Emerging Market Strategies

Chinese Debt Roll Over

2012-02-19T15:41:54Z

All financial crises occur for one reason: too much debt. We are seeing the endless drama with this issue in regard to Greece. Investors and banks lent Greece a lot of money based on the assumption that it was Germany. This assumption is rather silly in retrospect, but the result is that Greece, not being Germany, can’t pay its creditors back the full amount that it owes. This causes a problem.

In the US we experienced a similar issue. Lenders lent money to home owners based on the assumption that house prices would go one way: up. Worse through the magic of modern finance, the debts multiplied beyond either reason or even sanity and then were sold, not just in the US, but around the world. In retrospect this also turned out to be a bad idea.

Still the issue was not the form of the loans. Whether the debts were sovereign, as in the case of Greece, or collateralized debt obligations (CDOs), as in the case of US mortgages, in the end made little difference. They are both debts. The point was that an awful lot of lot of money was lent to debtors who could not pay the money back.

What is really interesting about financial crises though is not the cause. It is the trigger. The problems of Greece were not a secret. Perhaps the extent of the problem was, but the issue itself did not become obvious until the world went into recession and creditors decided that they wanted their money back. The same is true with the US housing mess.

The savage lending that led to the bubble could have gone on much longer than it did. If the creditors had never started to doubt the safety of their investments the lending would have certainly continued. If the creditors just assumed that everything was fine and did not try to collect, not much would have happened. Panics start when everyone tries to be the first out the door.

Now let us consider China. The Chinese government required its state owned banks to flood the country with loans, in excess of 4 trillion dollars since the beginning of 2009. Most of these loans went to either state owned companies or local governments. It was not only the banks that lent the money. The provinces and cities also created scads of finance vehicles to get around the lending limits. This lending binge was encouraged by the central government in Beijing to the extent that the loans were considered almost a patriotic duty, until now.

It should hardly surprise anyone that many of these loans went bad. When this amount of money goes out the door, much of it will end up in the wrong place. This is especially true of China where loans are made for political and not financial considerations.

But investors need not worry. This particular pile of toxic lending waste will not melt down. Why? Simple, the creditors are not rushing to the door. The great thing about the state controlled lenders is that they do what they are told. In this case they have been told not to try and collect the loans, just roll them over. If there is no panic and no one actually tries to collect the loans, then there is no reason to believe that their value has declined.

Is this a problem? Many commentators dismiss it. After all unlike Greece, Europe or the US, the Chinese economy is rapidly growing at a projected 8%, so it can easily absorb these bad debts. But one wonders that if the Chinese economy were not flooded with cheap loans whether it would be growing as fast.

It has also been suggested that the problem is nothing more than a flawed national financial system that needs to be reformed. If the provinces and cities could have issued bonds rather than borrowing from banks all would be well. The problem is now being resolved because a handful of cities are being allowed to issue bonds.

Exactly why bonds would be better than bank loans is not exactly clear, at least to me. It seems both are debts and both can go bad. But bad loans are not the problem. According to a Chinese investment banker, calling in the loans would be the “surest route to trouble”

But of course this entire assumption is just as absurd as the assumption that Greece is Germany or that housing prices won’t go down. No matter the form, a bad debt is a bad debt. It is money that could have been used more efficiently elsewhere. It prevents further stimulus and stymies growth. So maybe the Chinese have avoided a crash, but don’t expect growth either. Over time quick dramatic pain might have been the better option.

Assumptions of International Earnings Of US Multinationals

2012-02-12T17:36:19Z

The present stock market optimism is based on a very benign view of the world. The US economy continues to add jobs, although not as many as it should. Greece’s negotiations with its private creditors are going well and they will work out a deal to avoid default. Or at least that is what we are told to say nothing about increasing problems in Portugal and Spain. The emerging markets have been growing rapidly with Egypt up 25%, Hungary up 21% and Turkey up 21%. Perhaps surprising considering Egypt’s political upheaval, Hungary’s debt levels and Turkey’s double digit inflation.

But the best news is from China, where the official Purchasing Managers’ Index (PMI) was 50.5 in January, beating analysts’ expectations of 49.5. Of course the government figures were contradicted by a private-sector version of the survey put out by HSBC. Its number was 48.8 which indicates a slight contraction and was unchanged from December. What is more interesting than the Chinese government’s PMI fudge is that the statistics bureau decided not to publish figures on investment and other activity in January due to “distortions related to the national week-long holiday.” Were they that bad?

Despite all of these encouraging numbers demonstrating an improving picture for the global economy; it might be a good idea to look a little deeper into the earnings reports for the 4^th quarter. Since the crash of 2008 the developing world has experienced slow or no growth. The recovery was helped by the massive stimulus in China and insanely accommodative central banks in developed countries. This wall of money helped China and most emerging markets achieve robust growth while the developed world stagnated.

It was not only the emerging market economies, especially those in Asia, which grew. Many of the US’s largest companies grew with them. Although their revenue growth in Europe and the US remained anemic, many of them racked up double digit growth in Asia and other developing markets. This has gone on quarter after quarter until now. Apparently in this reporting season there are definite signs that things are changing.

Siemens the giant German industrial company makes everything from wind turbines to medical diagnostic equipment. Considering the problems in Europe, it would be considered natural if Siemens’ sales slowed, but the problem was not in Europe. New orders from China slowed by 16%. While Siemens’ chief financial officer, Joe Kaeser, acknowledged that “there had been a “clear slowdown” in China”, he was quick to reassure investors that things “in China could actually brighten in the second half.”

Siemens was not the only large company to experience problems in Asia. Eaton, the US manufacturer of industrial equipment and components for trucks and aircraft had problems too. Their sales have been hit by the slowdown in Chinese construction. Eaton’s CEO, Sandy Cutler, was not fazed. He told analysts that he still expected economic growth would still be faster in emerging economies such as China and India.

The American manufacturer 3M had similar problems. Its chief executive said: “Our China team anticipates continued below-trend growth in the first half of 2012.” United Technologies, the manufacturer of Otis elevators had the same experience for its sales in China, which slowed by 7% in the fourth quarter. While the Swedish-Swiss power and automation company ABB’s orders dropped 5% due to weaker demand for its power systems in China.

The problems are not limited to manufacturing companies. The largest US chemical company DuPont also had issues. Their sales in the Asia-Pacific region fell by 23% in the fourth quarter of 2011. The management of UPS ascribed the slower global growth to Europe, but also acknowledged that Asia-to-U.S. package volume slipped 3% and that it had reduced its Asia-to-U.S. capacity by about 10% because of the lower demand.

Certain parts of the automotive sector have also been hit by a slowdown in Asia. The commercial vehicles group, Volvo, warned last summer that Chinese demand for construction equipment fell, but of course they assured investors that it was just ‘temporary’. Ford experienced declining sales in both Europe and Asia as did Johnson Controls Inc, a US auto parts manufacturer.

Not all car companies had problems. Luxury brands like BMW and Volkswagen’s Audi had record breaking sales. Like the 35% rise in gambling revenues in Macau, these sales might represent instability and corruption. But even these might have problems. Wynn Macau just reported slower growth.

One US company, Caterpillar, also saw a drop in sales in China, but the stock still has risen 20% in January. Part of the expectation is Caterpillar can profit from sales in the US although those are still only 50% of their peak in 2006. The other bright spot for the company are sales to mining companies who look forward to booming demand for their commodities in, you guessed it, China.

Concentration in Emerging Equity Markets

2012-02-12T17:35:05Z

Last week I read an article about the IMF’s latest forecast. Confirming my most recent suspicions, the IMF was forecasting that China's economic growth in 2012 would slow to 8.25% from the 9.0% projected in September. Although in most countries a growth rate over 8% would be considered to be highly inflationary, the IMF advised that China could inject additional stimulus into its economy via its weekly open market operations.

Normally a central bank uses open market operations as the primary means of implementing monetary policy. The usual aim of open market operations is to control the short term interest rate and indirectly control the total money supply. But in China this is not necessarily the case. Interest rates may make little difference in China. Few Chinese use debt to buy homes and fewer still use credit cards. Loans at the controlled interest rates go to state owned industries and private companies are forced into the huge shadow banking system where interest rates have nothing to do with the money supply.

The IMF’s recommendation tells more about how economists and analysts from developed markets look at China and other emerging markets than about the economic situation in China. The IMF looks at China through the lens of developed markets, where its recommendations would make a lot of sense. In emerging markets things are different. One of the most important differences has to do with market concentration.

Emerging markets are dominated by two types of companies: state owned firms and family owned firms. Each emerging market is dominated by one or the other and sometimes both. In either case each market is made up of a few whales and a bunch of minnows. So the diversification that investors expect by investing in emerging markets is often simply an illusion.

For example in Russia about 45% of the market is dominated by five companies. They include three enormous state owned companies: Gazprom, the world’s largest gas producer, Sberbank, the largest Russian bank, and Rosneft, the company that ‘inherited’ the assets of Yukos. Together these three make up 35% of the market by capitalization. If you include two private companies, Lukoil, and Norilsk, the total market capitalization of just these five makes up over 45% of the Russian market. Gazprom and Sberbank make up over half the turnover. In addition the state also owns large chunks of other large listed companies including Transneft, a pipeline company; Sukhoi, an aircraft-maker; Rosneft; Unified Energy Systems, an electricity giant; and Aeroflot among others.

China is a little better. Its top five companies make up a bit less than 30% of the market. They include PetroChina, ICBC, Bank of China, China Construction Bank and the Agricultural Bank of China. It is not only the concentration of a few large companies that dominate emerging stock markets. The companies are overwhelmingly concentrated in either finance or commodities, usually oil. It is not only former communist countries like China and Russia where state owned companies dominate markets. The 179 listed companies in the Gulf are at least partially owned by 51 government entities. Governments controlled almost 30% of the region's total market capitalization.

Brazil at least has a mostly private firm, the mining giant Vale, dominating it stock market, but the combination of Vale and the state owned Petrobras make up 30% of the Bovespa alone. If you add the shares of Vale and Petrobras with the other three in the top five, which include two banks, Itau Unibanco and Bradesco, and, refreshingly, a brewer, Ambev, you end up with the most concentrated stock market in the world at 48%.

In contrast to the other BRICs, India is the model of diversification. The top five companies make up only 23% of the market. Still almost three quarters of the economy is in the hands of either state owned or large family owned firms like the two Reliance firms controlled by the Ambanis and various bits of the Tata Empire. India is hardly unique. Carlos Slim is the richest man in the world. His companies account for more than a third of the Mexican stock market. Even in Israel the market is controlled by a few oligarchs.

Investors around the world are advised of the wisdom of diversification including diversifying internationally and into emerging as well as developed markets. But there is hardly any diversification by investing in markets concentrated in state or family owned commodities and financial firms. This type of diversification also misses investing in the more dynamic firms that are supposed to make up the emerging market growth story. Finally, market concentration tends to distort the efficiency of markets, which negates the accuracy of analytic tools. To successfully invest in these markets requires different tools to understand the different rules.

Chinese Soft Commercial Power

2012-01-29T16:14:10Z

Last week it was announced that Reliance Communications, the mobile telecoms arm of the Reliance conglomerate in India had received a loan from three Chinese banks. Normally a loan by three banks to a large conglomerate would not be unusual. After all it happens all the time as part of regular business practices. This is what banks are supposed to do. They assess risk. If they find the borrower’s credit worthy, they make the loan. But this is loan is not ordinary. It is between two large emerging markets. The company involved is one of the largest in India. It is controlled by one of India’s best connected businessmen, Anil Ambani. Nor are the banks average, they are owned by the Chinese government.

Anil Ambani’s Reliance Communications had a $1.2 billion convertible bond, due to be repaid at the start of March, 2011. This was a problem. Reliance has a reported debt of $7 billion. Since shares in his telecoms, infrastructure, power and financial services company shares have fallen since the bond was issued in 2007, more than half last year alone, few holders elected to convert and the bond has to be repaid in full. Loans from traditional lenders like US and European banks would have been difficult due to economic conditions in Europe, India’s high interest rate and the falling rupee. But these problems are not of interest to Chinese banks. Their business model is a bit different.

Joseph Nye, an American professor at Harvard , coined the expression “soft power” 20 years ago. He defined it as “the ability to get what you want through attraction rather than coercion or payments.” Chinese state owned firms are not necessarily out for profits. Part of their mission is directly related to extending “soft commercial power”.

The Reliance loan worked for this objective on several levels. First and most importantly for the Chinese is that it helped to establish a relationship. All emerging markets are relationship based systems as Mr. Ambani knew well. Like the elder Ambani, the Chinese use it for their profit. In a society with few rules and less transparency large networks of networks of family, friends, classmates, and especially (Communist) Party connections are a necessity.

The Communist Party is especially involved with its state owned business specifically its state owned banks. In his book, “The Party”, Financial Times correspondent Richard McGregor writes that the bosses of China’s 50-odd leading companies all have a “red machine” sitting on their desks that provides an instant (and encrypted) link to the Communist Party’s leadership. Commercial enterprises for Chinese state owned companies are a “continuation of politics by different means”

This is not to say that there is not a very definite commercial side to state directed moves by state owned companies. No doubt Reliance’s loan was made easier by its Power Group’s October 2010 order for $10 billion worth of energy equipment from Shanghai Electric Group, a deal also financed by Chinese state banks.

Commercial strings are always part of the deal. For example in Africa and South East Asia Chinese companies are looking for guaranteed supplies of oil or other raw materials. Often this is exchanged for building infrastructure like roads, railways, power plants and bridges that help Chinese companies extract the commodities. The infrastructure is also built by Chinese state firms, which hold four of the top five positions of the world’s largest contractors.

Many of these deals lack transparency, because they may involve bribes. Relationship based systems like China’s are never fond of the rules. In Africa Chinese projects have been criticized for employing Chinese rather than local labor. When they do employ local labor, they can breach the rules as when managers in Zambia fired on a group of angry workers injuring 13. The Zambian opposition charged that the government had ignored labor law violations in exchange for political funding. Predictably the Chinese were not amused. The company executive complained that it was very difficult to do business in Zambia because “The opposition party always makes a big fuss over small problems.”

Still access to commodities and connections is secondary to profit. Mr. Ambani’s loan for an “extended” maturity period of seven years and an “attractive” interest rate of about 5 per cent may not have been such a good deal for the Chinese lenders, but this is not all that important. China National Petroleum Corporation is one of only two companies to win contracts to develop Iraq’s oilfields for the simple reason that the royalties required by the Iraqi government made the deal of questionable value. Maximizing production is more important than profit.

Ultimately though making political concern dominant over profit does cost. If neither the Chinese banks nor Mr. Ambani can allocate capital efficiently, the result will in time be a disaster.

What Flight Capital tells us about Emerging Markets

2012-01-22T16:09:54Z

At first hunters rarely actually spot their quarry. They usually track them following various other signs, like disturbed underbrush or the animal’s spoor. To determine the health and safety of any given market investors have literally hundreds of economic indicators. Part of the problem with these statistics is that they are usually compiled by some branch of the government. Their accuracy varies widely from country to country. Then interpreting these statistics can be a challenge. Different economists and analysts can read totally divergent meanings into the same numbers.

Perhaps a better alternative would be to consult local investors. Wealthy people from any given country usually have an excellent pulse on the local economy. Either they actually run businesses or they have connections. In either case they have specific relevant information that will never be available to foreign investors. Much of this information will never be known, because the locals have absolutely no wish to make their activities known to the authorities. But they do leave tracks.

One of the most interesting indications has to do with capital flight. If the locals are getting out, it is probably not a good idea for foreigners to get in. Capital flight, like bad debts, is also one of the principal indications of the end of a credit bubble.

Sometimes the signs of capital flight are quite predictable and obvious. With the default of Greek sovereign debt and its membership in the euro probably only a matter of time, it is hardly a surprise that money is flowing out of that country to find safer havens. According to the most recent statistics Greek banks have seen deposit out flows of about €65 billion, or about one third of the total, over the past two years.

Nor would it be a surprise that certain unstable Latin American countries are hemorrhaging money. In Argentina capital flight is estimated to be at about $3 billion in recent months. This has led the government to institute ever more stringent controls. Citizens must now justify every purchase of foreign currency.

Hugo Chavez’s policies in Venezuela have nationalized hundreds of companies, which has slashed non oil exports. The capital flight is estimated at $28 billion a month. The cost of this capital flight together with $11 billion in debt service and $100 billion worth of imports has made it difficult for Venezuela to service its debts unless oil remains high.

One would think that with the price of oil relatively high that Russia, a BRIC country, might be a good place to invest. Not so according to the flight capital statistics. Capital flight in 2011 totaled $84 billion, two and a half times the money that left in 2010. Even with the high price of oil, the ruble has weakened by 5%. According to one of the local billionaires, Mikhail Fridman, Russia’s poor investment climate and lack of protection of investor rights has made the developed world, specifically the US, a much better place to invest.

Brazil until recently was considered a good place to invest money, but things have changed. Brazilians and other Latin America nationals have helped put a floor under the high end condo market in Miami. The price per square foot bottomed at $200 and thanks to flight capital it has risen to $300. The sellers in Miami are particularly pleased to see the foreign buyers, because 85% of the Brazilians pay in cash.

Earlier this week markets improved substantially because of what was considered positive numbers coming out of China. The Chinese GDP grew at 8.9%, which was widely interpreted as evidence that China was slowing gradually and that the Chinese authorities had engineered a soft landing for their booming economy. The gaming tables of Macau tell a different story.

Many wealthy Chinese cannot directly move money out of the country or change their yuan into other currency, so they use other methods. The success of the former Portuguese colony of Macau is built not on the love of gambling, but upon the flood of nervous money leaving China. Macau is already four times bigger than its closest competitor, Las Vegas. More than 13.2 million mainlanders visited Macau in the first ten months of 2011. Awaiting them were many different ways to launder money, according to a local professor, “more than we can think of”.

It is not only gambling. In November Chinese purchases of gold increased by 20%. Analysts suggested the increase was due to the slight fall in price or that jewelry consumption had risen in expectation of gifts for the New Year celebrations. But the real explanation might have been protection from a failing economy.

In each of these markets it is important to consider the economic indicators, but the best one might simply to see how the locals vote with their feet.