron Ore Content

Red: General Index for Imported Powdered Ore

This dynamic will be awful for iron ore providers in the short term, but may have an eventual payoff. The “global miners” Rio Tinto, Vale and BHP Billiton are effectively an oligopoly that account for nearly 70% of the global trade of iron ore. China has a total of 77 large- and middle-sized steel mills that in 2010 posted net profits of RMB 89.7 billion. By contrast, 2010 profits for the three global miners more than tripled this figure.

The result of all of this money is that these giants are able to weather any storm. In flooding a waning market with a glut of commodities, these companies stand to take heavy losses. Indeed, recent reports show that BHP’s stock has fallen 24% this year. Rio Tinto is down 33%. However, the long-term benefit of this strategy is easy to see – the flood of ore into the market will strangle out smaller competitors. When the red dust settles in 2020, these companies will loom larger than ever with massive capacities to feed a rebounding India and a mature, technologically advanced China.

"If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

Pop Goes the Bubble (12-5-11)

What a difference a month makes. China’s central government has popped its own real estate bubble, trading the nameplate wealth of its middle class and local government revenues in the short-term for more sustainable urbanization and job creation in the mid-term. While this will not evolve into a financial crisis for China, there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.

Stoking the Fire

A massive real estate bubble has been looming ominous in China. The bubble has been most apparent in the cities of Ordos and Wenzhou where speculation is most extreme. In these areas, private lending networks have given investors quick and quiet access to loans to invest in speculative real estate projects. In the beginning, many residents became overnight millionaires, stoking local appetites for risky bets. A survey conducted in October showed that in Wenzhou, 60% of local businesses and 89% of households were tied together with outstanding private loans totaling RMB 120 billion, most of which has been invested in local real estate development projects.

Easy access to unofficial loans caused the hyperinflation of a real estate bubble, boosting the price of commercial real estate in Ordos by more than 1,600% since 2005. According to a survey done in October, the average household in Ordos owns three condos – an investment phenomenon that has produced 168 empty high-rises in this city, alone. Ordos only has one-tenth the population of Beijing, but still managed to sell two-thirds the square footage of real estate in 2010, 98% of which was previously unoccupied.

Although less extreme, a similar real estate bubble has been growing in the first-tier cities of Shanghai, Beijing, Shenzhen and Guangzhou. In Shanghai, real estate prices have risen more than 150% since 2003, and the average apartment is now more than 40 times the annual income of the average citizen. In Beijing, growth in real estate prices have outpaced increases in income by more than 80 percentage points per year since 2005. The middle class fueled much of this growth, viewing investment in real estate as a much safer bet than bank deposits or playing the stock market.

“I Love Government Assisted Housing… I Have Three of Them!”

The proportion of migrant workers to residents in the first-tier cities of Beijing, Shanghai and Guangzhou is more than 3:10. In Shenzhen, it is more than 7:10.  Sky-high real estate prices have created a massive barrier to entry for impoverished newcomers looking to settle down. The Chinese government has stated in its 12^th Five-Year Plan that level of urbanization will increase from the current 47.5% to 51.5% by 2015. China’s real estate bubble is not only a threat to its banks, but also threatens the country’s rate of urbanization. Less migration into China’s cities will mean less job creation, and for every million jobs lost, China forfeits one percentage point from its GDP growth.

In order to reach 51.5% urbanization, an additional 53.6 million people will have to move into urban areas by 2015. The average Chinese household has 3.3 members, meaning that new urban residents will generate a demand for 16 million additional housing during this period. Not only will China have to construct 16 million housing units in its cities, but it will also have to guarantee that the vast majority of these units are within the price range of a migrant laborer. The government has decided to inject 36 million units of government-assisted housing into the system over the next five years. This is more housing than the US has constructed since 1986. But how to keep these units safe from investors and market speculation?

The End of the Party

In the interest of urbanization and job creation, China popped its own bubble. In 2010, China intensified a series of restrictive purchasing policies in first tier cities, making it nearly impossible to buy non-owner occupied investment housing. Loans to first-time and second-time buyers of commercial housing now required deposits of 30% and 50%, respectively with base interest rates of no less than 10%. Households wishing to purchase a third unit of real estate are now ineligible for a bank loan. The policy also ended loans to non-residents unable to provide certification of paying one year of the city’s taxes and social security dues.

Inflationary pressures finished what restrictive policies started. Chinese citizens are currently squeezed in the triple vice of domestic inflation, an appreciating RMB and waning demand from a collapsing Eurozone. Indeed, China’s PMI for November was 52.5, down from 54.1 in October. Global PMI for the month was down to 49.6 showing a worldwide contraction in manufacturing – not a good sign for China.

When properties stopped selling, some of China’s more fragile real estate networks simply collapsed. In September and October, Wenzhou and Ordos were found to be two canaries in a toxic coalmine. When the Wenzhou Public Security Bureau reported that more than 40 indebted local business owners had gone into hiding as of September 27, central authorities moved in to investigate. It was soon revealed that a network of bank tellers and low-ranking government officials with access to low-interest loans had been borrowing money and then re-lending it with usurious annual interest rates as high as 80%.

Sensing an impending market correction, China’s central authorities moved to make sure that workers got away unscathed. The government started pressing developers in mid-November to sell off properties at discount prices to settle land payments and return bank loans. Deyang Liu, chairman of the board at Savills, said in a recent interview that the central government has been “keeping a very close eye on the construction accounts of developers. They have been pressuring developers to lower prices and sell more units in order to settle these accounts at the end of the year.”

China’s leading developer Vanke responded to the call by lowering the prices of new units in Shanghai, Beijing, Shenzhen and Nanjing by 20%-30% on average. Developers across the country quickly parroted the move, causing a decrease in prices for over 80% of properties on the Shanghai market, alone. Many new homeowners were caught in the middle and lost most of their nameplate wealth overnight. They responded with a series of protests in the offices of real estate developers. Offices were destroyed, but the cries of the middle class fell on deaf ears in the central government.

Reason to Panic?

Thankfully, it appears unlikely that the burst of China’s real estate bubble will trigger a nationwide financial crisis. Tighter purchasing policies have resulted in a 30%-50% cushion for each housing loan issued by banks. Former chairman of the China Banking Regulatory Commission has stated that banks can withstand a 40% decline in housing prices while still maintaining a debt service coverage ratio (DSCR) of 110%. Should prices fall 50% or more, however, banks may become insolvent.

The market is likely to correct downwards between 20% and 30% over the next twelve months, but this will still leave banks with enough liquidity to weather the storm. In fact, Standard & Poor’s upgraded its ratings for Bank of China and China Construction Bank while dropping ratings for Bank of America, Goldman Sachs and Citigroup. On several occasions, S&P has cited the strong liquidity of the Chinese government and the high likelihood of government support in times of distress as reasoning for its high ratings. Clearly, S&P is on to something; the firm realizes that even if China’s banks take a hit from a bursting real estate bubble, the government will surely use its piles of foreign reserves to soften the landing.

Governing the Debt

The real losers will be local governments. Currently, local governments obtain approximately 1/3 of their revenues from land transfer fees obtained by selling development rights to real estate firms. The central government has mandated that 36 million housing units be built over the next five years, and local officials know that their contribution to this sum will have a substantial impact on their careers. Political gain will not come without a price, however, as government-assisted housing yields much lower returns than contracts for developing premium condos.

Local governments are already buried in debt from the 2008 stimulus package. As of 2010, local government debt totaled RMB 10.7 trillion, or 80% of total bank lending, according to statements made by Liu Mingkang of the CBRC. These institutions already stood to loose big with large portions of land being allocated to building homes for the poor. Now, with the market in a downturn, it seems unlikely that local governments will be able to auction off what little land they have left.

Indeed, a report from Centaline China Property Research has shown that in November, 117 plots of land failed to sell in land auctions, up more than 530% from the previous month. There has been a 14% decrease in land sales from the previous year’s totals of RMB 92.1. Plummeting land sales will mean a significant dip in local government revenue, threatening liquidity. If leading indices continue to fall, signaling a contraction of gross economic activity, China may again have to bail out its local governments to help them maintain solvency. I believe that there is a 25% probability that local governments will receive a bailout before 2015 to maintain solvency.

"If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com

Days Are Numbered for BYD After a Tough October (10-23-11)

A poor October for China's auto market and a growing appetite for domestic 

M&A may spell the end for Warren Buffett favorite BYD Autos.

Hard Times

The October numbers are in and they don’t look good. Last week, the China Association of Automobile Manufacturers (CAAM) released the auto sale and production figures for the month of October. China’s auto sales are down 7.37% relative to September 2011 and are showing a 1.07% drop YoY. Production, too, has fallen 1.99% relative to September figures. This is a first for China and a major shock for the industry. Since China’s State Information Center started recording the statistic in 2000, China has never before reported negative growth in October auto sales.

In April 2010, Chinese consulting firm AlixPartners released a survey in which 50 auto industry executives stated their expectation that China’s auto sales would continue to grow by 20% per annum over the next five years. This may have been a safe statement to make in 2010 when auto sales for January-October were up 35.03% relative to the same period in the previous year, but 2011 has shown only 3.47% growth over this period.

These plummeting figures are a shock for a number of China’s small domestic auto manufacturers, many of which have already been struggling to stay alive in an overcrowded and highly competitive industrial landscape. China’s auto industry is renowned as being the most dispersed in the world. According to the October figures reported by CAAM, China’s top 5 sedan manufacturers represented less than 44% of the month’s sedan sales. Not a single one of these five firms are indigenous to China. Indeed, in the list of China’s top ten firms ranked according to sedan sales for October, only two names (Chery and Geely) are domestic. The other eight companies are made up of joint enterprises in which Chinese members own a mere 51% stake.

Recognizing the need for stronger domestic players in the industry, the Chinese government has chummed the waters with a series of policies encouraging domestic mergers and acquisitions. The party has publically stated its goal to reduce major market players from 14 in 2010 to less than 10 by next year. When the music stops, a number of firms are going to loose their seats for good, and investors are lining up to make bets on who’s going to get the chop.

Warren Buffett’s Big Bet

In 2008, Chinese automaker Build Your Dreams (BYD) looked like a sound investment. Despite its obvious theft of auto designs from Hyundai and Toyota, BYD claimed a level of technological maturity that other Chinese firms had yet to achieve. Originally the world’s largest manufacturer of cell phone batteries, BYD has since set its sights on leading the world to a future of plug-in hybrids fueled by lithium-ion batteries. The proposition was so exciting, in fact, that Warren Buffett put USD 232 million into purchasing a 9.9% stake in the company.  

Electric plug-ins may have been a hot promise in 2008, but since this transaction took place, the company has yet to sell even 500 units of plug-in autos. The Joint Research Center of the European Commission reported in a document released in June 2010 that pure electric cars will “remain very limited until at least 2020” and that major barriers for large-scale market development will remain in place up to 2030.

Despite this lukewarm outlook for new energy autos in the short term, BYD has initiated a series of long-term investments in industrial parks all over China aimed at increasing its stake in solar cells, electric cars and recharging stations. This expansion is a big risk, and BYD is relying on auto revenues and government support to keep the company afloat until the investments mature. This aggressive expansion into new energy led to a spike in fixed asset investment, boosting the value of its fixed assets and plants under construction by nearly RMB 10 billion in 2010 – an increase of 51.32% YoY.

Build Your Nightmare

Many investors now fear that BYD chairman Chuanfu Wang has grown reckless after years of gorging himself on the government punch. In 2008, 2009 and 2010, government subsidies paid 12%, 10% and 28%, respectively, of the company’s reported annual net profits. Additional revenues came from government contracts placing orders for hundreds of e-buses and electric taxis for Chinese cities.

Even with the government boosting BYD’s books, the fact remains that recent investments were made under the presupposition that sales and profits would continue to trend upwards for years to come. On August 22, BYD released a report stating that auto sales for H1 2011 only reached 225,800 units, down 22% from H1 2010. Profits over the same period took a nosedive to the tune of 88.6%. Paired with this report was an announcement that BYD would be significantly reducing its auto sales staff from 2,600 employees to just 800. Employees pushed back, and 50 days later management was forced to enter labor negotiations under threat of government intervention.

With sales and profits sharply dropping and capital tied up in long-term investments in new energy, BYD’s liquidity and quick ratios have dropped far below those of industry competitors to values of just 0.63 and 0.4, respectively. New reports say that the company is paying off its mature bank loans with borrowed money. With the People’s Bank trending towards tighter monetary policies, BYD has been having an increasingly more difficult time getting access to new loans to pay off old debts.

BYD’s existing capital is tied up with local governments in unbreakable industrial park development contracts. Its profits are tanking as auto sales plummet. The company is also losing access to new loans to pay off its old debts. China has stated that at least three of its major auto firms will not survive past 2012. Somewhere, Warren Buffett is starting to sweat.

 "If I have seen a little further it is by standing on the shoulders of Giants."

- Isaac Newton

Chris Lowder is the Director of Marketing Services at China Monitor. For more insights from China Monitor and the China Economic Information Network (中国经济信息网), please visit our website at www.chinamonitorisg.com