Friday, June 22, 2012

Follow up to the China kleptocracy post

The China kleptocracy post has received a lot of comment - mostly favourable. It was my first post to get 100 thousand views. I would like to thank all that commented on it (especially Paul Krugman who was good for about 35 thousand page views).

Only a few of those views are from China. My post was blocked by the Great Chinese firewall.* That said, within China the people who have been in business there for more than a decade were mostly in agreement. The people who have been there a couple of years were less in agreement. Bill Bishop (who I read and respect) was in the less in agreement group.

I will not name the people in agreement because many have to live in China.

My thesis was

(a). The savings rate in China was abnormally high driven by the one-child policy,
(b). The options for investing those savings for most the population were extremely limited - mostly bank deposits.
(c). The bank deposit market was rigged so that deposit rates were consistently below the inflation rate.
(d). That repressed interest rates were mainly used to subsidize state owned enterprises and that
(e). This funded the widespread looting of State Owned Enterprises by party officials.

Demographics is outside my field of expertise and I received (and expected) most criticism on the demographic point. The first bit came from my business partner who thought that the high savings rate and the property boom came in part from the (extreme) gender imbalance in China. The gender imbalance is another artefact of the one-child policy - where selective abortion and infanticide produce a large shortage of female babies and (later) eligible women to marry. This drives male preening behaviour - and the most successful preening behaviour for a man is to be rich and to own property. This is an extension of the men-will-do-anything-for-sex argument - and in this case "anything" is own apartments and big (negative return) bank balances.

Unknown to me this was the subject of a serious academic paper by Shang-Jin Wei - a professor of finance and economics at Columbia University who supports the men-will-do-anything-for-sex argument with lots of fancy econometrics.

There was little objection to my argument about limited options for saving in China. That seemed self-evident - however those limited options are being undermined by capital flight. The Chinese are washing an incredible amount of money through Macau. That money is being saved outside the Chinese banking system - and is thus not subject to extreme financial repression.

There is also little objection to my suggestion that bank deposit rates are rigged below the inflation rate. China dropped the regulated bank deposit rate recently as the inflation rate declined. However - and it was the point of my post - negative real interest rates are declining in China because inflation is declining.

The fourth point - that the repressed interest rates are the main source of subsidy for Chinese State Owned Enterprises was backed up very strongly by Michael Pettis. There are other sources of subsidy. For instance tobacco is largely provided by a State Owned monopoly and tobacco use is not subject to much social sanction making the tobacco company unbelievably profitable (and hence able to pay very high salaries and benefits to senior staff). Indeed Michael Pettis points to a Mainland think-tank - Unirule which suggests that monopoly and direct subsidies have accounted for as much as 150 percent of the profitability of the State Owned Enterprises over the last decade. Pettis himself calculates that repressed interest rates may have accounted for another 400 to 500 percent of total profitability over this period.

Monopoly profits and financial repression are a subsidy from the household sector. Pettis thus states the obvious - five hundred to six hundred and fifty percent of SOE profits come from a subsidy from the household sector.

Absent subsidy the SOEs are staggeringly unprofitable. In a market economy a business that goes from making X per year to losing X per year usually fails or closes pretty quickly. A business that goes from making X per year to losing 5X per year crashes and burns very rapidly.

Absent the subsidies the whole SOE sector with its current expense base crashes and burns very quickly. By far the biggest subsidy is the subsidy of being allowed to borrow at repressed interest rates.

This of course leads to the fifth part of my argument. That was that the expense base of the SOEs was the (looted) income of Communist Party apparatchiks. Here surprisingly the New York Times came to my rescue with an article about the difficulty of economic reform in China. Reform in this article really meant reform of State Owned Enterprises. The difficulty was that:

Publicly controlled enterprises have become increasingly lucrative, generating wealth and privileges for hundreds of thousands of Communist Party members and their families.

That is - of course - precisely my point. And the Times goes on to say that the Government is moving to stifle debate on anything that challenges this status-quo.

Deflation of course will challenge the status-quo anyway. If 400-500 percent of the profitability of SOEs comes from financial repression then the end of financial repression will result in the collapse of the State Owned sector and the collapse of the wealth and privilege led by "hundreds of thousands of Communist Party members and their families". I suspect that the centre would find it increasingly hard to control their regional elites and the regional elites would revolt. [Revolution is almost always an affair of the second-tier elite versus the first-tier elite - the masses rarely drive it. This would be no exception.]

However in the face of that the centre would do anything to keep the inflation rate high. Ben Bernanke might not literally be prepared to throw dollars out of helicopters. The Central Committee - they might go there...


*I have been informed by someone that blogger is always blocked in China. The Chinese people who were telling me they can't get the blog usually get it via a virtual private network.


Wilfried said...

John, I do not dispute your opinion on China. But is it not the same game that is played in the western world? Do we not have massive financial repression? And does it not serve our elite? Why do you continue to single out China and ignore other offenders?

John Hempton said...

I have plenty of places I can invest my money. There is a share market that is (sometimes) honest, I can take it internationally.

I have choice.

It is repression because you do not have choice.

Forthcoming post on negative real interest rates though.


Unknown said...

John, your description of revolution being driven by 2nd class elites vs 1st class elites fascinates me. You have books or articles that expands on this thesis?

Anonymous said...

Nice, male preening behaviour.. never thought of it that way.


Bill Bishop said...

Thanks for the mention. To clarify, I have been in China a lot longer than a couple of years.

Of course China is extremely corrupt, but I disagree that the system is maintained solely to enrich insiders. Rather, it seems more like a delicate balance between corruption and development, a balance which has skewed dramatically towards corruption since the 2008-9 fiscal and monetary stimuli pumped 20 trillion+ renminbi into the economy.

As I wrote last year ( when some were predicting that the Arab spring would spread to China:
"To oversimplify, the Chinese Communist Party is focused on three basic things. First, staying in power. Second, driving the “Great Chinese Renaissance” and all that entails, from improving standards of living to expanding global influence. Third, getting rich, both personally and as a way of maintaining loyalty to the system, so long as it does not threaten the first and second principles."

Expect the pendulum to swing back from the more egregious corruption. Otherwise the Party is doomed, and they know that better than any outside observers. Maybe it is too late, but don't expect them to do down without a fight, or helicopters as you suggest.

Three other points. One, as your blog is hosted on blogspot, it was blocked in China before this post, as all blogspot blogs are.

Two, the New York Times article you cite dramatically overstates things. There is still quite robust debate about reform, and one of the examples the correspondent cites is just wrong. Zhang Weiying's speech at Yabuli China Entrepreneurs Forum earlier this year, which the NYT says is not available in China, is up on Sina here: for anyone in China to watch.

Three, jade is an under appreciated investment and store of value. Chinese love it and the price has risen far faster than the price of gold. I am looking for a good public play outside of China. So far I have not found one.

Bill Bishop said...

Have you seen any data on the sex ratios of children of Communist Party apparatchiks versus the children of the "financially repressed" and rural residents?

My personal experience is that the "repressor" class (and urbanites in general) is much less concerned with the sex of their child and therefore the gender distribution of the spawn of that class is much closer to the expected, "natural" ratio

Anonymous said...

When people say "Kleptocracy", they usually assume few hundreds of thousands people being enriched. China, where everything is bigger, has kleptocratic class the size of population of medium nation. Thus it's a bit harder for some to accept that it's not just "upper middle class" (or middle class for the matter) but something quite different.

Anonymous said...

Having looted so much from the domestic populous, maybe it's time to give foreign suckers another bite at the cherry via the H Share market?

Before there is an implosion of SOE's wouldn't one expect the elites to have a crack at selling them through either liberalizing access to A shares or inviting foreigners to share the fabulous profits

Anonymous said...

In the annals of country development, kleptocracies are no surprise. Spanning the globe from Saudi Arabia to Venezuela to the Phillipines to China, they've all been stealing billions.

The question is to what degree of balance between reasonable economic development and outright rape and pillage.

I would suggest that China is more akin to Saudi Arabia than the Phillipines under Marcos.

Anonymous said...

There is one alternative to the collapse of the ruling elite that you didn't mention - that would be war.

I believe that there are studies have suggested that countries with a male surplus tend towards violence. Have no idea how legitimate they are but do know that they have been bandied about.

F.S. said...

You still insist on focusing on trees instead of forests. Two quick points:
1) You completely ignore the fast rising real income. If real income rises fast why would the majority of the populace care about a small negative interest rate? And why should guaranteed bank deposits provide a positive real rate? It makes no economic sense. It is not often that deposits make a positive real rate even in the U.S.
2) If financial suppression is all why not compare China with Japan during Japan's fast growing phase? My bet is that Chinese would be pretty happy to attain the standards of livings of Japan even if after getting there they may face prolonged stagnation.
You remind me of the story of an emperor in ancient China. When informed of famine caused by shortage of grain in the country he asked "Why don't they eat meat?"
You theory (an extractive economy) can't explain the productivity gain that is just obvious for everyone to see.

F.S. said...

All we could tell is that you studied the stock markets and you found frauds. And now you are predicting revolution in China. Tell us what qualifies you to be such an expert on China.

Colin P said...

John, I have to disagree with the post. No man in the history of the world has ever done anything to impress a woman. It's irresponsible to suggest any member of our gender would do something with the intent of hopefully having sex with a woman.

Many people think Eric Clapton wrote "Layla" to impress model, Patty Boyd. Common misconception. Layla was actually the name of his beloved dog as a child.

My best friend didn't get an earring at his girlfriend's suggestion to try to look cool. He did it because he was considering becoming a pirate after graduation.

Newly divorced PIMCO bond manager, Bill Gross, didn't run five marathons in five consecutive days and rupture his kidney to impress his new girlfriend. He did it to lose weight and his kidney was already ruptured. (See Runner's World Magazine from six or seven years ago).

At university, I didn't go to the first meeting of the Latin Dance Club hoping to run into a girl from class. I did it because I have a rarely expressed, but nevertheless deeply profound love of dance.

If Paul Krugman is reading this, could you please provide further proof our editor is misguided, perhaps from your own life?

So I think your argument collapses under the weight of these examples. Otherwise above average post.

Colin P

Anonymous said...

John, I have two practical questions for you or anyone on this thread that feels like sharing. First, any views on how much gold the Chinese are buying? That would seem to be a more attractive investment than an overvalued building shell (no certainty that it is overvalued at the time of purchase, and easier to hide from the authorities and easier to monetize). Second, you state that there is an incredible amount of money being laundered in Macau. Are the major casinos (WYNN, LVS) getting a piece of this, or does it happen without them? Thanks in advance for any responses.

Luke said...

As far as I can tell, there were no comments on your remarks about auditors, and precious little comment in the media. I know it wasn't the main point of the piece, but I'm surprised there seems to be so little reaction to your - shall we say "trenchant"?- views on what auditors are doing.

Conscience of a Conservative said...

Low interest rate policy as China (and the U.S.) cause great mis-allocations of capital. That Krugman can't see the comparison to the U.S. where instead of State Kleptocracy we have that wealth being transferred to the big banks is interesting. said...

Most of the Chinese live better today then they used to 20 years ago - fact. Look at the number of Chinese tourists and students everywhere around the world.

The same low interest rate argument could be made about U.S.

There is always someone stealing from someone. A huge deficit is a form of stealing (stimulus)

B.G. said...

Colin P

Why don’t you check out Maslow’s hierarchy of needs and review your comments after familiarizing yourself with that. You might realize that your opinion, woven together with meaningless anecdotes, does not quite make fact nor does John’s argument collapse under the “weight of these examples”.

B.G said...


You don’t have to be an expert on China to realize that where there is smoke there is fire. And oh boy is there a lot of smoke, from the endless avalanche of stock market thievery and fraud to corruption and bribery at the highest levels of government. One only has to look at the scandal at the Ministry of Railways with Liu Zhijun ,the former railway minister, and most recently Bo Xilai and his wife who has just admitted murdering Neil Heywood.

The stakes were just raised yesterday when Hu Jintao ordered high-ranking military officers to declare their personal assets.

The argument is that when the fuel runs out which drives such a kleptocracy (inflation and negative interest rates as John argues), revolution is not improbable. I think John’s argument is fascinating and it scares me that he might be right.

gv said...

John wrote "It is repression because you do not have choice".
That is what I cal the "I-am-representative-for-the-world-argument"

The choices of the average man are restricted to some basic choices. Going international and investing in shares are not really options for him, unless he intends to loose money.

Saving deposits, real estate (with a low yield too here in Belgium), and pension funds (which are only attractive due to tax deductibility, not return) are his options.

If I reason the same way you do then the Chinese do have options and all of them should be smart enough to channel their money through Macau.

Laban said...

BG - I think Colin P was being sarcastic.

Colin P said...

Thanks Laban, yes BG I was being sarcastic. Sometimes sarcasm doesn't translate well into written words. Besides, oceanic piracy hasn't been a respectable profession since at least 1998 when the tech industry began attracting away would-be talented mariners.

That comment was also sarcastic.

B.G. said...

Laban - I hope you are right. If he was being sarcastic his post is rather amusing....and I have got to lighten up a bit.

Anonymous said...

F.S. said...

> You still insist on focusing on trees instead of forests. Two quick points:
> 1) You completely ignore the fast rising real income. If real income rises fast why would the majority of the populace
> care about a small negative interest rate? And why should guaranteed bank deposits provide a positive real rate? It makes
> no economic sense.

As I understand the argument, the problem is that where adults since they must pay for themselves are saving hard for the old age, it is necessary for them to know that their savings will be there when they are old. If the interest rate *stops* being negative and the SOEs in fact have to actually pay what they really owe, they will find they cannot, and that will be the problem.

> It is not often that deposits make a positive real rate even in the U.S.

Yes. But in the US, you have choice of investment, so the fact any given instrument is ineffective is not very important.

> You theory (an extractive economy) can't explain the productivity gain that is just obvious for everyone to see.

I don't see how it matters? if you've invested your savings (and your ability to save may indeed be growing over time) but then find they cannot be returned to you, because they've been burned away, there's going to be trouble, especially when that is the wealth you saved to support you when you can no longer earn.

Unknown said...

Lets not forget… nearly all countries throughout history have undergone lengthy periods of kleptocracy or cronyism. There is a lot to be concerned with in China, but lets not kid ourselves into thinking the Empires of the West were not built upon the same idiosyncrasies. Lets just hope that China also makes the transition over time, as other developed countries have... but God help us if it ends up with democracy as paralysed and misguided as we 'enjoy' in the West

Martin Gercsak said...

Great post. I can't comment on the validity of it but so far the best explanation I heard of what is happening in China. All other theories were about Chinese people being smarter, their leaders being different, etc.

When you hear "this time it's different" from even supposedly smart people you can be assured you are in a bubble.

F.S. said...

In 1989 the party sec. gen. was sacked for being soft on protesters; in 1995 Beijing party chief and politburo member was removed; in 2006 Shanghai party chief and politburo member was removed; both were sentenced to long prison terms on corruption charges; in 2007 Chinese FDA head was executed for corruption ... One shouldn't simply conflate political fragility with economic fragility.
Do you know of any old Chinese living on financial savings? They are much more likely either dependent on their children; or else if they have pension income they exhibit positive savings rate well towards the end of their life expectancy (high 70s). Negative real rates are irrelevant to people who don't have financial savings and only psychologically relevant to people who don't actually ever spend down their savings (nominal loss would be much more painful in comparison). In principle retirement savings are illusory in macroeconomics. It is all redistribution, whether through tax or wealth or family. Chinese government may be kleptocratic, it is also paternalistic. In redistribution schemes what matters is the productive capacity: tax needs tax bases; wealth needs claims to be honored; family support needs family income. That is why productivity is relevant.

It is amazing how many value investors have jumped on the short China bandwagon. It may be the right trade. It may be a good trade. But it is not even funny suddenly so many people turn into macro experts and China experts. One valueinvestorsclub poster justifies shorting FXI by saying: "Second, China's best universities are like community colleges based on what I am told". I mean really? Now that is scary: someone could bet his investors' retirement savings based on such flimsy understandings.

Why does it matter to me? I don't short. There may be some real bad news coming out of China in the near future. There may even be political shocks. The more misunderstood the situation is the more likely that there will be opportunities, esp in companies outside of China. Good luck to all.

Unknown said...

Just sayin':
"Chinese Premier Wen Jiabao pledged to ban the use of public funds to buy cigarettes and “high- end” alcohol, warning that corruption may endanger the ruling Communist Party’s survival."

Anonymous said...

"Revolution is almost always an affair of the second-tier elite versus the first-tier elite - the masses rarely drive it."

Looks like someone has been reading The Theory and Practice of Oligarchial Collectivism.

Anonymous said...

Another investment option in China that is often missed is starting a small shop or company. A lot of Chinese tries that.

Most of them fails...

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