I am writing this from the back of a taxi in Hong Kong?s Central district. My meetings with assorted bankers, hedge fund managers, Taipans, and the press stretched on longer than expected, with the result that I am now stuck in rush hour traffic on the way to the airport. So I might as well use the time productively and sum up my thoughts on my recent trip to China.
When I first cajoled my way into to the Middle Kingdom in the early seventies, it was in the back of a broken down truck carrying bags of wheat, no doubt destined to a thriving black market. We drove down a heavily potholed single lane road that had not seen serious maintenance since the thirties.
The Communist border guards couldn?t have been more hostile, and sneered at my US passport. Chairman Mao was then constantly railing against American imperialists and capitalist roaders to massive crowds of people wearing green, blue, or grey uniforms chanting with little red books in hand. The Korean War, where China lost 2 million men, had ended only 20 years earlier, and bitter memories were still fresh.
I arrived to find a country in utter chaos. Bands of Red Guards were rampaging through the countryside, lynching anyone with a connection to the West, such as university professors or those with a single foreign possession, like a violin. The lucky were simply made to wear dunce caps and paraded down the street where abuse was hurled upon them. Famine was rampant, and authorities were piling up the bodies of those who had starved, burning them with kerosene. Even getting just a single egg to eat was hard work, no matter how rich you were. My paper money was worthless.
Fast forward four decades, and conditions couldn?t be more different. As I waited patiently for an attractive young immigration official to clear me, I noticed a small voting machine asking if I was satisfied with my experience. It showed 4,734 ?yes? votes for that day. I counted 1,000 people a minute crossing the border, squeezing into packed trains that were leaving every 15 minutes. The sheer scale of this human tide was breathtaking. Welcome to the new China.
On this trip, I approached the country from the end of its long distribution chain and worked my way back towards the source, starting in New Zealand, and traveling on to Australia, Singapore, and Hong Kong. The message was the same all the way down the line: China is slowing. I heard countless stories of cancelled orders, reduced volumes, and thinning shipments.
So it was no surprise to me when, one my first day in Shenzhen, a local developer slashed the prices on new condominiums by 25%. This should come as no surprise, as the Chinese government has been determined to slow the economy for the past two years with no less than eight interest rate hikes and 12 bank reserve snuggings. Local residents were surprised when I explained to them that the 5% they were getting on overnight deposits seemed incredibly generous compared to the zero we get at home.
But slowing is not crashing, contrary to the view argued assertively by some prominent hedge fund managers, like Jim Chanos, who constantly refers to ghost cities of unsold real estate easily visible via Google Earth. Well, I checked out those ghost cities. It turns out that the cities in question change every six months. That?s how long it takes the Chinese to fill one city with people and bring another one somewhere else up for sale.
The Chinese essentially have an assembly line for cities which runs 24/7. They are really building a Rome a day. That?s what you would expect in a country that is attempting to bring another 400 million into the modern economy.
What I think is true is that China is in the midst of permanently downshifting from a blistering 11%-13% annualized growth rate to a more sustainable 8%. This is a good thing, and I saw the Japanese economy go through the same teething process over four decades, first growing at 10%, then 7%, 5%, 3%, and finally bottoming out at 1%. More stability in China will lead to less volatility in the global economy. This will be welcomed with open arms by oil and copper traders whose lives have been shortened by the extreme market moves this year.
The good news for the rest of us is that a China with a GDP today of $5.5 trillion today growing at 8% generates far more GDP growth than it did a decade ago with a $1 trillion economy growing at 10-13%. In fact, a China growing at 8% generates much more new GDP ($440 billion) that a US economy growing at 2% ($290 billion). This means that China is still a great investment for the long term.
What if it starts to grow less than an 8% rate? Senior government officials refer to this as the ?red line? below which the risk of political instability rises. No government fears its own people more than China, which refers to its ?bicycle economy?; it must keep moving forward or fall over. And in China they don?t send retiring political leaders off to putter around at country clubs, they put them in front of firing squads.
Fortunately for the health of the current leadership, they have a lot of resources to head off this worst case scenario. China currently has the largest accumulation of foreign exchange reserves in human history, some $3.2 trillion. During the 2008 crash, they implemented a $500 billion emergency stimulus package, which was three times larger than ours on a per capita GDP basis, and they had a second one on the shelf which they never had to use.
The country now has enough savings to execute six such packages to head off a hard landing, or even a substantial slow down. This is not idle speculation. The budgets have already been drawn up with triggers ready to pull. They involve spreading the country?s impressive modernization inland from the coast to enfranchise more of the population.
Of course, such action would be massively inflationary and require inconveniences like making the Yuan, or Renminbi (CYB), a freely floating and exchangeable currency. Development of a serious secondary renminbi (or people?s currency) bond market would also be a big help. But these liberalizations are eventually going to happen anyway (by 2015?). There is also the additional benefit in that this would help pacify the 2.3 million strong People?s Liberation Army, which is largely recruited from the countryside and is unhappy with the unequal distribution of the country?s wealth. Sound familiar?
This will fundamentally change the investment targets in the Middle Kingdom. Huge fortunes have been made investing in Chinese Internet and export companies. Go no further than my own call to buy Baidu (BIDU) at $12 three years ago, 10% of its current value, by clicking here. In the future the focus will shift to firms capitalizing on the growth of the domestic economy.
None of this makes the Middle Kingdom immune from the ?RISK ON?/?RISK OFF? paradigm that has the world?s financial markets marching up and down in lockstep. As long as the global economic and political scene is jittery, Chinese financial assets are going to trade just as poorly as everyone else?s. But when emerging markets catch a bid that lasts more than a day, China (FXI) will be a good place to be.
Will you Take a 2 Bed, 2 Bath With a Hot Tub?
My hedge fund friends in Shenzhen asked what I needed in a translator and guide to accompany me on my local forays. I said that I required someone who could walk at least ten miles on the city streets on the 90 degree heat, and be prepared to ask the price of everything and everything.
The next morning a diminutive young woman showed up at my hotel wearing an imitation pair of Nike?s and a cheap polyester suit. She told me that she migrated to the city from a small village eight hours away by train after learning English from the radio. I quickly discovered that she free lanced for local hedge funds as a research analyst. Not only did she know where all of my target companies were, she had cousins working at all of them. Talk about a total home run.
At the top of my list was a visit to a fake Apple (AAPL) store. She looked perplexed, and then told me she would not take me to a single store, but an entire city where every business sold the full range of Apple products, from IPhones, to iPods, tablets, and iMacs. Sure enough, I found a building downtown with at least 500 such businesses. They were even offering products that Apple itself hadn?t invented yet. Want a G5s iPhone for $75? No problem.
An iPhone G5? No problem
At one dinner the country?s second largest furniture maker told me of his hugely successful strategy of offshoring manufacturing from China to Vietnam, where labor is one third the cost. This means that the automation and globalization that has decimated America?s labor force was now turning full circle and coming back to haunt Chinese workers. If he can replace 1,000 men with a single high end machine imported from Germany, he will do it in a heartbeat. He then whisked me off to a karaoke bar in his brand new, yellow, Ferrari 360.
As modern as China is, you still stumble across pockets of the 19th century. Prostitution is absolutely rampant, with the hotels posting security guards at the front door to keep them at bay. I will not delve into this topic in any detail so as not to offend my female readers. Suffice it to say that the current market price for virgins is $150, but are probably as authentic as the $75 Apple G5 iPhones.
Not All of China is Modern
On my last evening in the Middle Kingdom, a state dinner was given in my honor thanking me for 40 years of service to the People?s Republic of China. As the evening drew to a drunken close, I thanked my hosts and outlined the broad sweep of my family?s connection with China over the past century.
I once listened with rapt attention as Alice Roosevelt Longworth, President Teddy?s oldest daughter, described the wreckage in the wake of the short-lived 1900 Boxer Rebellion. Senate majority leader, Mike Mansfield, told me of the sweating Chinese coolies who carried bags of coal onto his cruiser when it docked in Shanghai in 1920.
Veteran AP correspondent, Roy Essoyan, riveted younger correspondents at the Tokyo Press Club with a blow by blow account of the Japanese invasion of Shanghai?s foreign quarter in 1937. My dear friend, Al Pinder, head of the OSS in China during WWII, described how children working in sweatshops in China during the thirties dipped tiny, but deeply scarred hands into boiling water to fish out silk cocoons.
My Uncle, Mitchell Paige, recalled his adventures as a young Marine on gunboat duty on the Yangtze in 1935. He later fought off massed waves of Chinese attackers when his First Marine Division conducted its infamous frozen retreat from Chosen Reservoir in Korea in 1950.
The First McDonalds in China
When I came on the scene, the Chinese initially treated me as a capitalist tool and CIA spy, while the FBI viewed me as a communist sympathizer, opening my mail for years. For all I know they still do. When I asked Premier Zhou Enlai about the long term impact of the French Revolution, he responded that ?it was too early to say.? When
I queried Generalissimo Chiang Kai-Shek why he continued his stubborn 50 year battle to wipe out the communists, he responded simply that ?the sky cannot have two suns.? My impudence didn?t prevent him from introducing me to his wife, the lovely Madame Chiang Kai-Shek, one of the Soong sisters famed for being the most beautiful women in China.
I mentioned that the scar on my hip still itched whenever the weather changed. That?s the one left from a slug fired from a Chinese supplied AK-47 in the jungles of Cambodia.
In 1978, I questioned Deng Xiaoping, the father of modern China, when he would allow free emigration. He responded ?Feeding our people is our biggest problem. How many do you want? 20 million? 30 million? I?ll give them to you.?
In the late 1990?s I became an unofficial advisor to the Chinese government on their financial and economic modernization efforts, meeting regularly with friends at the Ministry of Finance and the People?s Bank of China. More than once I responded with ?You want to do what?? as they outlined grandiose plans for a nationwide network of bullet trains, 200 nuclear power plants, the damming of the Yangtze at Three Gorges, and building new cities to accommodate a half billion people. Needless to say, I told any of my hedge fund friends who would listen, this represented the investment opportunity of the century.
I finished by saying that over four decades, I had known the Chinese as both friends and enemies, and definitely preferred the former. It?s better to trade than to fight. I believe they felt the same way. The younger people sitting around the table sat there with their jaws dropped.
