Chinese Muzzle

In the past year, I have become less enthusiastic about investing in China and more confused about the country’s economy and politics. One of the reasons for this new caution is more psychological than entirely rational: I hate to pay up for stocks I have owned at much lower prices. But it’s not only about price; it’s also about value.

When we started investing in China-related companies, in the midst of the 1990’s Asian Crisis, it felt like shooting fish in a barrel. Many companies in manufacturing businesses we understood well, with compelling exporting models, were selling at price/earnings ratios in the mid-single digits, while net cash on their balance sheets amounted to a significant portion of their stock market capitalizations. Today these companies’ prices fully reflect prospects which, in my view, have become much tamer.

What I would like to own, instead, are companies that will benefit from China’s coming tidal wave of consumption and from its need to clean up the country’s environment. Unfortunately, I’m not alone in this. These companies’ prospects have hardly gone unnoticed and their shares already are selling at high valuations, while the challenges of succeeding in their sectors of activity remain very real.

A final reason for my new caution was summarized in a paper I wrote almost a year ago, A New Nationalism in China, from which I quote:

“Beyond its welcome aspects, this new rise of popular nationalism does carry some risks...

… In particular, it coincides with a hardening of the central government’s control over the country. By all accounts, the Party’s grip is being tightened everywhere: dissidents are systematically muted or eliminated under the excuse of fighting corruption (which, by most accounts has not lessened in recent years); censure is being applied more harshly on the media and the Internet…

... For a while, now, I have been uncomfortable about developments inside China. At the same time that President Hu Jintao has seemed to be engineering what some have labeled a new personality cult (àspan> la Chairman Mao), Beijing has been busy putting out an increasing number of fires around the country. So far, everyone agrees that the revolts and riots, though reported in the thousands, remain isolated incidents. They usually are caused by gripes against local employers or government officials, and there seems to be no general resentment against the central government in Beijing – nor any visible effort by anyone to coordinate local uprisings into a national movement. But the longer-term risk seems to be on everyone’s mind.”

The recent crackdown on foreign media access to the Chinese market confirmed my doubts. New restrictions make it illegal to distribute articles that “endanger China’s national security, reputation and interests”. My italics on the last two words make it clear that the new censure can be totally arbitrary.

Under the new rules, companies like Reuters, for example, can only sell their products through the China Economic Information Service, an agency appointed by Xinhua (the official news bureau!). Simultaneously, various allegations of tax cheating were floated against foreign news agencies, while occasional bullying has intimidated other segments of the media. The sudden removal of the heretofore well-regarded chief of the National Bureau of Statistics, only seven months after his appointment and under rather vague allegations, seems to foretell a broader and longer campaign.

Some observers will mention the Communist Party Congress next year and the Beijing Olympics Games in 2008 as justifications for some tightening of the news flow. Others will see a mere business plot by Xinhua to supplant the growing competition. But the measures are quite drastic and farther reaching than similar maneuvering in the past. So, I can’t help asking: “Are those the kinds of reactionary measures, with their high global visibility, that a government takes when everything is going well?” My intuitive answer is: “No”.

Natural Limits to Growth

In visits to many manufacturing plants, over the years; having been stuck for hours in miles-long traffic jams of coal-carrying trucks; and, more recently, in conversations with the managers of a number of waste-water plants, I have become increasingly aware of the limits that environmental problems will ultimately impose on the growth of the Chinese economy. Pell-mell from various newswires:

· Late last year, the government announced that about 300 million Chinese drink contaminated water, with some 190 million being sickened by it each year. 90% of China’s cities have polluted ground water. Needless to say, these official figures may still understate the problem.

· More than 130 water-pollution accidents have contaminated China’s water supplies in the past year.

· According to the Vice-Minister of Construction, 278 Mainland cities had no water-treatment facility at all. In 30 other cities, 50 plants were operating at less than 30% of capacity or were simply idle.

· There are severe water shortages in China’s north, which boasts two-thirds of the country’s arable land, produces half of its grain and is home to much of its manufacturing and population. It’s not only that water is naturally scarce in China, but the available supply is increasingly unsafe to use.

· China already uses more coal then the United States, the European Union and Japan combined. In the north-central region, coal-burning power plants account for more than half of the total pollution. Yet, despite repeated fatal accidents, no one is talking about shutting down power plants. In fact, every 7 to 10 days, another major coal-fired plant opens somewhere in China.

· Experts estimate that 400,000 Chinese annually die from breathing polluted air.

It is not only water quality and availability that is likely to become a constraining factor on economic growth. Other environmental problems (acid rain, deforestation, serious soil erosion, silted reservoirs and growing carbon-dioxide and sulfur-dioxide emissions) only worsen the outlook.

According to the director of the State Environmental Protection Administration: “It is clear the conflict between economic growth and environmental protection is coming to a head”.

A report released jointly by the State Environmental Protection Administration and the National Bureau of Statistics estimates that the “true” growth rate of the Chinese economy in 2004 would have been closer to 7% than to 10% if the cost of pollution had been factored in. But that’s not all: the report estimated that it would cost 6.8% of 2004’s GDP plus 1.8% of GDP in operational costs to clean up all the pollutants released in that single year. (South China Morning Post, 9-7-06).

Even if remediation generates some investment activity, I would not be surprised if the government’s announced intention to aggressively tackle China’s pollution problem seriously slowed the economy, while boosting costs throughout. (For example, the government plans to implement higher water utilization rates for industrial users by early 2007; Through various measures, it will also boost land acquisition costs).

Local Obstruction

Beijing leaders have no qualms about blaming corruption and fraud by local officials for the government’s failure to control pollution.

It’s also local officials that have frustrated efforts to slow speculation and wasteful investment in the economy. Some argue that failure to control wild investments at the local level amounts to pouring stimulus on an already overheated economy that the central government is attempting to cool down.

Traditional macro-economic measures such as raising interest rates to slow the economy do not work well in China, because local banks are susceptible to political pressures. In fact, since they often do not expect to be repaid by local firms that are either owned or controlled by local officials, lending rates become sort of irrelevant!

According to a World Bank economist (Wall Street Journal, 9-15-06), up to 20% of all investment in China is made by local governments. But that does not include huge investments by real-estate developers that are nominally private but often act as agents for local authorities. The true figure thus is likely much higher.

Even the most honest local official would have little incentive to abide by Beijing’s wishes to rein in investments. When Deng Xiaoping started to decentralize the economy, after 1978, he made local governments responsible for growing their own communities. Until now (some changes have been promised), that has been the basis on which local officials were rated and promoted. Since, each year, China’s cities must absorb at least 10 million official immigrants from the countryside and fund the cost of their health, education and welfare, this is quite a challenge.

Also, China does not allow local governments to raise local taxes or to issue debt, although these restrictions are often circumvented through the use of inventive usage fees. “Instead, they are cashing their most valuable asset – land. The sale of land now accounts for 40% to 60% of all local government revenue… To acquire more land [for resale], cities simply redraw their boundaries to engulf the surrounding farms. The compensation they pay farmers for the land is far less than its value to developers. When the city flips the land, the revenue isn’t part of regular budgets that can be audited by Beijing”. ((Wall Street Journal, 9-15-06)

And there begins the vicious circle. Laurence Brahm summed it best in a recent South China Morning Post editorial: “In this era of decentralization, local governments cannot look to Beijing for funding. Therefore, anything goes, locally, in the name of making money – especially if the proceeds are to be spread among greedy local officials. Local authorities have the power to say “no” to a Beijing decree that comes with no funding… The situation is complicated by so-called democratic processes. In village-level elections, gang bosses win votes with cash or threats. Upon election, they raise their thugs into key village positions, including financial auditor. Then, the extortion begins, and many legitimate businesses are compelled to shut.”

Clearly, there is no reason to doubt the word of the Ministry of Land Resources when it says that as many as 90% of all land acquisitions are illegal.

Corruption, Pollution and Social Unrest

In 2005, there were 87,000 mass protests officially recorded in China, up from 74,000 in 2004 and 10,000 in 1994 (AsiaNews 10-10-06). Most of these incidents were local in nature and related to corruption, land expropriation, pollution and, sometimes, to the non-payment of workers.

Hence the vicious circle that the central government has been unable to break, in spite of its oft-stated desire to do so. To schematize:

· Under demographic and other pressures to boost the development of their communities (and to fund it), local governments acquire land that has been allotted to local farmers.

· The land is then sold to real-estate developers or to industrial companies attracted by the low price and some other incentives. (The competition between communities to attract industry is fierce).

· The proceeds of this flipping, not subject to Beijing supervision, serve to build the infrastructure necessary for the community development and, in corrupt communities, to enrich local officials.

· Environmental controls are not applied (or loosely so) to the new investors, especially industrial ones, since this would reduce their profits. At best, this would discourage future investors and at worst, it would reduce the illegal profits of local officials.

· Pollution worsens in the community, water becomes undrinkable and wells become contaminated. Diseases occur with greater frequency.

· Residents that retained and continued to farm their land see their crop yields decline or their land become unproductive altogether.

· A number of residents, seeing the transactions that followed the sale of their land and their own aggravated situation, complain that they have been illegally expropriated. Resentment rises against corrupt, visibly enriched local officials.

· Riots ensue, with reprisals, beatings, etc.

Hence, at this local level, all the major problems that plague China today converge: excessive, wasteful investment; loss of control by Beijing over local authorities; corruption; and pollution that threatens to strangle the economy’s growth over time.

Reasserting Control

The growing unrest in the countryside, if allowed to spread, runs the risk of becoming a more national, destabilizing force – which has not yet been the case.

With few effective macroeconomic tools at its disposal to engineer its stated goal of a harmonious society where the benefits of growth are more fairly shared, the Chinese leadership has no choice but to turn back to micro-managing the economy by edict, as it had in the past.

This has been rendered much more difficult by the privatization of a large segment of the economy and by more than two decades of government decentralization, which has resulted in a loss of power by Beijing to unsubordinated local authorities. The Communist Party itself requires some re-indoctrination.

All of this is taking place, but the leadership needs to rally the opinion behind its project, which is sure to ruffle some feathers.

Traditionally, in times like this, it has been useful for the government to designate a scapegoat, preferably a foreign one. Today, it is engaged in a charm offensive toward Taiwan, in anticipation of elections there that might advance Beijing’s re-unification agenda. The election of a new administration in Tokyo also opens the possibility of a thaw in relations with Japan, with which China shares the North Korean thorn. The two scapegoats traditionally used to rally public opinion in difficult times are not available.

The next best choice is local officials. They often are unpopular and even discredited, whereas President Hu and Premier Wen retain some credibility as defenders of the people – particularly the rural population. In addition, they increasingly frustrate whatever macro-economic policies Beijing wishes to implement.

Finally, they can easily be linked to, and blamed for, the vicious circle of corruption and pollution – two problems that increasingly move popular sentiment and have been generating calls for action.

The crackdown that we have been witnessing in recent months, culminating (maybe) in the firing of the Shanghai Communist Party Secretary is a sign that Beijing’s campaign to regain control has started.

A Period of Uncertainty

But not everything is going to go smoothly. Just one example:

Only recently, China had touted plans to close all its unsafe, small-sized coal mines, where 6,000 people die each year in explosions, floods, collapses, etc. This would reduce the number of its small coal mines, which produce one third of the country’s coal, from 17,000 recently to 10,000 by 2008.

In January, the government admitted that, of 5,000 mines that were to have been closed in 2005, 60% were still operating. Then, on October 13, it was announced that, due to strong opposition from local governments, the deadline had been postponed to 2010.

There will likely be more roadblocks and frustrations for the government on the road to a more obedient system and a more harmonious society. Some episodes are likely to be hectic and the reactions rash. Private industry is unlikely to go unscathed through these uncertain times.

For example, Andy Rothman, of CLSA, has repeatedly warned that “the Party’s increasing focus on water pollution represents a significant risk for firms in the sectors that produce the most industrial wastewater: chemicals, power, steel and nonferrous metals, textiles, processed foods and paper. The risks include higher capital expenditures to add waste-treatment capacity; higher operating costs because the price of water will rise and, more importantly, because running treatment plants, which are power-hungry, is expensive; and potential civil and criminal liabilities for evading pollution-control regulations.”

Going back to my earlier comments about the current media crackdown, few people in that industry would deny that the risk of an increasingly erratic and unpredictable regulatory environment has been rising.

Finally, as in most developing countries, the availability of food is critical to China’s political stability. China’s food consumption is irresistibly rising, along with economic progress and changing diets, whereas the land and water available for farming are shrinking. If China becomes a large food importer, which could happen soon, both its international vulnerability and its domestic political stability will be threatened.

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I recently learned that the famous Chinese curse “May you live in interesting times” may be no more Chinese than the fortune cookie. At least, there is precious little mention of it in Chinese literature. We’ll see if, after the few coming years, this remains true.

François Sicart (in Paris)
October 22, 2006