The Tycoon Report

China: Be Cautious Where You Invest! Part 2

In Part 1, I discussed China’s political situation and economic perception. In Part 2, I will take a closer look at their economy, and examine some of the strains it faces.

China’s economy is one-dimensional, and lacks concern for the future after manufacturing. Their economy is fueled by foreign demand, primarily to the U.S. The U.S. accounts for over 50% of all China’s exports. It is estimated that foreign demand causes 65% of all domestic investment in China.

The only way to truly continue China’s economic bomb is to retain strict controls over the population. Economically free people demand higher wages, better working conditions, healthcare, and education. Benefits in which the PRC is unwilling to invest.

Even as their society has grown wealthier, healthcare and social benefits severely lag behind modern nations.

Investing in social needs would be crippling to China’s manufacturing business fueled by cheap labor. Manufacturing is already feeling the costs of rising wages (which I will speak about more in depth later).

Another predicament influencing the future of China’s economic success: the PRC’s involvement in enterprise. The majority of China’s enterprises are state owned and operated. Private companies begin to feel party pressure as they find success.

To give you an idea, here is what analysts are saying about the effects of party influence in business:

"Successful businesses have to be successful in business terms - with managers freely exploiting opportunities, developing products and brands and promoting on ability. No such autonomy is possible, party needs come before those of business, enforced by a national system of party committees in every enterprise, finance from state-owned banks and a complex system of accounting and ownership rights that leaves majority ownership of most enterprises with the state," Hutton argues.

Investors are falsely led to believe publicly held companies are free from the state yet "private shareholders have very limited ownership rights; companies' fixed assets are separated out in company accounts and can still only be legally owned by state and public bodies," says MIT economist, Yasheng Huang.

"Government shareholders interfere, especially if a firm is successful. Countless Chinese firms have been driven to bankruptcy or thwarted in their growth ambitions because the government has exercised its ownership privileges to meet party objectives."

Hutton explains state owned enterprises produce significantly less than their private counterparts. "The performance of China's State Owned Enterprises (SOEs), which control two-thirds of industrial assets, has hardly improved during 20 years of reform... SOE’s are on a financial edge and barely profitable."

Call me crazy, but I don’t want any part of it. Think about this situation for a minute! In the U.S. securities industry, we look for quality management before making an investment. This type of analysis is almost obsolete in Chinese corporations.

Is this the type of investment you want to make? When I look around the U.S., the most inefficient companies are state owned and operated. I honestly would not want to invest in anything state owned or operated. But hey, that’s just me.

UNEMPLOYMENT & INFLATION

China's unemployment rate has been reported at a little over 4% since 2001. This figure is a farce and does not reflect actual labor conditions in China. Make no mistake about it, unemployment is a serious problem!

First of all, unemployment numbers are urban and do not account for the rural workers. Rural workers comprise the majority portion of China’s population. Yet, every media outlet gives you a 4% range as a true indicator.

Look a little closer, you will find half the urban workforce is migrant. Migrant workers are excluded from unemployment numbers because they are unable to register for unemployment benefits.

Actual unemployment in urban areas is more in the range of 7 to 8%. Add rural China to the equation, and unemployment is between 12-15%. These statistics also include working for less then a dollar a day as employment. I can go collect cans in the street for more then a dollar a day.

Rural China consists of 60% of the population; as of 2005, 340 million worked in agriculture, 44.8% of population’s total employment.

According to the World Bank, "China is still home to 18 percent of the world’s poor." Between 150 and 300 million people in China live on less than a dollar a day. Nevertheless, as the economy expands, so does inflation, at unprecedented rates.

The World Bank's Quarterly Report showed in September 2007 the consumer price index rose 6.5%, well above the bank's target of 3%. This was the highest rise in inflation in more then a decade.

To give you an idea how the rise in prices is affecting the public: 3 people died and 31 were injured during a stampede in the city of Congging. The stampede occurred while shoppers were trying to get some cooking oil selling at half price. These types of incidents are becoming common throughout China.

CNN reports, "Food prices jumped 17.6 percent in October over the same month last year, while the price of pork, China's staple meat, soared 54.9 percent," according to the National Bureau of Statistics. "The overall October inflation rate was higher than the 6.2 percent reported in September and matched August's 6.5 percent, the highest rate in 11 years." Yikes!

Inflation on food is truly being felt throughout the country, and "the food price spike is especially sensitive for the communist government, because China's poor majority spends as much as one-third of its income on food," according to CNN.

The broader price of food is up over 15% this year.

Officials are reporting inflation at 4.5% for the year. They missed the official target of 3% by 1 1/2 %, a large miss. Furthermore, this figure is what they are reporting; we have no way to know for sure!

CORRUPTION

Government corruption is threatening on many levels. Corruption makes it impossible to reign in pollution and the sale of pirated goods. Each of these factors negatively impacts the economy. Corruption is also the cause of the government's inability to enforce manufacturing standards and limit monetary theft

BBC news says, and a report by the Carnegie Endowment for International Peace contends, corruption costs the Chinese economy $86bn a year.

The report points out bribery and theft by officials are rising, and cost China more than its annual education budget.

Carnegie concedes, however, party bosses have taken many measures to tackle the problem. But the report says the leaders have not gone far enough, because they fear losing their grip on power.

"Corruption has not yet derailed China's economic rise, sparked a social revolution, or deterred Western investors," the report states.

"But it would be foolish to conclude that the Chinese system has an infinite capacity to absorb the mounting costs of corruption." Says the report's author, Minxin Pei.

He estimated that 10% of the government's procurement budget and administrative spending was used as illicit payments, bribes, or was simply stolen. The total cost: 0.65% of gross domestic product (GDP). "Even after adjusting for inflation, the sums of money looted by government officials today are astonishing."

Mr. Pei argues the vast scale of corruption is possible "because of extensive state involvement in the economy, and the party's reluctance to adopt necessary reforms." Earlier this year, almost 1,800 officials confessed to corruption.

You must understand this is not a growing democracy weeding out corruption in their path to freedom. This is a communist country where corruption is embedded in the party of absolute rule. To weed out corruption is to weed out communism!

For example, when it comes to pirated goods and enforcing manufacturing standards, corruption is the main obstacle.

Party leaders that oversee provinces (like a governor) rule over vast areas with lower members acting as say, mayors. Pirates sell their knock off goods, and give kickbacks to local party members that send the money up the chain.

The same with manufacturing standards. If a company can produce a good cheaper alternative by ignoring safety measures, party members are paid to look the other way.

This type of corruption is inherent in the system and growing with the party’s wealth. Every aspect of government operation has this type of pay-to-play system.

The west has been pleading with China to increase manufacturing standards for years, and the PRC is still unwilling, or unable, to reign in party leaders and enforce standards.

Recalls, caused by short cuts allowed by corrupted officials, are beginning to hurt China’s imagine as a quality goods producer. Toys were just the latest in a series of recalls involving toothpaste, dog food, and prescription drugs, just to name a few.

Recalls are having an effect. During the holidays, a few relatives told me if I bought presents for the kids, make sure they are not from China. If I could only find toys from China, make sure they have no metal or paint.  To be safe I should probably just get some clothes. I personally think they are taking it to far, but this is the perception being created.

POLLUTION

The biggest problem facing China may be pollution! Manufacturing has been the catalyst behind China’s rise; it may also be the catalyst for their demise!

China's robust industrialization has created the worst pollution the world has ever seen. China has 20 of the world’s 30 most polluted cities. For your info, a significant amount of smog seen in California originates in China.

One scholar says, "Chinese cities often seem wrapped in a toxic gray shroud. Lakes run dry from the constant digging for natural resources."

Recently, the World Bank published a report titled, "The Costs of Pollution in China", detailing dangerously high pollution levels.

The PRC government has been petitioning the World Bank not to include mortality rates, for fear of civil unrest. The report, produced in co-operation with Chinese government’s ministries over several years, found about 750,000 people die prematurely in China each year from pollution, mainly from air pollution in large cities.

Other figures range as high as 1.5 million deaths a year related to pollution.

According to a National Geographic article, "Suppressed Information": "The World Bank is perceived as a staunch ally to China. The organization has committed roughly 40 billion U.S. dollars to Chinas development." They go on to argue World Bank's investment caused them to manipulate, or even leave out, the actual findings.

The most severe pollution problems of any nation in history, the report argues, the total cost of air and water pollution in China is about 5.8% of GDP. Other estimates run as high as 8%.

Air pollution alone produces damages costing 3.8% of GDP, including water pollution and crop damage form acid rain.

Pollution propelled cancer to be the number one cause of death in China. Nearly 500 million people do not have safe drinking water, and only 1% of the 560 million city residents breathe safe air.

Waste is dumped directly into rivers and lakes, causing large portions of the coastline to no longer support marine life. All these factors attribute to the skyrocketing healthcare costs.

Although the government admits there is a pollution problem, the New York Times reports, "most of the government’s targets for energy efficiency, as well as improving air and water quality, have gone unmet. And there are ample signs that the leadership is either unwilling or unable to make fundamental changes."

One analyst puts it this way, "China is more like a teenage smoker with emphysema. The costs of pollution have mounted well before it is ready to curtail economic development. Typically, industrial countries deal with green problems when they are rich, we have to deal with them while we are still poor. There is no model for us to follow," said Ren Yong, a climate expert at the Center for Environment and Economy in Beijing.

The World Bank's research provides alarming evidence that the environment has become one of the biggest causes of death in the nation.

LABOR

The “one birth policy” is one of the most concerning PRC controls morally, but it also affects the economy. The birth control policy has come with wide spread allegations of forced abortions and sterilization. Certain ethnic groups in China are only allowed one child, while others are allowed two.

The one child law created rapid drops in fertility during the 1970’s, yielding a large bulge in the working age.

An aging population, along with rising wages, is going to limit China’s labor surplus and become a significant problem for manufacturing going forward.

According to the World Bank, wages have been rising by "10-15% across all sectors." Even migrant workers are beginning to see increases in wages.

"Based on these trends a number of analysts have argued that China is approaching the end of its labor surplus phase and faces a tightening labor supply, which will inevitably lead to higher wages."

We all know low cost labor has been driving China’s economy, "prospects of rising labor costs are feeding concerns about future competitiveness among foreign investors, policymakers and academics."

Increased wages, along with decreasing demand, makes for a bad combination as manufacturing prices will rise with wages. (If you are interested in labor information, there is a ton out there. I could have written a book on that alone.)

CONCLUSION

Investing in China comes with a Communist government, a one-dimensional economy, skyrocketing inflation, high unemployment, an aging work force, corruption, debilitating pollution, and piracy, among other factors.

The majority of analysts believe China’s party is unable or unwilling to act on these problems. The effects of these problems grow in conjunction with industrial growth. Meaning as they produce more goods, they produce more pollution; as they increase business, they increase their influence over business; as they maintain a one-child policy, they add to the aging population; and so on.

China may very well continue their rapid pace of growth, but growth is just one aspect of an economy. Many other aspects are very, very, alarming.

To dismiss Communism’s affect on China’s economy is to be blinded buy their GDP growth. The government and economy work hand in hand.

My point here is to expose China’s troubles, and show investors China's cheeks are not as rosy as they seem. The political instability, which ways heavily on China’s economic success, should limit investors to only those that can sustain a tough loss.

China is not the type of investment vehicle for retirement or savings. When my dad (a postal worker), is asking me about Chinese stocks to invest in, I know the public is being misinformed. If you are looking for a secure investment for retirement, you are wise to keep your money in the good old US of A.

Investing in the U.S. is hard enough; we all know how unpredictable the U.S. stock markets can be. Trying to understand China’s economy, markets, and effects of government influence with out reliable information is impossible.

I want to be clear: for savvy investors and those with money to gamble, I believe there is money to be made in China!

Just be careful where you invest, and always know both sides of the story before you put your money in it.